Do you understand the profit/loss ratio well?

According to the prevailing view in the money management strategy, it is required that the average loss per trade should be less than the average profit trade. However, let’s examine the concepts of profit and loss and see how this old statement can be adjusted. 

What is the relationship between profit and loss ratios?

A profit/loss ratio applies to the average profit size compared to the average loss size per trade. For instance, if you expected a profit of $900 and a loss of $300 for a particular trade, your profit/loss ratio will be 3:1. It is $900 divided by $300.

Many trading books promote a profit/loss ratio of at least 2:1 or 3:1. Even though most people agree with that recommendation, this advice can be misleading and harmful to your trading account. This recommendation doesn’t consider the market’s practical realities, the individual trading style, and the APPT factor. 

The importance of average profitability per trade

APPT, average profitability per trade, applies to the average amount you can expect to win or lose per trade. Usually, people are so fixed on their profit/loss ratios that they become oblivious to a bigger picture. Your trading performance depends mainly on your APPT.

Here is the formula for average profitability per trade:

APPT = (PW×AW) − (PL×AL)

PW = Probability of win; AW = Average win; PL = Probability of loss; AL = Average loss​

Let’s examine the APPT of the following possible scenarios:

Scenario A:

Consider that you place ten trades. You profit on three of them and lose on seven of them. Therefore, your profitability is 30% or 0.3%. Meanwhile, your loss is 70%, or 0.7. 

So, trade makes an average winning of $600 and an average loss of $300.

In this situation, the APPT is:

(0.3 \x\$600) – (0.7 \x\$300) = – \$30(0.3×$600)−(0.7×$300)=−$30

The result is a negative number which means that you will possibly lose $30 for every trade you place. 

The profit/loss ratio is 2:1. However, this trading approach provides only 30% of winning trades.

Scenario B

Now examine the APPT with another example with a profit/loss ratio of 1:3. Consider that out of ten trades you place, you profit from eight of them and lose two of the trades. 

Here is the APPT:

(0.8 \x\$100) – (0.2 \x\$300) = \$20(0.8×$100)−(0.2×$300)=$20

This example shows that despite having a profit/loss ratio of 1:3, the APPT is positive. So, with this trading approach, you can be profitable over time. 

How to calculate profitability for specified periods

It is also interesting to analyze how an investment behaves during specific periods concerning the previous ones. Depending on the data you have, the periods can be weekly, monthly, quarterly, annually, etc.

To calculate the one for these periods, you have to use the simple profitability formula again.

Cost of investment

We should also discuss the cost of investment.

The cost of investment is a crucial aspect of financial planning and wealth building. It refers to the amount of money or resources that individuals, businesses, or organizations allocate to acquire assets or engage in activities with the expectation of generating a return or profit in the future.

Investments can take various forms, including stocks, bonds, real estate, mutual funds, business ventures, and more.

Understanding the cost of investment is essential for making informed financial decisions and achieving long-term financial goals.

Initial investment: The most obvious cost of investment is the initial amount of money or capital required to start the investment.

The size of the initial investment often depends on the type of asset or venture you are investing in and the current market conditions.

Transaction costs: In addition to the purchase price, investors often incur transaction costs, which can include brokerage fees, commissions, and taxes.

These costs can vary widely depending on the type of investment and the specific brokerage or platform used. It’s important to factor in transaction costs when evaluating the overall cost of an investment, as they can significantly impact your returns.

Opportunity cost: Opportunity cost is an important but often overlooked aspect of investment costs.

Holding costs: Holding costs are ongoing expenses associated with maintaining an investment.

Risk-adjusted return: Investments are inherently associated with risks. The cost of investment includes the risk of losing part or all of your capital.

To account for this risk, investors often assess the risk-adjusted return, which considers the potential returns in relation to the level of risk involved. Higher-risk investments may require a higher expected return to justify the cost of investment.

Time horizon: The cost of investment can also be influenced by your time horizon. Short-term investments may have lower holding costs but could be subject to more significant price fluctuations.

Long-term investments may require patience and discipline but can potentially offer higher returns over time.

Diversification costs

Diversifying your investment portfolio by spreading your capital across different asset classes can help manage risk.

However, diversification also comes with costs, such as the need to monitor multiple investments and potential rebalancing expenses.

Inflation: Inflation erodes the purchasing power of money over time. Failing to factor in the impact of inflation on the cost of investment can result in a reduced real return.

It’s important to choose investments that have the potential to outpace inflation to preserve and grow your wealth.

The cost of investment encompasses various elements, including the initial investment, transaction costs, opportunity costs, holding costs, risk-adjusted returns, time horizon, diversification costs, and the impact of inflation.

Investors must carefully consider these factors when making investment decisions to ensure they are aligning their investments with their financial goals and risk tolerance.

Additionally, seeking advice from financial professionals can help individuals and organizations make more informed investment choices and optimize their overall financial strategy.

How is the average return on investment calculated?

How to calculate the average profitability of an investment? Many investors do not do it correctly. Let’s explain why.

For example:

Year 0: Investment is $1,000

Year 1: The investment is $2,000. Profits of $1,000 (annual return + 100%).

Year 2: The investment profit to the initial $1,000. Losses of $1,000 (annual return – 50%). 

To calculate the average profitability of this investment, we have to add each year’s returns (+100% and -50%) and divide the result between 2 years. An average profit of 25% comes out.

But if you look closely, the final amount of the investment ($1,000) coincides with the initial one ($1,000). So, the total return on the investment is 0%.

How can this be? The average profit of +25% and total return of 0%?

This is because, in the example, the arithmetic means of profitability is being used instead of the geometric profitability.

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