Understanding Investment with Return to Risk Ratio
When investment market is not working for you, the amount of money you may lose in one particular investment event is what we call risk. When represent risk with an R index number. We identify the possible worst situation and the worst loss that can happen when the item did not progress according to our plan. When you start estimating the amount of risk, the R, you bear in an investment item, you are focusing on the return to risk ratio. Perhaps you are already doing the same in other aspects of your life and now is the time to apply it to money.
When you are given two choices, how would you come up with your decision? For example, there are two different methods for you to go home, one is to go on the high way, and another one is to go through the street. If you choose the high way, you may be able to get home within 30 minutes if everything is smooth. But there is a possibility that there is a traffic accident and you would need two more hours to get home. Choice number two is to try the streets with fewer cars. There are many traffic lights and whatever the traffic is, you would need 45 minutes to get home.
The way you choose which way to go is the estimate the advantage of arriving home 15 minutes earlier and the hassle of potential traffic jam. This decision making process can be applied to investment management totally. We assess an investment opportunity with the return to risk ratio and see whether it worth noticing.
We have worked with top investors and see them use the return to risk ratios in real situations. The best always consider the risk they bear before putting their eye on the potential return. Investment opportunities are ranked with the ratio, denoted in R, the risk factor. If the largest amount of money you may lose in an investment could possibly get you 3 times the amount as return, we label it a 3R investment opportunity. This system is applicable to all kinds of investments, like stock, mutual fund, property or other investment vehicles. And it means the same for a 2R investment in stock market or in the property market. They mean the expected return over the worst loss equals 2. Below is an illustration.
Let’s say you predict that the property market is going up and you spot a fine house to capture the chance. You decided to buy it and sell it quickly to make a quick cash profit. For example, the price of the house is $80,000 and you have to pay $5000 to buy the house. The worst case is you lose the whole amount you pay, the $5,000. Therefore the amount $5000 is R. You plan to sell the house with $100,000. That implies a profit of $20,000. The profit is 4 times the amount you risked. So, we call this a 4R opportunity.
Perhaps your prediction was too optimistic and the best price you could get someone to buy is $90,000. The profit becomes $10,000 and it becomes a 2R investment because the amount you earn is 2 times the amount you risked.