Understanding Investment Risk
If investment is so easy, why isn’t everybody rich? Investment involves risk by definition. You invest an amount of money and hope that it earns an extra amount for you, but we must be aware of the risk. Risk is defined by the amount of money you would potentially lose in the worst situation. This is the factor R we see in return to risk ratio. This is a intuitive method to estimate the quality of an investment and chances are you already know how to use it in your daily life.
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.
The best investors use this return to risk ratio to assess their investment opportunities. A seasoned professional investor would always start an investment consideration with the possible amount of money he could lose in a particular investment. And we denote the amount by R. Let say the expected return is 3 times of the risk you bear, we say this is a 3R opportunity. Whether we are talking about stock, mutual fund, property or any other investment vehicle, we use this same system to categorize them. The assets are just the tools. What we concern is the money. So a 2R in stock market is in substance the same as a 2R in the property market. They all mean an opportunity to earn twice the amount of money you may lose. The below example would make it clear.
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.
Let’s say it turned out the market didn’t go up as much as you thought and you sold the house with $90,000. You made a profit of $10,000. So, we say the investment becomes a 2R one because the profits is 2 times the risk factor.
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