A major topic when investing is your own expectations and in this context, the question, “what am I willing to invest and risk for this expectation?” One of the indicators that can be used here is the so-called risk/reward ratio (CRV).
Contrary to what you might believe, CRV has nothing to do with the probability of success of your next trade, but rather, CRV describes the ratio between your potential profit and the risk you are taking. CRV simply tells you what you can expect to gain for every dollar you risk, assuming your goal is met.
- A CRV of 20 means that for a potential profit of $20, you risk $1
- A CRV of 5 means that for a potential profit of $5, you risk $1
This might not be helpful in the short term, but what we can do with this information is simple: If you have 20 investments with a CRV of 20 and all of them are equally weighted, one successful trade would offset the other 19. So in the long run, high CRV allows us more room for error. The key conclusions to be drawn from this are diversification and preference for long-term investments.
If I were to invest all of my money in just one company with a CRV of 20 and everything went well, I would not have to offset the losses of the other 19 companies and therefore have a much higher profit. But I also take the risk of choosing the wrong company. The risk of suffering a total loss is greater and no matter how much work and research goes into selecting investments, there are countless external factors that an investor cannot foresee.
Diversification reduces your profit, but secures it much more strongly and sustainably.
The shorter the holding period, the more difficult it is to predict movements. This is because the stock market is very large and investors are spread across a wide range of age groups, population groups, continents and countries. Therefore, daily decisions are made for very different reasons: An investor might withdraw their entire investment in a company out of self-interest, a large inheritance may be suddenly invested by another trader, or a third investor might have taken a day off to restructure their portfolio. These actions are taken by several million people every day. In addition, various news reports come out every day, which may also impact markets. All of these coincidental constellations provide short-term fluctuations, large, small and arbitrary, which cannot be predicted.
The longer the observation period becomes, the more a trend and a direction can be recognised.
The calculation of the risk/reward ratio is very simple: CRV = Take Profit / Stop Loss
The derivation of Take Profit and Stop Loss is the hard part. This is because CRV is not a standardised ratio, but rather, is based on the expectations of an investor and will therefore differ between each investor.
In order to derive a CRV as realistically as possible, it is also necessary to show a realistic and rational expectation, which is far from the extremes of euphoria or fear. Most people have trouble with this, and one of the reasons for this is the fact that people are used to linear relationships.
In our familiar everyday life, movements always take place in a straight line. Wages rise, age increases, etc. But in the stock market there is no straight line. Prices do not rise linearly. Prices fluctuate and we must decide how much fluctuation we want to endure and how much loss we want to accept. However, these expectations cannot be completely arbitrary, but must be realised on the basis of a realistic feasibility. I cannot expect 100% increase and 0% decrease, because then we would be back to linear growth.
What is the conclusion to be drawn from this?
In my opinion you should ask yourself how much risk you want to take, diversify your portfolio and determine an investment horizon that is as long as possible.
If you are new to the matter, eToro and CopyTrader offer you various metrics to better classify your risk management. Besides the risk score, the drawdown offers you the possibility to see the strongest loss within a defined period, gives you small insight into the volatility of a portfolio and helps you determine whether you are willing to take those fluctuations for the profits. This simplifies your work of calculating a CRV for each position individually and reconciling it with the portfolio, since someone else does it for you.
Deano Meffert (@DeanoMeefert), an eToro Popular Investor from Germany, has a medium-term investment strategy, focusing mainly on tech stocks, while sometimes hedging these investments using short positions or reverse ETFs.
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