Investing in any market requires the right mindset and knowledge to achieve maximum potential. One simple, yet often overlooked aspect is the risk/reward ratio. It is crucial to know what potential returns to expect prior to making any financial commitment.
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The Risk/Reward Ratio in a Nutshell
There is no investment option on the planet that is free of risk. Any sort of commitment, be it big or small, will carry certain risks. Even holding money in one’s wallet is a financial risk, due to external circumstances such as inflation, purchasing power, and so forth. Regardless of how one approaches their finances, the risk/reward ratio will always come into play.
At its core, the risk/reward ratio is a very simple concept. It depicts the potential reward an investor can earn for every dollar spent on investment. The higher the reward and lower the risk, the better one’s investment outlook is. However, it is often an “and-and” situation. Low-risk investments often come with low rewards, whereas high rewards can only be derived from high-risk investments.
To offer an example: if a risk/reward ratio sits at 1:5, an investor can earn up to $5 from investing $1. Such a golden opportunity can be hard to pass up on, even though they are extremely rare. In most cases, the risk/reward ratio will not show such big gaps between the potential risk and reward.
Why and How You Should Use the Risk/Reward Ratio
It is always best to get a basic idea of what a future investment entails exactly. Calculating the risk and potential reward is a crucial aspect of making a well-informed decision. Planning ahead before making any trades or investments can only be done by carefully weighing the risk/reward ratio.
One way of calculating this ratio quickly goes as follows:
- Take the amount of money you can potentially lose if the market turns sour
- Divide that amount by the amount of profit you expect to make if the market evolves in a normal manner
- If this outcome is bigger than 1:2 in favor of the reward, it can prove to be a good – albeit still risky – investment.
On its own, the risk/reward ratio is merely one indicator to take into account. It is not something to base one’s investment decisions on without consulting other factors. However, it is a good place to start. Based on this calculation, one can determine to either analyze an opportunity further or move on.
Where Is the Risk/Reward Ratio Best Applied?
In theory, there is nothing in life that won’t benefit from making a risk/reward ratio analysis. Doing so for every single aspect of life can get tiresome, however. Even with investments, this ratio is primarily useful for certain types of financial commitments.
A common example is trading stocks, precious metals, or cryptocurrencies. All of these markets have periods of volatility and market cycles that tend to repeat themselves every so often. Using all of that information to determine the risk/reward ratio can lead to different trading strategies and ways to make a profit.
In an ideal scenario, the ratio should be close to 1:3 in favor of the reward. Expecting three times the return on investment – either in the short-term or long-term – is a realistic expectation. Any calculation deriving from this norm, either by yielding lower rewards or far higher potential rewards, should not be ignored either. That said, as a rule of thumb, any calculation returning a 1:3 ratio is a good starting point.
Don’t Be Blinded by the Return Potential
When calculating risk and reward for new investments, it is easy to be blinded by all of the money one can potentially earn. Even if the ratio calculation is positive, it should not be taken at face value. This is merely an indicator of what CAN happen if the market continues to exhibit normal behavior. There are no certainties in the financial world, and the overall momentum can sour very quickly.
Most investors look at the risk/reward ratio as a way to calculate how much money they may lose on certain trades. Maintaining a “win streak” of over 50% is a lot more challenging than people may think at first. As such, it is always good to know how one’s portfolio may be affected if certain trades don’t pan out well.
It is for this reason that investors tend to utilize “stop-loss orders” and “take-profit orders”. Setting up these limits in advance will ensure only the calculated amount of money will be lost if the worst case scenario comes to pass. A take-profit order ensures one automatically takes the projected profit if a price hits that particular threshold, instead of hoping for an even bigger profit.
Analyzing Risk Appetite
With all of the above information in mind, it is still worthwhile to deviate from the norm. More specifically, the “normal” risk/reward ratio needs to be between 1:2 and 1:3. However, not everyone has the same risk appetite.
Some investors will try to take bigger risks, and others want to play it safer. There is no right or wrong approach when investing, assuming one makes use of all the tools at their disposal. Only executing trades if the ratio sits at 1:5 or higher may seem conservative to some. If it makes you feel better about investing, that is the self-advice you should adhere to at all times.
On paper, the risk/reward ratio may not seem all that significant. Once one begins to put it into use, however, it can often paint a different picture as to how specific markets may behave in the future. Knowing what to expect is half the battle, even though it can never be predicted in an accurate manner.
Using this calculation in conjunction with stop-loss and take-profit orders will often lead to a smoother user experience. There is no reason to watch price charts permanently, as the orders will be executed automatically, either for better or worse. It also makes it much easier to determine what one could gain, but also how steep the overall losses could be.