Understanding Investment Risk

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.

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.

You would begin analyzing the two options and decide whether getting home 15 minutes earlier is worth the risk of being trapped in traffic jam for 2 hours. Similar decision making process can be seen in investment managements. The important reference is the ratio between the expected return and the potential loss you may pay. The ratio must be high enough to justify the actions.

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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