How to Analyze Risk and Return in Trading

The dynamic world of investment can seem exciting. We expect returns and higher profits from the invested money, but we also know investments come with risk. You must be able to maintain a balance between the two – risk and return- to develop a profitable profile.

In this article, let’s understand what is risk and return, their types and how risk-return trade off work.

What is Return?

Return is the gain or loss incurred from the investments made at an initial price, often represented in percentage.

How to calculate return:

Say you buy stock at Rs 1000 and sell it after a while at Rs 1200/-

Return (%) would be – {(1200-1000) /1000 } * 100 = 20%

What are the types of return?

While calculating return is crucial, it is important to know the different types of return you can use to measure them. These include:

Nominal Return

The overall investment value over a period of time that is calculated after taxes or fees are paid for the investment. To calculate nominal return:

Purchase Price- Current Value = Nominal Return

Total Return

It includes both taxes and fees paid for an investment and cash flow received. To know the total return:

Purchase Price + Fees & taxes- Current Value + Cash Flow= Total Return

Real Return

Real return does not include factors like total returns, but it does consider the impact of

Inflation on the return over a period of time. Inflation is the increase in prices of goods and services that decreases the value of money.

What do you mean by risk in trading?

In trading, risk is the potential of losing money or the uncertainty of the outcome of investing your hard-earned money in stocks or other assets.

Types of risk

• Liquidity risk – Losses may happen from investors’ inability to buy and sell assets quickly.
• Market Risk– It is the investment loss that happens from unfavourable price movements, which can be caused by a number of factors.
• Systematic Risk- It is a kind of risk that impacts all traders and investors in the market due to instability in the financial system.

How does the risk-return trade-off work?

The financial world has two parallels: risk and return. We must be prepared to take on greater risk if we wish to increase our investments and anticipate a larger return. Because of this risk-return trade-off, you can anticipate a higher return the more risk you take. However, you will be prepared to take fewer chances and anticipate fewer rewards if you wish to be cautious.

A few investments can help you determine the risk and return of an investment.

You can calculate risk and return in an investment with the aid of a few investment ratios. These include:

• Alpha ratio: This ratio shows mutual funds’ performance in relation to its benchmark.
• Beta ratio: It indicates a fund’s sensitivity to changes in the market.
• Sharpe ratio: This metric helps you to define if a fund’s return is worth the risk you are taking. Like, a higher sharper ratio means there are better chances of returns from the risk you are taking.

How to manage risk and return in your portfolio?

To build an appropriate trading roadmap, risk-return trade-off must be thoroughly understood. By selecting a range of investments, you can balance risk and return in your investment portfolio. They are:

• Goal-based planning: Know your objectives before investing. For example, you might decide to invest for short-term needs like a trip plan, or you might decide to save for a long-term goal like your child’s education. Knowing your goals is, therefore, crucial to calculating a good return.
• Diversification: It entails spreading out your financial investments. Investing in a variety of assets can protect your portfolio from significant losses. You can keep the balance if one asset performs poorly.
• Prevent overexposure: Don’t make excessive investments in stocks or mutual funds, for example. It lowers risk and keeps your portfolio from becoming overly reliant on any one kind of investment.

In trading, risk management is more important than risk avoidance. Traders weigh risk and return when evaluating each move. They create systems that withstand losses and expand gradually rather than heedlessly pursuing profits.

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