How To Work Out Your Risk Reward Ratio For Investing
As you know, ideally you buy stocks with the idea that they’ll go up.
And you will have a variety of stocks to mix up your risk in return as well too.
If you put all your money on one stock and it’s a high technology stock for example where you might have a great upside with that stock but you also have a great downside, that stock possibly will go into bankruptcy or whatever where you lose everything.
Because you’re invested only in that versus let’s say a basket of stocks you might have heard like the S&P 500 which is the 500 largest U.S. company.
Well that’s you’re buying a mutual fund or exchange traded fund where you’re buying all those companies as one block in a mutual fund the whole idea behind that is to spread out that risk across many companies 500 and across many interest rates not just one Wistrom is all it’s health it’s financial whatever.
All these different industries.
So we do certain risk or we do so the long time and also over the long term and risk takers are rewarded right.
So if you have a long time horizon you may be 30 years away from when you need this money or not in 10 years depending on your level risk you want to take by investing in more risky investments.
You’ll get rewarded more is the idea you just want to be smart about that where you diversify have a right of investments so you can try to mitigate that risk as best you can.
But if all you do is invest in stocks you know very less real low low low risk things like cash for example.
Right now Kinvara and you make it 1 percent back and your cash me maybe up to happy to.
But if inflation’s running two or three percent or more in some parts of the world if prices are rising faster than you’re making with your cash return you’re actually losing ground by being too safe.
So you do have to manage as well.
One thing to show you here is let’s call the curve here where it looks at the you know efficient market markets segment of all market efficiency or whatever you know little fancy term.
The other person won a Nobel Prize for this.
But you can see you know the idea of risk and return in a graphical form here so along the bottom the horizontal axis is RIFs So as you go out from the midpoint out to the right you’re taking on more risk is the idea on the scrap and then with the return from where the intersect as you go up or you know on the vertical axis go up that would be a higher return.
So let’s see at the top of this chart it had numbers on and maybe it’s 20 percent return of the top at the bottom might be zero or negative return and then risk would be more risky going out to the right.
So the idea is if you go to the right more risk but as you go up higher more returns see the relationship between there and then the plot’s at a point that on here the A B C and D Those are like representations of portfolios of mixtures of stocks bonds other investments let’s say this is just two items you know just of stocks and bonds and it might be represented by the letter is 100 percent.
You’re invested completely in bonds.
Less risky further to the left the axis the horizontal axis or the less risky in bonds versus let’s say if you’re a hundred percent stocks where you’re way out to the right and that’s something that’s very very risky.
But you should have a longer or you should have a higher return with that number.
So over a long period of time.
The interesting thing with this crap is this has been proven out many different types of investments might change over time.
But the idea of this of this flattening of the top between like the D and the B and then the hook or the curve on that ACMD.
This is something that’s been proven out many many times and what we mean by that is let’s start with the hook part.
So if you look at a higher percent bonds you can see you’re at this level of risk and you get a return and it intersects at that age or the age.
But if you look at that D you’d say oh if I took on maybe more stocks maybe this is 20 percent stocks and 80 percent bonds at that portfolio.
I’m actually at the same amount of risk as the aper 400 but I’m getting a better return because I’m mixing in another asset class a misc mixing in stocks and this can happen.
So if you’re only in bonds traditionally lower risk class but you’re only in that you’re actually taking on more risk.
If interest rates rise for example bonds false you’re taking more risks where you can mitigate that by an asset adding a more risky investment stocks.
In this case you know to get that portfolio deal where you get a better return with less risk.
So those are some things to look at.
And then from dealer B you see how it starts to flatten out.
It doesn’t go straight up fast it starts to flatten out because you get to a point where you have to add in lots of stocks.
You go to more of 100 percent stock portfolio you’re gigging you’re taking a lot more risk with without a lot more returns.
So financial planner if you go look at it like mutual funds or things they’ll give you all these different options of these mixtures of portfolios you know how much stocks much bonds how much other things other course the millionaire investing success million of course goes into great detail on this.
But the idea is managing your risk versus reward and sometimes it can he can.
If you think you’re being too risk averse like being just in cash or you’re just in bonds you might actually take on more risk particularly when it comes to inflation.
And to wrap this section up you might be saying there’s several That’s nice.
But how do we know how much risk am willing to take.
I get kind of a gut feel.
Well there’s actually some tools here that you can do to kind of calculate your risk profile So for example if you search just gone do search in Google search whatever and put an investment risk profile and calculator just put that in or some combination like that up will pop all these different free things
like we like to the money to him compound interest cochlear.
There’s other calculators out there though help you to calculate your risk profile T.J..
What they’ll do is they’ll actually ask you a series of questions like you know would you like this or that.
You know if you were guaranteed $10000 today or $50000 in future which would you take.
And based on your answers they’ll come up with a kind of an idea of a profile for you.
As far as if you like to take on lots of risk or less risk you might have an internal feeling in this.
This gives you a field with some new metrics behind a little bit more process behind it a deal with your spouse your husband wife or if you have a partner or somebody that you are investing together with
that you both do it to really understand each other’s risk profile.
That was really helpful for my wife and I.
She is less risk averse and I’m more risk taking.
So between the two of us we kind of meet in the middle but when we’re talking about investments it really helps because I can understand her point of view of understand that she wants to be less risky and she can understand my point of view of taking more risk better return fish over a long period of time and really helps from.
So you’re married from the marital standpoint so do those two things together.
A couple of examples out there you can one thing and searcher’s a lot of them out there I like this one actress from Australia an Australian bank v. i. SS f risk calculator just type it in just like that.
That seems to me a nice real easy question spits out some information gives you a nice little graph.
Good way to get started.
Try a couple of these different calculators.
Another thing you could do is just kind of you got to you know ask yourself like all of my portfolio all my investments dropped 10 percent in one day.
How would I feel that I would be like oh my god I’m afraid my panicking and my like oh my gosh this is terrible.
Or would I be more like investing something.
Something has to go down.
But I feel good because the long run is going to be great or it may be on the aggressive side I may be more like myself say oh 110 percent.
Maybe there’s bargains out there I can put buy some more stuff at it at a cheap discount.
So you can see how different people might react based on their gut.
So between your gut and using some of these profiles it can really give you an idea of your risk tolerance so understanding long time horizon investing as much as it can and then maximizing that based on your risk profile and then generally that reward those three really go hand in hand together.
You know from a classic investment sense and if you are in a long time getting back to those basics real real real critical now in the next two sections we’re going to hobble things are a little bit more behavioral.
Because once again we’re we’re not machines right we’re not robots.
We do things that we’re not supposed to do because we’re emotional and we’re human beings and these tie around the core concepts of fear and greed.
My gosh if I was right it bugs me so now I’ll write a book and all I’ll title it like fearing greed because that really drives the stock market down.
In case of fear but also up in case of greed.
So next time I will post about fear and greed and how they play in your investments.