How to know your investment strategy is working I Risk reward ratio - YouTube

Hi, When we invest in any investment option we often pay attention to 2 factors

The first thing is the returns and the second thing is there is risk involved.

According to these two factors, we compare the investment options

We try to make a balance of both and invest which we also know as the risk-reward ratio.

So in today's video, we will discuss that -

What is meant by risk-reward ratio?

How do you calculate the risk-reward ratio?

What does the risk-reward ratio tell us?

What are the limitations of using the risk-reward ratio in investing?

How to use the risk-reward ratio effectively?

If you haven't subscribed to your channel then click on subscribe button now and like the video.

Because we come up with content every week that will help you become a better investor.

First of all, we will discuss- What is risk-reward or RR ratio?

The RR Ratio tells us that if you take a risk of Re 1 in any investment, then how much reward can you get from it?

Let's clear it with an example.

If the risk-reward ratio in investment is 1:10, it shows that the investor is ready to take a risk of Re 1 to earn Rs 10.

Similarly, if the risk-reward ratio is 1:5 then it shows that an investor has to invest in Re 1 or take a risk of Re 1.

If you go through these two examples carefully,

then you can understand that the risk-reward ratio of the first example is better than that of the second example.

Let's deal with this in a little more depth.

You must have often heard that government bonds are risk-free.

This is because we can assume that our government will never default.

That's why we consider the returns of government bonds as risk-free returns.

The 10-year bond yield in India has declined by 6.5%.

That is, you are earning a 6.5% return without taking any risk.

So if you invest in risky assets like debt or equities, ideally you would expect returns above 6.5%.

The risk in debt asset classes is slightly higher than that of government bonds.

Debt means loan.

That is, if you invest in debt funds, you are giving a loan to someone.

Hence, when you invest in debt instruments, there are various risks involved like credit default risk, interest rate risk, etc.

Whenever a company goes bankrupt, the investors of debt instruments are the first to be paid.

And it is not that the terms like default are seen again and again.

So in this, you have to take some risk of capital loss.

But for this reason, the returns in debt instruments are also higher than government bonds and FDs.

But if we talk about equity asset class then it's riskier.

Because of volatility and correction, sometimes investors lose even 40-50% of their capital.

Apart from this, if a company goes bankrupt or closes its operations, then you can also lose 100% of your capital.

Suppose you invested in a company and that company went bankrupt.

So first of all the assets of the company are liquidated i.e. converted into cash.

And after this, first of all, those people are paid who have given loans to the company in any form.

And after that, the balance amount is paid to the shareholders.

This is why you must have heard that equity or stock is riskier than debt.

Because the investors of debt instruments are paid before equity holders in such terms.

Now if the risk is high in equities, then as an investor we would expect higher returns as well.

Let's say if you earn a 10-12% return in equities and the bond interest rate rises to 9%.

Would you still risk that much for 2-3% extra returns?

This will not be one wise decision.

In such a situation, the expectations of the investors from the equity market increase.

With the 2 examples, we just discussed above, you might have understood how to trade off risk and return.

The higher the risk involved in an investment option, the higher the return we expect from it.

And we should invest in such stocks then assets that have a good risk-reward ratio.

One thing we should pay more attention to when it comes to risk is our investment time horizon.

For example - If you want to invest for only 6 months then FD can be a risk-free option for you and stocks can be a risky option.

But if you want to invest for 10 years then FD can be risky for you and stocks become less risky for you.

What I mean by FD becoming risky is that the returns in it will not be able to beat inflation.

So overall you will get negative returns which is a risk.

We have understood the meaning of risk-reward ratio very well.

Now let's settle on how to calculate it.

To calculate the risk-reward ratio, you must first decode it into 2 words - risk and reward.

Risk is the total amount that you can lose in an investment option.

Considering the example of stock, the risk is the difference between our entry point and the stop-loss.

And we know the total potential profit as a reward.

This is the difference between our selling point and entry point.

Mathematically, we can understand {Risk-Reward Ratio=(Entry Point–Stop-Loss) / (Profit Target–Entry Point)}

Let's talk about a practical example.

Suppose you buy a stock for Rs.25 and put a stop loss of Rs.24 and you sell it for Rs.30,

then its risk-reward ratio can be calculated from the following (25-24) / (30-25) = 1/6 = 0.167

As a rule, if this ratio is greater than 1 then the potential risk to us is greater than its potential reward.

And if the ratio is less than 1 then its potential profit is greater than its potential risk.

So in the example, we have just taken, the risk-reward ratio is in favor of the investor.

What does the risk-reward ratio tell you?

This ratio helps us to manage the risk of capital loss.

Probability plays a big role in investing.

You may have earned very good returns on one of your investments

But if you keep investing in options that have a very high risk i.e. the risk-reward ratio of more than 1 then you have lost your capital at any time.

So with the help of ratios, you can help make better investment decisions.

Limitations of risk-reward ratio in investments.

If the RR ratio is less than 1, it does not mean that you will earn good returns.

You should also know what are the chances of reaching the target.

When we invest only according to the RR ratio, we set a stop loss and target based on the entry point.

But in this, we ignore the business conditions and the market value of the business.

With a good RR ratio, you should also check whether the price has a reasonable chance of reaching the target before the stop-loss.

Because ultimately the profit will come from the target price.

And when the market is volatile, there are times when your investment hits the stop-loss.

So if you are a long-term investor then you should not exit or else you may miss some opportunities which will give multi-bagger returns.

Let us now understand in the next point how to use it effectively.

Points to be taken into account to use the risk-reward ratio effectively:

Awareness of market conditions

Entry point and entry time of a stock

Setting stop-loss and target based on market conditions

Other risk-management tools use based on fundamental business characteristics.

So we have talked about the risk-reward ratio in the video.

But there are also some limitations which we have just discussed.

Therefore, you should not decide to buy a stock solely based on the risk-reward ratio.

Although it is a useful tool, this one tool alone is not enough.

You should also consider other factors.

Comment us and then tell us how you use the risk-reward ratio while investing.

Also, we would like to tell you that we have launched a new channel named Groww Plus

Here we post videos on interesting topics like Career, Investment, Health, Entrepreneurship, and many more.

So if you also want to be your best version and want to create wealth, then you must subscribe to Groww Plus.

You will find the link to the channel in the description of the video.

Don't forget to subscribe to Groww channel for the latest updates about the market. Bye.