There are three crucial things to analyze and evaluate as an investor before investing even a penny.
Most investors don’t do this and instead fail to understand risk and reward correctly, making poor decision after poor decision because the key to understanding risk and reward lies in the third point.
Knowledge and Skill
Preferring to receive “free” information from mainstream media and the mouthpieces that make up the perma bull, rent-seeking establishment crowd, they feed their minds with soundbites of mindless drivel, believing themselves “educated”. Then they’re left wondering what happened to their money when they get wiped out. I’m reminded of the saying, “If you think education is expensive try ignorance.”
It’s easy to lose track of one of these, rendering the others more powerful than they should be.
You should be continuously asking yourself these three questions:
- What is your understanding of risk?
- What is your expectation of reward?
- What skills and knowledge do you have?
Evaluating and understanding risk is an important part of investing and speculating.
You’ll often hear traders and investors say that they will invest where the risk-reward ratio is favourable. But what does that mean?
If, for example, a trader sees a trade as being 2:1 ratio where he can produce double the amount risked he may look at this as being too risky and will look for trades where there is a 3:1 ratio. This is where he can produce 3 times the amount of capital risked.
But there’s one ingredient missing in this.
Let me show you with some examples:
1. (Perceived) Low risk with high reward + low skill/knowledge
This is where many investors sit. Unable or unwilling to spend the time to really understand the market, they see a setup that appears favourable to them. They’re like the guy sitting on his sofa watching the Formula 1, thinking to himself, “Gosh I know what he should be doing. I know how to drive”. But when put on the racing track, the lack of skill and knowledge quickly become evident.
2. (Perceived) High risk, low reward + high skill/knowledge
Not optimal but often better than the above. Now I hear you yelling, “Why would you take high risk with low reward?” The answer is that adding skill to the mix substantially lowers risk and so the REAL risk-reward ratio changes.
Come back to my Formula 1 analogy. Putting Lewis Hamilton onto the racetrack substantially increases potential reward without a commensurate increase in risk – due to his knowledge and skill.
Needless to say that the result is going to be better as well.
3. (Perceived) Low risk, high reward + high skill/knowledge
REAL risk is lowered with a higher level of skill or knowledge and REAL reward is also adjusted. This is where the optimum lies, where the best outcome exists.
Recently I mentioned that risk is subjective to your own personal situation. Risk increases with less knowledge or skill and decreases with increased knowledge or skill. You wouldn’t let a mechanic operate on your eyeball as the risk-reward ratio would be out of the park crazy.
Putting all this together for a trading and investment strategy means that every individual should identify where on the spectrum they lie so that they don’t land up jumping onto the Formula 1 track only to be run down. By the same token, they needn’t shy away from the race track where all the rewards exist.
At the end of the day, we have to risk in order to learn and we have to learn how to risk. And skill and knowledge are the oil that lubricates the engine.
One way to quickly and substantially reduce your risk while exponentially increasing your skill/knowledge and reward is to surround yourself with a network of investors who understand ALL of these 3 circles.
“Never was anything great achieved without danger.” – Niccolò Machiavelli