Heads-Up: Upswing Resilient Investor Guide Risk/Return Ratio
Let’s get down to the nuts and bolts of the TLS and related metrics. As mentioned earlier, the ultimate universal goal of a resilient investor is to minimize the Risk/Return Ratio (RRR) by minimizing Risk whilst maximizing Return as follows:
min(RRR)=min(Risk)/max(Return),
where RRR = (Entry Point – Stop-Loss Point)/(Profit Target - Entry Point).
The problem is that Return and Risk are intertwined cogwheels: they influence and counteract each other. Depending on the involved investment decisions, the focus can be on either one of them, but the effect will always impact both. That’s why this problem is sometimes referred to as the Risk-Return Trade-Off “No Risk, No Return”.
For example, RRR=0.1 means that an investor should be prepared to lose $1 for the prospect of earning $10. Here, Risk is the difference between entry point for the trade and the stop-loss order [1]. The unrealistic zero value Risk=0 refers to the theoretical rate of return of an absolutely risk-free investment (white flag); the general rule of thumb is to consider the most stable government body offering T-bills in a certain currency [15]. In the above formula, Return is the total potential profit, established by a profit target [3]. Hence, it is the difference between the profit target and the entry point. If RRR>1.0, the potential risk is greater than the potential reward on the trade (red score). The acceptable green/amber range is RRR<<1.0.
The Bottom Line: the best investment has the lowest RRR.
This is about the nuts and bolts of the risk aware Traffic Light System (TLS) and related metrics. As mentioned earlier, the ultimate universal goal of a resilient investor is to minimize the Risk/Return Ratio (RRR). The problem is that Return and Risk are intertwined cogwheels: they influence and counteract each other.
ReplyDeleteLinks:
ReplyDelete[1] https://www.investopedia.com/articles/stocks
[3] Tyson, E., 2011, Investing for Dummies, 6th Edition. John Wiley & Sons, Inc.
[15] https://online.hbs.edu/blog/post/financial-performance-measures
Real-world example 1.Risk/Reward Ratio
ReplyDeleteLet’s consider the following example to understand RRR. Investor A wants to create a balanced portfolio using the following input data:
Asset Value 10000
Accepted Risk 0.1
Time Period Y 1
Predict Growth 0.2
This is about investing $10000. He is willing to accept 10% of the risk with the expected 20% of the return on a short-term investment of 1Y. He shortlisted the two stocks, AAPL and MSFT, at the current prices $157 (AAPL) and $330 (MSFT) per share. He analyzed both stock trends using historical market data. According to his stock BI analysis, the predicted AAPL share price range is $100-200, whereas the predicted MSFT share price range is $300-400 in a period of 12 months:
Stock Current Price Stop Loss Target
AAPL 157 100 200
MSFT 330 300 400
The outcome of the RRR calculations is as follows:
Metrics AAPL MSFT
Risk 0.36 0.09
Reward 0.27 0.21
RRR 1.33 0.43
Investor A suggests that MSFT is the best investment in terms of RRR because RRR(MSFT)1.0 and RRR(MSFT)<<1.0. The dollar outcome of this analysis is
Min Exit Value 6369.43 9090.91
Max Exit Value 12738.85 12121.21
Exit Loss 3630.57 909.09
Exit Return 2738.85 2121.21
Accept Exit Loss 1000 1000
Accept Exit Return 2000 2000
Loss Excess -1738.85 90.91
Return Excess 738.85 121.21
Conservative investor A comes to the decision of accepting low-risk and low-return MSFT while rejecting high-reward and excessively high-risk AAPL. He may want to increase MSFT returns by extending the investment period at least 3-5 times. On the other hand, assertive investor A may choose to invest in both companies by dividing his investment while extending the investment period for MSFT.