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.
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.
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.
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.
Assume the property market is going up. You notice the chance and are buying a house and selling it immediately to monetize the opportunity. The price of the house is $80,000 and you got a leverage to do the acquisition. The amount you must pay is $5,000. If you couldn’t sell the house promptly, you would lose the whole amount of $5,000. Hence, the risk factor R is $5,000. The price you aim to make a profit of $20,000 and sell the house is $100,000. Therefore, this is a 4R investment opportunity because the expected return is 4 times the amount of money you could possibly lose.
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.
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