Risk Vs. Rewards: Using An Investment Calculator To Weigh Your Options
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Unfortunately, retail investors could end up losing money. There are various reasons for this. But the most important is that individual investors need help managing the Risk. Risk and Reward is a very common things in finance. But what does it mean, and what's the impact?
Let's understand Risk vs. Reward.
Investing money in the financial markets has a huge risk. One should be compensated for being involved in such Risk.
Suppose someone marginally trusted asks for a $ 50 loan and tells you they will offer you $70 In two weeks. It is not worth the Risk. However, if the same is offered in exchange for $100. It is appealing.
It's a 2:1 risk/reward. It is a ratio where professional investors get started as it allows investors to increase their amount in doubles. Similarly, the same Investment is offered at the exchange of $150. The ratio is 3:1
Leta understands the same in the stock market. Suppose you did your stock research and found the Stock of your choice. You found ABC stock is trading at $25. Down from $30
You are determined and believe if you buy the StockStock now. That ABC will go back to $30. It can cash you in. It would be best if you put it as an investment. So you could purchase 20 shares of ABC trader. But now, do you know about the Risk and Reward ratio?
There are some special considerations.
Before we understand, ABC trade is a good investment idea. It is in terms of Risk. So there is only a little one would know about Risk and ratio. It is completely objective. It is a calculation, and the numbers are true.
The other major Risk component is that only some have the tolerance capacity. Risk and rewards give you no indication of probability. It's like investing $500 and winning the lottery. Investing $500 for millions is understandable and profitable. It is a fine choice regarding Risk and Reward but not in probability.
How to calculate the Risk and Rewards?
To calculate Reward or Risk, you need to divide your net profit by the maximum price for the Risk. Considering the same example of AbC trade, the Stock goes upto $30. You would make $4 for all your 20 shares. It is for a total of $80. So one paid $500. You need to divide 80 by 500. It gives a value of 0.16
So it means your Risk and Reward for the idea of 0:16:1.
Most professional investors will only give a glimpse of a low risk/reward ratio. It could be a better idea or profitable.
To use the risk and reward calculation
To incorporate Risk and Reward into research. Follow these steps.
- Pick a stock with thorough research.
- Set targets upside or downside depending on the current price.
- Calculate the Risk and Reward
- If the target achieved is below your threshold. To achieve an acceptable ratio
- If you still need to achieve an acceptable ratio. Set Different Investment Ideas.
- Once Risk and rewards are incorporated, the difficulty in finding good investors and trades is addressed.
How to limit the Risk and stop loss?
Unless you are a pro-investor or experienced investor, you will not let the $500 go in vain. The actual Risk is $500.
Every good investor has a stop the loss or limits the Risk on the downside. Suppose you set a limit of $30 as the upside. You can set a minimum downside of $20. So once you reach the stop the loss order at $20. You can sell the Stock and look for the next investment or opportunity.
Now that the downside is limited, the numbers can be changed. The New profits stay the same at $90. So the Risk is $100.
$ 5 maximum loss multiplied by 20. Or 80/100, the ratio is 0.8/1, it is still not fit or ideal.
What if the stop the loss was raised to $24/and Risk only $2 per share? It could be a total loss of $40. The risk and reward ratio is 80/40=2:1. It is acceptable.
Most investors will only commit their money to Investments that equal 4:1 or 2:1. It is considered the minimum cost. Hence one has to make the wise decision of an acceptable ratio.
To achieve Risk and Reward at 2:1. So when you researched the stocks. You concluded that the maximum upside was $30. It was completely technical and fundamental research. Suppose you changed the numbers to achieve an acceptable risk and rewards. It is completely dependent on good research.
Investors know that relying on hope is not wise. Be conservative when it comes to risks. At the same time, being aggressive when rewards are involved. Risk and Reward are calculated very practically and realistically.