Risk To Reward Ratio & Opportunity Vs Risk

The Risk to Reward Ratio Dilemma

Two words that are synonymous amongst most investors is opportunity and risk.

Merriam defines opportunity as

A favourable juncture of circumstances
A good chance for advancement or progress

It defines risk as:

The possibility of loss or injury
The chance that an investment (such as a stock or commodity) will lose value

When the markets are surging everyone is hoping and praying for the stock or stocks they love to drop down to a price they were hoping but too scared to buy one month or 1 year ago. The odd thing is that two years ago, they were hoping for the same development, but on each occasion, they refused to act when opportunity gave them what they so desperately wanted. That is the Mass Mindset for you, it begs, it pleads for a chance, but when given a chance it does precisely what it was programmed to do the last time and the last time before that. One thing to keep in mind is that every bull market experiences one (very) strong correction and one cannot predict which correction will end up falling into this category.

Every Bull Market Experiences one Strong Correction

All bull markets experience this, Bitcoin experienced this and then it went on to surge to new highs, and when everyone thought that things would only get better, the bottom dropped out. When the bottom dropped out, it appeared that it was another buying opportunity, but what was different that time, the masses were not fearful when Bitcoin started to pull back, in fact, they embraced those pullbacks.

Even today you still have individuals predicting that Bitcoin could end the year at 15,000 when 3,000 is closer to the truth. Bull markets always end on a note of euphoria, therefore until the crowd is ecstatic, the pullbacks ranging from mild to strong have to be viewed through a bullish lens unless the trend turns. We have yet to see the trend changes when the masses are in a state of disarray.

Now let’s look at risk Component of the equation

All investors talk about wanting to get into a low-risk opportunity. However, when do they start to obsess about risk when the market is tanking. Remember the Tulip Mania of the 17^th century? What about the Stock Market crash of 1929 or the 1987 stock market crash. Let’s move a bit closer to the current timeline; the housing crash of 2008, the Bitcoin crash that took place earlier this year. To date, over $700 billion has been wiped from that sector. On what note (sentiment) did the bull get shot in every instance? In all instances, the crowd was ecstatic; they were sure the markets would go higher. It appears that the mass mindset has a problem when it comes to gauging comes to gauging opportunity and risk; it seems to confuse one for other.

Solution to the Risk to Reward ratio Dilemma Most Investors Face

So we know that opportunity is defined as “A favourable juncture of circumstances or A good chance for advancement or progress”. Hence, by logic would one not be better off by not following the directives of the Mass Mindset; how could you possibly spot an opportunity when everyone is ready to act in the same manner at precisely the same moment?. Would one not be better off, if one diverged and took a different route?

How could one lower’s one’s risk when one is ready to buy at a price that is in many cases double of what one deemed before (before could mean one month, one year, etc)? Why did this person not buy one year ago when the market pulled back strongly but is now willing to pay a much larger sum when the market and the stock is trading significantly higher. What happened to the concept of risk?

The average trader has a convoluted view of the markets and the world

They are forever willing to bend the definition of risk and opportunity to suit whatever perspective is taking the lead role at the moment. The solution is to spot this trait and how does one attain this goal? Well by keeping a diary; a real-time diary of how you feel when the markets are soaring and especially when they are pulling back sharply.

A crash is nothing but a perception based on when you opened the long positions. To one trader it could be a pullback because he got in low, while to the one that got in right at the top, its the end of the world. When you keep a notebook, and you can read what was going through your mind in real time when the dust settles, you will spot a pattern that is unique, and you will then be in a position to change. It is not too late to keep that diary, panic is running high, and the masses are not sure of what to expect

Market Crashes Operate under the same theme

Sit back and reflect slowly; go through all the crashes you have experienced, and you will see the above theme in action, in every single instance. There has never been an exception, and you would think by now that the masses would have finally learned something, but alas this is not to be. The masses are always willing to be used as cannon fodder and the players of Wall Street know this only too well.

Hence they put the same game plan into action over and over again; when it comes to investing its groundhogs day every day for most investors. They refuse to accept that there is another possibility. They refuse to alter the angle of perception, and by doing so they are trapped in a prison of their making. Plato’s allegory of the cave is a perfect example of how the mass mindset operates. For those of you not familiar with that concept, we covered this and the topic of psychological manipulation in this article Psychological deception techniques employed by Wall Street

Distorted view of the risk to reward ratio concept

When prices are low, they assume that it is the wrong time to buy because they are bound to go lower, and when they are soaring upwards, they assume that it is the right time to buy because they are bound to soar even higher. The concept of risk to reward ratio concept is thrown out of the window; they state the seek an opportunity with low risk, but their actions speak otherwise. No Bull Market has ever ended on a note of fear; they end when the crowd is in a state of ecstasy

One needs to understand the difference between a battle and a war. You can lose several battles but still win the war, or win many battles and still end up losing the war. It comes down to how much damage you incur as opposed to losing or winning the battle. If you minimise the damage, you can lose several battles in a row, retreat and regroup and come back and win the war.

Every bull market goes through one shakeout (strong pullback)

And you never know when that will occur exactly. A shakeout is not the same as a market putting in a long-term top. The big players need someone to sell these stocks to before they cash out.

Unlike the shakeout phase, one can identify a topping phase based on market sentiment. During the topping phase, the masses remain unusually resilient when the market experiences a sharp correction; they have now been lead to believe that every pullback is an opportunity. When the masses believe this, its time to head for the hills. Case and point Bitcoin. Throughout its fall, the masses remained bullish, and despite the heavy beating it has already taken experts are still issuing insane targets even now when Bitcoin is trading below 5K, which means that Bitcoin the odds of it hitting 3K are far higher than 15K.

Once you understand the simple concept above, read the following article as it continues from where this article leaves off Risk and Opportunity; When To Buy & When To Run