The risk-to-reward ratio (RRR) is the governing principle behind the investment world.
With higher risks, you get higher yields and vice-versa.
When investing long-term, it’s usually a brilliant idea to be more conservative with your investments.
Still, being too timid will get you nowhere.
So, your best bet would be to find a perfect balance between the risk and the reward.
Incorporating this into your strategy is a way to make a great long-term plan.
First of all, strategies provide consistency by making your investments systemic.
Second, abiding by a well-established principle makes you less likely to engage in gambling-like behavior, as some investors have a habit of doing.
With all of this in mind and without further ado, here’s what you need to know about investing for the long term.
Here’s how you balance risk and reward in your trades.
How does the risk-to-reward ratio work?
Measuring RRR is relatively easy as long as you understand some basic terms in this calculation.
- PT: Profit target is the amount of money you expect to make. This is the potential reward.
- SL: Stop loss is the amount you’re willing to take before pulling out. This is the potential loss.
- Divide the reward by the risk (PT/SL) to get the RRR.
Here’s an example to help clarify things further.
- If you expect to make $100 (PT) and place a stop order at $25 (SL) lost, your reward-to-risk ratio is 4:1.
The importance of RRR is to give you a simplified explanation of what you’re getting into.
Instead of getting volumes of data, you simply get a percentage of risk-to-reward.
If we follow up on our previous example, the RRR asks you: “Are you willing to risk losing $25 for a chance to earn $100.”
That’s really all there is to it.
Once again, you must understand that this estimate is crude and, in many cases, inaccurate.
This is not an exact science, but it provides insight into potential trade.
The more research you invest, the better; however, it’s better to be guided by the RRR alone than to just walk blindly into a trade.
Related: How to Invest in the Stock Market for Beginners
Backtesting stock portfolio is a real-life alternative to time-travel
Imagine if you could place a trade, wait for the results and then travel back in time.
This way, for a successful trade, you could increase your initial investment and back out of the stock that loses you money.
Sadly, there is no time travel in real life.
In investment, however, you can backtest the stock portfolio, which is as close as possible.
Sure, it’s not as reliable as this theoretical time travel, but it’s real and available to every trader.
The fact that many people are still not using it is a significant missed opportunity.
So, what is this backtesting?
It’s a concept where you develop a trading strategy and use a tool to figure out how it would have performed in historical market conditions.
The very reason why people study trade charts is that they believe that previous patterns overlap and that history might repeat itself.
This is a theory that has proven itself many times.
The biggest problem with this method is that some people try to make this calculation manually.
This just doesn’t work.
A tool has an algorithm capable of accessing and incorporating vast quantities of data into this estimate.
This is something that you just can’t do manually.
With the right tool, on the other hand, the result of backtesting can be impressively accurate.
Learn how to use stop orders (and then actually use them)
Stop orders are just one of the three common order types.
The other two are:
- Market
- Limit
Still, stop orders are the type most people use when they try to automate their trades and investments.
The benefits of these orders are numerous.
- They’re always active. This means that even if you miss a significant change in the market, the order will still be executed.
- They’re automatic, which means that they won’t allow you to change your mind at the last second in
- Stop orders will make your trades systemic. According to one estimate, if you set your stop loss at 1% and your stop gain order at 6%, you can still make money with just 25% of successful trades. In other words, this is a dependable system, not an automation trick or a gimmick.
You can also use an order to buy.
You can set an order to buy X stocks when the price of a stock reaches the Y value of dollars.
This way, you won’t miss an opportunity.
As more people buy, the price will start rising, which is why you can set a stop-buy order to prevent getting into unnecessary losses.
How to invest for the long term?
So, how does one make a long-term investment strategy?
Well, there are a couple of techniques that you should keep in mind.
Start by understanding that you’re freezing your assets by investing long-term.
Even if there is a dividend in question, it will take a long time for these dividends to reach the break-even point of the original investment.
So, never invest more than you can afford to.
Second, don’t make a one-year investment if you need this money in three months.
Second, make sure to diversify your portfolio.
This is the key aspect of your risk management. Even if a stock seems incredibly profitable, putting all your investment money into it is too risky.
So, spread your investments over various stocks or, better yet, different investment types.
For instance, some suggest keeping at least 10% to 15% of your assets in precious metals.
Since commodities usually follow an opposite trend to stocks and currencies, this will act as a safety net for your portfolio. In an era where hedge funds lost $208 billion for clients in just one year, this is a common-sense move.
The most important advice is that you shouldn’t try to “time the market.” Even if you’re 100% sure that the value of an investment will go down, you can never know when this will happen.
Remember the movie Big Short? Some people figured out that the housing market was a bubble, but no one knew when it would burst.
Most importantly, you need to keep a tab on yourself. You won’t know precisely how well you’re doing without seeing the bigger picture.
Consider dollar-cost averaging
There are different interpretations of the concept of long-term investing.
Sure, it can mean positional trading.
Here, you invest and then wait for the price.
However, it can also mean consistently investing over a long period.
For this, adopting an established strategy might give the best results.
An example of such an effective strategy is dollar-cost averaging.
This strategy is great because it focuses on dollar amounts, not share prices.
If you invest $200 every month, you buy fewer shares.
The critical thing is that you continuously invest the same amount of money.
This is consistent, but it also helps lower the stress level.
Whenever money’s involved, decision-making can become anxiety-inducing.
Suddenly, making the wrong move has negative consequences.
Even being too cautious can cause you to suffer from FOMO.
Keeping up with tax and compliance obligations
Traders sometimes forget that they still have tax responsibilities.
Sure, the news is full of stories of unethical or morally dubious management by major hedge funds and companies, but you’re not out of the woods either.
In general, day traders pay taxes using the short-term capital gains rate.
This ranges from 10% to 37%, and you must get familiar with the model as soon as possible.
You must also pay attention to who you’re working with.
We’re not suggesting that you would trade over a platform that no one has ever heard of but looking into the headquarters of the platforms you use is essential.
For instance, California Privacy Law provides an impressive amount of protection to the user.
No matter how compelling the offer from a third-world tax haven country may be, this should always be in the back of your mind.
There’s a reason why some countries have record-high levels of cybercrimes.
This is another risk that you need to bear in mind.
Keeping everything clean and on the books is the only way to move forward in trading and investments.
The sooner you learn how to balance risks and rewards, the sooner you reap the benefits
While we are talking about long-term investments and long-term investing, you must start right away.
Every day that you postpone implementing these principles, the more you expose yourself to risk.
Remember that some people adopt gamble-like behavior when dealing with their finances.
Your responsibility as a trader and an investor is to steer as clear from this behavior as possible.
By Srdjan Gombar.
Veteran content writer, published author, and amateur boxer. Srdjan is a Bachelor of Arts in English Language & Literature and is passionate about technology, pop culture, and self-improvement. In his free time, he spends time reading, watching movies, and playing Super Mario Bros. with his son.
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