They say opposites attract, and while this might not be always true when it comes to personalities, it’s undeniable in the world of investments: risk and return are inseparable. To make things even a bit harder to handle, those two move together in a positive correlation: the higher the potential returns, the higher the risk!
If you are into wild rides, you can easily understand such interplay. The riskier the game, the more thrilling it is! The world of investment promises you some kind of exhilarating ventures, akin to that of wild rides. The main difference is that you do not need to plan for your ride, but you need to be a careful analyst who can understand the ins and outs of the financial market when it comes to investing. By studying the markets, you can assess the risk and tolerance level and hope for better potential returns. Let us learn more about how to do that.
How Risky Can You Afford to Be?
Before diving into the techniques and tools, you need to study what you have in your hands. In other words, you should analyze how much you are willing to lose. Having such an understanding in mind will guide you throughout the journey and inform you what is the most appropriate next step to take. Many factors come into play when assessing the risk you can afford, like your savings, debts, financial goals, and the challenges you might be facing at a certain period in your life. Be sure to have a clear list of all those elements, and be honest with yourself as that will help you mitigate the risks at a later stage.
Probably the seriousness of the previous information has got you a bit scared, but do not run away yet! The good part of the ride is about to start. After you have got an idea about how risky you can afford to be, it is time to also assess your return potential.
Tools to Assess Both Risks and Returns in Trading
You need to delve into the markets to understand what opportunities they are holding for you, and unfortunately also what risks.
Risk-Reward Ratio
The risk-reward ratio is used by investors to evaluate the reward they can possibly earn for each dollar they risk. For instance, 1:7 reward ratio means that the investor is willing to risk one dollar for the prospect of earning 7 dollars in return. To calculate the risk and return ration, investors make benefit of:
Fundamental Analysis
Fundamental analysis is important for long term investors. The main objective of this kind of study is to determine the intrinsic value of an instrument. To do so, analysts usually study financial statements, including balance sheets, income statements, cash flow statements, revenues, assets, liabilities, etc. to consider if the asset is overvalued or undervalued when compared to the market price.
if the intrinsic value exceeds the market price, then it is considered undervalued and can be a promising opportunity.
if the intrinsic value is less than the market price, then it might be overvalued, and thus, not a good opportunity to invest in.
Technical Analysis
In contrast to fundamental analysis, this study’s focus is the shorter term operations. While fundamental analysis concentrates on economic, political and social conditions, technical analysis focuses on price patterns, future price and quotes. Technical analysts make use of various economic indicators, creating charts to help investors track the performance of different assets over time.
Standard Deviation
One mathematical tool that can be used to measure how risky, or not, an asset is is standard deviation. Hope you are good at math, since we are going to use some math terms to explain standard deviation in more detail. In fact, standard deviation measures the average amount by which individual data points differ from the mean. Sounds a bit complicated? We can explain it in simpler terms: this mathematical concept helps investors to know the spread of asset prices from their average price. Let us see how this applies to evaluating risks.
If the price goes up or down significantly,then the standard deviation is high. Higher deviation means a more volatile market, and a more risky investment.
If the deviation is not high, then the prices are not moving as much, and the investment is less risky.
Value at Risk
This tool helps you to evaluate how much you could potentially lose within a specified time frame and level of confidence. To simplify it with an example: Value at Risk or (VaR) helps you to check the worst case loss of your $100 investment with a specific level of confidence (e.g., 90%).
Value at Risk can be calculated using
The historical simulation method: In this method, investors sort historical returns, select the appropriate percentile corresponding to the desired confidence level (e.g., 95%), and determining VaR as the negative of that return
The variance-covariance method computes VaR by multiplying the Z-score (derived from the desired confidence level), the standard deviation of returns, and the initial investment amount.
Risk Management: The Trader’s Armor
Stop-Loss Orders
Risks are inevitable, but can be mitigated significantly by setting a stop loss. A stop loss functions as your parachute while diving through the skies of investments. When setting a stop loss, the investor gives the instruction to the broker to sell a certain security when the price reaches a specific level, thus protecting them from having a hard free fall.
Diversification
“Diversify your portfolio” is the advice you would hear every time you are planning an investment, and the reason? Because it helps you manage risks better! When you diversify your investments across different assets, you make sure that the profits from some can set off for the losses from others.
Demo Account
Before you start your trip with actual money, it is better to practice your strategies with a demo account. A demo account gives the chance to practice and hone your skills with adjustable virtual funds.
Forex Copy Trading
If you find it all overwhelming, there is a strategy that can save you time, and effort while also reducing potential risks, which is forex copy trading. The reason behind that is that you can follow expert traders and follow their strategies. Investors can track performance of the providers or master traders to choose the ones that they are performing better.
Final Takeaway
A financial venture can indeed be a wild ride. Yet, investors can protect themselves from hard falls by carefully studying the market and assessing the risks and returns of their investments. Moreover, it is highly advisable to utilize tools that help mitigate potential risks such as stop-loss and diversification. Assessing the risks and returns is an ongoing process that you can keep re-evaluating as you are moving forward in the trading journey. Use the tools available for you and keep updating your strategy accordingly, and then you are set for a more rewarding endeavor.
