Risk-Reward Ratio

The risk-reward ratio is a metric used by investors and traders to compare the potential risk of a financial investment to its potential reward. This ratio helps determine whether an investment’s potential return is worth the risk involved. It is calculated by dividing the amount an investor stands to lose if the price moves in the unexpected direction (risk) by the amount of profit they expect to make when the price moves in the expected direction (reward).

Understanding the risk-reward ratio 1.01

Investment decision-making

The risk-reward ratio is a critical tool for making informed investment decisions. It helps investors evaluate the potential profitability of an investment relative to its risk.

Risk management

Understanding the risk-reward ratio enables investors to manage their risk more effectively. It helps in setting stop-loss and take-profit levels, which are essential for protecting investment capital.

Portfolio optimisation

By evaluating the risk-reward ratios of different investments, investors can optimise their portfolios. This ensures a balanced mix of high-risk, high-reward and low-risk, low-reward investments.

Financial planning

The risk-reward ratio is integral to financial planning, as it aligns investment choices with an individual’s risk tolerance and financial goals.

Maximising returns

Using the risk-reward ratio helps investors identify opportunities where the potential reward justifies the risk, thereby maximising returns.

Calculating the risk-reward ratio

The risk-reward ratio is calculated using the following formula:

Risk-Reward Ratio = Potential Loss (Risk) / Potential Gain (Reward)

Example

Consider an investor who is considering buying a stock priced at $50 per share. They set a stop-loss order at $45, meaning they are willing to risk $5 per share. They have a target price of $60, indicating a potential gain of $10 per share. The risk-reward ratio is calculated as follows:

Risk-Reward Ratio = $5 / $10 = 0.5

This means that for every dollar of risk, the investor expects to gain two dollars.

Key components of the risk-reward ratio

Potential loss (risk)

Potential loss is the amount an investor is willing to lose on an investment. It is determined by setting a stop-loss level, which is a predetermined price at which the investor will exit the investment to prevent further losses.

Potential gain (reward)

Potential gain is the amount an investor expects to make from an investment. It is determined by setting a target price, which is the price at which the investor plans to sell the investment to realise a profit.

Risk tolerance

Risk tolerance is an individual’s ability and willingness to endure financial loss. It varies from person to person and influences the acceptable risk-reward ratio for different investors.

Pros and cons of the risk-reward ratio

Pros of risk-reward ratio

• Informed decisions: Helps investors make informed investment decisions by comparing potential risks and rewards.
• Risk management: Assists in setting stop-loss and take-profit levels, thereby managing risk effectively.
• Portfolio optimisation: Facilitates the optimisation of investment portfolios by evaluating and balancing different investments.
• Maximising returns: Identifies investment opportunities where potential rewards justify the risks, maximising returns.
• Alignment with goals: Aligns investment choices with individual risk tolerance and financial goals.

Cons of risk-reward ratio

• Simplification: The risk-reward ratio simplifies complex investment decisions, potentially overlooking other important factors.
• Market unpredictability: Market conditions can change rapidly, making it difficult to accurately predict potential risks and rewards.
• Subjectivity: Determining stop-loss and target price levels can be subjective, leading to inconsistent risk-reward assessments.
• Excludes other factors: The ratio does not consider other important factors such as market trends, economic conditions, and company performance.

Applications of the risk-reward ratio

Stock trading

Traders use the risk-reward ratio to evaluate individual trades, setting stop-loss and take-profit levels to manage risk and maximise profits.

Investment analysis

Investors use the ratio to compare different investment opportunities, ensuring they choose investments with favourable risk-reward profiles.

Portfolio management

Portfolio managers use the risk-reward ratio to balance portfolios, combining high-risk, high-reward investments with lower-risk options.

Financial planning

Financial planners use the risk-reward ratio to align investment strategies with clients’ risk tolerance and financial goals, ensuring a suitable balance of risk and reward.

Real estate investment

Real estate investors use the ratio to evaluate property investments, comparing potential rental income and appreciation against the risks of vacancy, maintenance costs, and market fluctuations.

Risk-reward ratio in action

Consider an investor in Melbourne evaluating two stocks:

1. Stock A: Priced at $100, with a stop-loss set at $90 and a target price of $130.
   • Potential loss (risk): $100 – $90 = $10
   • Potential gain (reward): $130 – $100 = $30
   • Risk-reward ratio: 10 / 30 = 0.33
2. Stock B: Priced at $50, with a stop-loss set at $45 and a target price of $60.
   • Potential loss (risk): $50 – $45 = $5
   • Potential gain (reward): $60 – $50 = $10
   • Risk-reward ratio: 5 / 10 = 0.5

By comparing the risk-reward ratios, the investor sees that Stock A has a lower ratio (0.33) compared to Stock B (0.5), indicating a potentially more favourable investment in terms of risk and reward.