If investment is so easy, why isnt everybody rich? Investment involves risk by definition. You invest an amount of money and hope that it earns an extra amount for you, but we must be aware of the risk. Risk is defined by the amount of money you would potentially lose in the worst situation. This is the factor R we see in return to risk ratio. This is a intuitive method to estimate the quality of an investment and chances are you already know how to use it in your daily life.
We make decisions every day, every hour. When options come up, we have to assess each one and go for our final decision. Just like things as little and normal as going home. You have two choices. You get choose to drive on the high way where you could arrive home within 30 minutes. But there is a risk you bear. In case there is a traffic accident, the traffic jam would engage you for another two hours. A safer choice would be to take the street where it is less crowded. But there are many annoying traffic lights and it takes at least 45 minutes to get home no matter how free the road is.
You would begin analyzing the two options and decide whether getting home 15 minutes earlier is worth the risk of being trapped in traffic jam for 2 hours. Similar decision making process can be seen in investment managements. The important reference is the ratio between the expected return and the potential loss you may pay. The ratio must be high enough to justify the actions.
We have worked with top investors and see them use the return to risk ratios in real situations. The best always consider the risk they bear before putting their eye on the potential return. Investment opportunities are ranked with the ratio, denoted in R, the risk factor. If the largest amount of money you may lose in an investment could possibly get you 3 times the amount as return, we label it a 3R investment opportunity. This system is applicable to all kinds of investments, like stock, mutual fund, property or other investment vehicles. And it means the same for a 2R investment in stock market or in the property market. They mean the expected return over the worst loss equals 2. Below is an illustration.
Assume the property market is going up. You notice the chance and are buying a house and selling it immediately to monetize the opportunity. The price of the house is $80,000 and you got a leverage to do the acquisition. The amount you must pay is $5,000. If you couldnt sell the house promptly, you would lose the whole amount of $5,000. Hence, the risk factor R is $5,000. The price you aim to make a profit of $20,000 and sell the house is $100,000. Therefore, this is a 4R investment opportunity because the expected return is 4 times the amount of money you could possibly lose.
Lets say it turned out the market didnt go up as much as you thought and you sold the house with $90,000. You made a profit of $10,000. So, we say the investment becomes a 2R one because the profit is 2 times the risk factor.