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.
In the investment world, a reward-to-risk ratio indicates how much money an investor can gain against how much they’ll have to risk. For example, a reward-to-risk ratio of 6:1 means that for every dollar an investor stands to lose, they have the potential to gain $6.
How Risk-reward Ratios Work
Typically, the more money one invests—such as in high-risk stocks—the more ample the reward if the investment is a winner. Conversely, the less risk you take with an investment, the less reward will likely be earned on the investment.
The less risk you take with an investment, the less reward will likely be earned on the investment.
In addition, the investment itself directly impacts the risk-reward ratio. For example, if an individual parks his money in a bank savings account, the risk of losing that money is significantly low, as bank deposits are insured, and there’s little chance the bank saver will lose any money on the deal.
Likewise, the investment reward for parking cash in a bank savings account is also low. Bank savings accounts offer routinely low-interest rates earned on insured bank deposits, meaning the individual will likely earn little interest.
Compare that scenario to a stock market investor, who has no guarantees that the money she steers into a stock transaction will remain intact. It’s even possible the stock market investor will lose all of her investment principal if the stock turns sour and loses significant value.
Correspondingly, this investor is presumably looking at a greater reward for the risk of buying a stock. If the stock climbs in value, the investor is rewarded for the risk she took with the investment, as she’ll likely earn significantly more money on the stock deal than the bank saver will make on the interest earned on his bank deposit.
How Risk Reward Ratio is Calculated
The reward-to-risk ratio formula is straightforward, as follows:
Divide net profits (representing the reward) by the investment’s maximum risk cost.
For a risk-reward ratio of 1:3, the investor risks $1 to gain $3 in profit, hopefully. For a 1:4 risk-reward ratio, an investor is potentially risking $1 to 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 his investment by putting in a “stop-loss” order at $95, ensuring his investment will do no worse by automatically selling out at $95. The investor can also lock in a profit by instructing the broker to automatically sell the stock once it reaches its perceived apex of $115 per share.
(A stop loss order is a stock transaction 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 limit an investor’s stock position.)
In this scenario, the “risk” figure in the equation is $5—the total money 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 to gain $15.
Three Risk-and-Reward Investor Types
Investors have their comfort levels when assessing risk and reward ratios with their portfolios, with some proceeding cautiously, some taking a moderate dose of investment risk, and others taking on more risk by investing aggressively regularly.
The investment portfolios you build, either by yourself or with the help of a money management professional, reflect your personal risk tolerance.
Typically, there are three different types of investors when it comes to risk:
• Aggressive investors. This type of investor may bypass conservative investments and fill his investment portfolio with higher-risk stocks and funds (like overseas stocks or small company stocks), along with higher-risk assets like gold and oil (commodities), stock options and futures, and even digital currency exchange.
• Conservative investors. These investors focus on low-risk, low-reward investments like cash, bonds, bond funds, and large-company stocks or stock 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, along with a small slice of alternative funds and investments like real estate, commodities, and stock options and futures.
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 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 is repaid), she takes on the small risk that the bond will default. The principal and interest on the bond disappear.
An aggressive investor understands that placing money in a high-risk stock is potentially risking some or all of his investment if the stock goes under or significantly under performs. In return for that risk, the more aggressive investor may reap the financial rewards of a booming stock price and a resulting significant return on his investment.
In either scenario, the investor gauges the risk-reward ratio and acts accordingly, betting that the outcome will work out in their favor and that the risk outweighs the reward.
By not acting and taking the risk and reward out of the equation, the investor won’t see their investment portfolio appreciate and risk losing ground as economic realities like inflation, taxes, and stagnation consume their wealth.
The Takeaway
Zero risk doesn’t exist in the investment world. When money is moved around the financial markets, some margin of risk is involved.
Zero risk doesn’t exist in the investment world.
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 can make.)
Once the risk and reward boundaries are set, the investor can weigh the potential outcomes of the investment scenario and decide to go forward (or not) with the investment.
