| Understanding Investment Risk |
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| Written by Matthew Wong |
| Sunday, 07 February 2010 14:37 |
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The market may not be going in the direction you wish all the time. When that happens, we lose money. And we represent the amount of money you may lose with a letter R. We know that this is the largest amount you may lose if the investment turned bad. When we talk about risk, we also consider the potential return in an investment. We estimate the relationship between the two with a ratio in R. In fact, you might already know and actually be using such a method in other aspects of your life, you just need to be conscious of it and apply it to your assets management.
The market may not be going in the direction you wish all the time. When that happens, we lose money. And we represent the amount of money you may lose with a letter R. We know that this is the largest amount you may lose if the investment turned bad. When we talk about risk, we also consider the potential return in an investment. We estimate the relationship between the two with a ratio in R. In fact, you might already know and actually be using such a method in other aspects of your life, you just need to be conscious of it and apply it to your assets management. We are constantly making choices in our lives. From little decisions of choosing which restaurant to eat to biggest decisions like choosing who to marry, you have already developed a set of skills to make up your mind. An example is the way to get home. There is a high way or you can take the street. If you go with the high way and if you are lucky, you may be able to arrive home within 30 minutes. But the possibility exists that there is a traffic accident on the road and the traffic jam may trap you for 2 more hours. The alternative is to take the street full of traffic lights. There are fewer cars and you would need 45 minutes despite the traffic. 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. The first example is the situation where you have already decided to buy a house with a compromised price and sell it quickly thereafter. This is a quick cash transaction. You have decided to use USD5000 to buy a USD80 000 house. The amount USD5000 is the risk factor R which is the largest amount you can bear to lose. You wish to sell the house with a USD100 000 price. That is, a USD20 000 profit. This will be a 4R opportunity, because your planned profit is 4 times of the risk you bear. If the property market turn out milder than you predicted and you sold the house with USD90 000, you get USD10 000 profit. It would become a 2R investment, i.e. the return you get is 2 times the risk you bear. DISCLAIMER: This article is provided as information only and is not to be taken as financial advice. Learn more about investment, visit: automated forex system trading |