Risk-to-Reward Ratio puts risk into perspective

Every single time you read up on financial tips especially ones associated with stocks, trading, and diversification, you will always find so much advice from financial analysts. One that really stands out and gets repeated often so it can stick to your brain is understanding your risk tolerance profile or level.

You will always be advised to make investment decisions based on that profile and to never go overboard. Going overboard your risk tolerance level is certainly not going to do you any good. In any case, you will clearly be trading above your margin of safety.

Why this gets drummed in is because the possibility of making a killing with your portfolio and drawing up the board to financial independence is basically dependent on how much you can factor in your risk-to-reward ratio into perspective.

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So, you ought to understand why you need to risk say $1 for every $3 profit you are supposed to be making with your portfolio. This is the common and closely accepted ratio for investors alike. But you can most certainly create yours depending on your risk tolerance profile as we discussed above.

Using Stop-losses to facilitate risks

Using the risk-to-reward ratio to your advantage will put your money into a good yielding capacity. In fact, if your investment doesn't go up in value as a result of other factors, you would clearly know what you stand to lose and this wouldn't shake up your entire world much because you were prepared for it.

What most people fail to do is think about what happens when an investment doesn't bring the desired results. So, they tend to calculate their risk-to-reward ratio by putting into perspective the risk they have to take to close winning trades. They avoid thinking about how they will react to the market if things took a different turn.

Whereas, as much as we are all in business to make a profit, there could always be a fair chance of losing and losing hard. So, traders need to put their emotions aside and make friends with stop-losses. They can protect at least some of their capital if they utilize stop-losses more.

A good risk-to-reward ratio

A good risk-to-reward is mostly 1:3, because it is more appropriate compared to say 1:15 especially if you are buying, holding, and receiving dividends with a long-term outlook.

Armed with this sensitivity, you can always make buying and selling decisions better than before. This, of course, would be after thorough research on the portfolio you are investing in because decisions made around the risk-to-reward ratio are often done on the fly since the calculation is easy.

Any odds?

Yes! As mentioned above, relying on this calculation could be detrimental to your portfolio if you forget to put into perspective the possibility of losing as the market likely makes a turnaround. In such scenarios, the theoretical loss or gain may be useless because the turn of events wasn't accounted for. Even the thought of seeing stable market prices could affect the risk-to-reward ratio calculation.

Closing thoughts

It doesn't matter which path an investor takes while making investment decisions, it's always important to create safety nets in case something goes wrong. A buffer. Diversification. Stop-loss orders, etc. Anything that would keep them in the game long enough to recover should be in the blueprint.

However, long-term investors need not worry about market fluctuations since they will always have the chance to experience many market cycles as they wait patiently for their portfolio to grow.

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