Trading in financial markets is quite complicated. You have to have technical knowledge, keep up with the news, and know a bit of psychology... and even then, you can still lose. In fact, you're bound to lose more times than you win — you can bet your money on it.
However, a little trick will ensure you'll stay on the green side of the ledger. Meet your new best friend: proper risk measurement.
Understanding risk
Before we begin, we must understand how risk works.
In the investment world, there is no such thing as a risk-free product — there are simply different levels of risk. And this is what we must understand before we invest.
We will determine how much we will invest depending on the level of risk.
To assess risk, we must keep different elements in mind: how liquid it is, how safe it is, and how fast it grows.
The safer the investment, the more we can invest. However, the greater the security, the lower the return. And the same goes the other way around: the riskier an investment is, the less you should invest... but this is where you can earn the most money.
Now, how do you translate "risk" into numbers? Well, if there's a risk, there must be a reward, right?
Risk-To-Reward Ratio
The risk-reward ratio helps us determine how profitable a transaction is. We use this ratio to assess the risk of each trade.
Let's say an investor has an opportunity where for every dollar risked, he could earn 5. In that case, the investor has a risk-to-reward ratio of 1:5.
The risk/reward ratio marks the premium an investor can get for each dollar he or she risks on an investment. The closer this ratio is to 0, the worse the trade will be. In other words, it is difficult to justify a dollar for only 50 cents.
Now, this ratio can change the way we see investing.
How the R:R ratio works
Let's say you have $2,500 to invest. You decide that the most you are willing to lose is 1.8% of your portfolio per trade. That means that if things don't go your way, you will only lose $45. That $45 is the risk you are willing to take.
Now let's think about taking your first trade in XYZ coin. You think it will go up in price, so you enter at $100 per coin. You think it could go to $140, and this would give you a profit of 40%. But still, you must be cautious and determine your stop loss. Let's say you think your stop loss will be at $90.
Your R:R ratio is at 1:4 — you could earn four dollars back for every dollar risked.
With the entry price and stop loss, you can determine how much you should invest. If you enter at $100 and $90 is the price at which you assume a $45 loss, you should buy 4.5 XYZ.
Despite having invested about $450, you will only lose $45 if things don't go your way.
But if things go the way you planned... you would have made $180 on the trade.
In this way, you limit your losses and boost your profits. The best thing about measuring your risk is that you can win even if you lose more trades than you win.
Let's imagine again that you only want to trade XYZ and enter a total of five trades. Of these five trades, you lose three. But the two you win are 4R and 2.5R.
When you add up your losses, you lost -3R or $135. A bummer, right? But your profit is 6.5R or $292.5. The final balance is +3.5R or $157.5 in your favor.
Psychology and different kinds of investing
While position sizing and risk management are critical to an investment's success, your beliefs are much more influential.
The psychology underlying your beliefs will influence how high or low your risk tolerance is. Likewise, the risk is different for those who want to invest than those who wish to trade.
A high tolerance to risk may lead to adding more capital to higher-risk investments. Low tolerance to risk leads directly to loss aversion.
Israeli-American psychologist and Nobel laureate in economics, Daniel Kahneman, has talked about this. Kahneman suggests that losses have 1.5 to 2.5 times more psychological impact than gains. That is, having a losing trade in which you lose about $5 can have the same impact as a $10 bucks winning trade.
People would rather not lose $50 than make $100.
Can we overcome this loss aversion? Of course, we can. To do so, we need to have clear investment objectives, study the markets and trust the process. Once you tame the risk beast, no market can stop you.
