Every action you take involves a risk. If you cook good food, you can burn your hands. If you practice your favorite sport, you can get an injury. Moreover, if you get in the car to go to that one sweet party, you can get an accident. The good news is that these 'risky' daily actions can give you a taste sensation, better health, and vibrant social life. Those are the own rewards.
Traders and investors also take risks. These are more explicit than the daily examples above. They result in tangible monetary rewards or losses. The great thing about this is that traders can calculate in advance whether a trade is worth taking a risk. You may wonder how and I will come back to that after stating a few facts about why we take risks. The well-known clinical psychologist Jordan Peterson has the following to say about it.
· Not the actual reward, but the anticipation of a reward is what motivates people.
· Overall, men are more aggressive than women. This may have to do with higher testosterone levels and biological drivers like status and wealth men pursuit.
· Not taking a risk, is also a risk. You risk staying behind your peers for example.
· Most people are risk-averse. This is because the pain of losing something is stronger than the pleasure of winning something of the same magnitude.
· People like to follow others in behavior. If well-known celebrities promote a product, there is a higher chance people who are a fan of the celebrity will buy it.
So how do traders calculate their risk and own reward and prevent emotional decisions? Well, the calculation is pretty simple. Traders have to divide the forecasted profit by the forecasted loss. Then they get a number called their risk/reward ratio. The hard part is in managing your emotions to act on your calculations.
Imagine a coin is now 100$. After analyzing the chart, you think a coin goes to 120$, but if it goes wrong, the coin goes to 95$. In this example, you have a chance of winning 20$ or losing 5$. 20$ divided by 5 = 4. The risk/reward ratio of your trade is 4. You can win 4x as much as you can lose if you adjust your take profit and stop loss orders to those price points.
Another thing to be aware of is that it is more difficult to recoup your loss if you lose. Because a 5$ loss on 100$ = a 5% loss. But bringing $95 back to $100 = a 5.26% profit. As the losses grow, it becomes more difficult to recoup them. Imagine you have 150$ and you lose 50$. That is 33.33% loss. To win your losses back and make 150 from 100 again, you have to make a 50% profit. This makes losses you make expensive. Therefore it is crucial to calculate your risk/reward ratio for every trade.
Calculating your risk/reward ratio seems easy, but the majority of traders or investors do not think this way. They buy what they believe in emotionally or what their favorite Twitter personality tells them about a particular coin. That can sometimes turn out well, but usually not. It is recommended to do your calculations and research first before you read about the opinions of others. Another thing you can do to prevent emotional decisions is by decreasing your exposure to social media with emotional people and by only the following information sources you know can be trusted.
Conclusion
People always take risks. Even if they do nothing. That is why it is essential that the risks they take are worth it. In everyday life that is mostly a vague process, but you often know intuitively what is right and what is not smart. With investing and trading this is a simple rational process of calculations for good traders. You calculate your risk/reward ratio, and you are aware of the fact that it is difficult to recoup your loss. However, your emotions can unbalance you like it upsets many traders. Therefore it would be wise not to blindly follow Twitter personalities, to do your calculations and to decrease exposure to social media. This makes you a rational and thus winning trader and investor.