Risk-to-reward Ratio (风险回报率)
There are some investors do not realize they are exposed to a relatively high risk when they tend to buy a stock. However, how should we know whether we are buying at a higher risk or lower risk? The writer believes this article can somehow solve this problem for you.
Risk-to-reward ratio is a proportion to show is it worth to buy a stock with the possible risk compared to the possible return. For example, Stock A has a historical high price art RM2.00, and has recently just rebounded from RM1.00, and is currently sitting at RM1.80. We can see that the possible return in RM0.20 if it goes back to its previous high, but a possible RM0.80 losses when the market is bad, and it dropped back to its recent low. Having its risk-to-reward ratio that is around 4:1 means that investors are exposing themselves is a rather risky situation when they decided to buy Stock A at RM1.80.
On the other hand, if Stock B has just rebounded from RM1.00, currently sitting at RM1.20, where its historical high is RM1.80. This makes the risk-to-reward ratio to 1:3, that means you have a higher chance to be rewarded and have a lower risk to suffer big losses. This ratio is also one of the method to conduct risk management, where you pass the chance to buy at a higher point, but wait for a slight retracement before buying the stock.
In short, risk-to-reward ratio is a mechanism that shall be used by investors before buying a stock. The best ratio shall be at least 1:2, where reward is still two-time the risk, however do note that the lower the risk, the higher the reward, thus better chance for you to earn more.
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