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The risk-reward ratio in trading is a way of assessing the potential gain from a trade versus the potential risk of loss. This ratio is also useful for comparing the relative risk and reward potentials of different trades.
For example, a risk-reward ratio of 1:3 means that an investor is prepared to risk losing $1 for the possible gain of $3. A risk-reward ratio of 1:1 means that the risk of loss is about the same as the potential gain.
The risk-reward ratio is a valuable analytical tool available to investors. Since no investment is genuinely risk-free, the risk-reward ratio helps calculate the potential outcomes of any investment transaction — good or bad.
Key Points
• The risk-reward ratio is a useful tool for investors, capturing potential gains against the risks involved in an investment transaction.
• Calculating the risk-reward ratio requires dividing net profits by the maximum risk of an investment, providing a straightforward evaluation of investment potential.
• Utilizing the risk-reward ratio aids in informed decision-making, helping investors assess whether potential rewards justify the risks taken, given their own risk tolerance.
• Investors demonstrate different levels of risk tolerance: conservative, moderate, and aggressive.
• Despite its utility, the risk-reward ratio has limitations. It is not predictive, and it cannot account for market volatility or external factors that may impact investment outcomes.
What Is the Risk-Reward Ratio?
As noted, the reward-to-risk ratio is a way to assess how much money an investor might gain versus how much they’re risking in order to generate that potential gain. Although the risk-reward ratio is chiefly an analytical tool, it can be particularly important for those with small portfolios, and it may be helpful to review tips on risk for new investors.
Typically, the more risk involved in an investment — when trading stocks, for example — the more ample the reward if the investment turns out to be a winner. Conversely, the less risk you take with an investment, the less reward will likely be earned on the investment.
For example, when buying bonds, investors take on relatively low risk for a relatively low return.
Compare that scenario to a stock market investor, who has no guarantees that the money they steer into a stock transaction will be intact in the future. It’s even possible the stock market investor will lose all of their investment principal if the stock turns sour and loses significant value.
Correspondingly, this investor is presumably looking at a greater reward for the risk taken when buying a stock. If the stock climbs in value, the investor is rewarded for the risk they took with the investment.
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How to Calculate Risk-Reward Ratio
The reward-to-risk ratio formula is a fairly straightforward calculation.
Risk-Reward Ratio Formula
To calculate risk-reward ratio, divide potential net profits (which represent the reward) by the cost of the investment’s maximum risk.
For instance, for a risk-reward ratio of 1:3, the investor risks $1 to hopefully gain $3 in profit. For a 1:4 risk-reward ratio, an investor is risking $1 to potentially make $4.
Example of a Risk-Reward Ratio Calculation
Let’s say an investor is weighing the purchase of a stock selling at $100 per share and the consensus analyst outlook has the stock price topping out at $115 per share with an expected downside bottom of $95 per share.
The investor makes the trade, hoping the stock will rise to $115, but hedges their investment by putting in a stop-loss order at $95, ensuring the investment will do no worse by automatically selling out at $95.
A stop loss order is a type of market order in which the order is placed with a stockbroker to buy or sell a specific stock once that security reaches a predetermined price level. The mechanism is specifically designed to place a limit on an investor’s stock position.
The investor can also lock in a profit by instructing the broker to automatically sell the stock, if it reaches its perceived apex of $115 per share.
In this scenario, the “risk” figure in the equation is $5 — the total amount of money that can be lost if the stock declines and is automatically sold out at $95 (i.e., $100 minus $95 = $5).
The “reward” figure is $15. That’s the amount of per-share money the investor will earn once the share price rises from buying the stock at $100 per share and selling it if and when the stock rises to $115 per share.
Thus, with an expected risk of 5 and an expected reward of 15, the actual risk reward ratio is 1:3 — the potential to lose $5 in order to gain $15.
Pros and Cons of the Risk-Reward Ratio
There are pros and cons to using the risk-reward ratio when investing.
As for the upsides, it’s a relatively simple formula and calculation that can help investors gauge whether their strategy makes sense.
On the other hand, it’s a relatively simple formula and calculation that may not be terribly accurate, and doesn’t necessarily deliver a lot of additional insight into a strategy. That’s something investors should take to heart, and why they may not want to only rely on risk-reward ratio to guide their overall strategy.
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Three Risk-and-Reward Investor Types
Investors have their own comfort levels when assessing risk and reward ratios with their portfolios, with some proceeding cautiously, some taking a moderate dose of investment risk, and still others taking on more risk by investing aggressively on a regular basis.
The investment portfolios you build, either by yourself or with the help of a money management professional, reflect your personal risk tolerance. When doing so, it also helps to know stock market basics.
Typically, there are three different types of investor when it comes to risk tolerance:
• Conservative investors. These investors focus on low-risk, low-reward investments like cash, bonds, bond funds, and large-company stocks or stock mutual funds.
• Moderate investors. These investors look for a blend of risk and reward when constructing their investment portfolios, putting money into lower-risk investment vehicles like bonds, bond funds, and large-company stocks and funds with more broadly based categories like value and/or growth stocks and funds, international stocks, and funds.
They may also consider a small slice of alternative funds and alternative investments like real estate, commodities, and stock options and futures.
• Aggressive investors. This type of investor may completely bypass conservative investments and elect to build an investment portfolio with higher-risk stocks and funds (like foreign stocks or small company stocks), along with higher-risk assets like gold and oil (commodities), stock options and futures, and more.
How Investors May View Risk vs. Reward
Each of the above investors recognizes the realities of risk and the potential of reward and balances them in different ways. Even conservative investors will accept a little risk to gain some reward.
For example, a conservative investor may invest in a corporate bond or municipal bond, knowing that in return for a guaranteed profit (in the form of paid interest) and upside asset protection (the bond’s principal being repaid), they take on the small risk that the bond will default.
An aggressive investor understands that by placing money in a high-risk stock, they are potentially risking some or all of the investment if the stock goes under, or significantly underperforms. In return for that risk, the more aggressive investor may reap the financial rewards of a booming stock price and a resulting major return on his investment, but there are no guarantees.
The Takeaway
The risk-reward ratio is helpful in allowing investors to get an idea of how much they stand to gain versus how much they stand to lose in a given investment situation. Any risk-reward engagement depends on the quality of the research undertaken by the investor and/or a professional money management specialist.
That research should set the proper expected parameters of the risk (i.e., the money the investor can lose) and the reward (i.e., the expected portfolio gain the investment might make.) Once the risk and reward boundaries are set, the investor can weigh the potential outcomes of the investment scenario and make the decision to go forward (or not) with the investment.
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FAQ
What is a good risk-reward ratio?
Generally speaking, a good risk-reward ratio is one that skews toward reward, rather than risk. But that range will depend on each investor’s tolerance for risk, as well as other means of assessing the potential outcome of a trade.
What is a poor risk-reward ratio?
A poor risk-reward ratio would be one that is higher or greater than 1, as that would indicate that an investment involves more risk relative to the potential reward. But again, it depends on the individual and the investment in question.
What are some things that the risk-reward ratio doesn’t take into account?
The risk-reward ratio doesn’t take several factors into account, and some of those include external and current events, market volatility, and liquidity in the markets.
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