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Understanding Risk vs Reward

 

Article Last Updated: 28 January 2021

Risk and reward are both fundamental aspects of investing, and a sound understanding of the relationship between the two is essential for success. No matter how you are investing, there will always be risks, and by weighing these against the potential reward you can determine whether a risk is really worth it.

The risk/reward ratio is an important risk management tool that helps to create a clear picture of whether or not a venture is likely to pay off. It is only an effective mechanism for understanding risk however, should be considered alongside other factors.

What is the risk/reward ratio?

small bags labelled risk and reward balancing equally

Image Source: Getty Images

As the name suggests, this ratio considers risk vs reward, expressing projected benefits compared with the investment risk. Put simply, for each dollar you risk it illustrates the potential return. For instance, a ratio of 1:2 indicates the potential to make $2 for every dollar invested. Meanwhile, 1:6 shows a prospective return that’s six times the dollar value of the money initially risked.

The underlying purpose of this ratio is to assist investors in managing the capacity to lose money on particular trades. There are ways to mitigate the risk and reduce your risk/reward ratio. 

How the risk/reward ratio works

To be effective, the ratio should be used in combination with another risk minimisation tool such as a stop-loss order (a directive with the broker to sell if the stock drops to a particular price point). This way, you can be certain about the risk from the outset.

Imagine you buy 50 shares of company ABCD at $25, with a stop-loss order that kicks in at $20 (ensuring a maximum loss of $250 on this trade, at an investment risk of $5 per share). If you determine this stock has the potential to reach $40, there is a $15 reward for every $5 that is risked, amounting to a ratio of 1:3. Without the stop-loss order, the entire investment of $1,250 is at stake, with a ratio of 5:3. However, by reducing the risk down to $250 for the potential of $750, the ratio now becomes 1:3.

The ideal ratio is up to the individual and will vary depending on your trading strategy. Deciding where to fix your risk vs reward measure is basically a matter for individuals to trial, determining what works best for you. However, many analysts recommend an optimal ratio of around 1:3.

Understanding risks

When it comes to investing, the mantra of “the bigger the risk, the greater the return” is not necessarily the case. Approaching your portfolio with just this in mind fails to consider individual factors that are vital to your ongoing investment success. Before calculating the investment risk against potential returns, you must appreciate your own risk tolerance as the degree of exposure that suits one person will be quite different from the next.

By assessing your risk profile, you will be able to evaluate just how much to risk regardless of any likely reward. To test out your own risk-tolerance, try this quiz.

Carrying risk

Investment risk is inevitable, so it’s important to go in with your eyes open. There are several possibilities to consider when deciding whether it’s worth carrying a risk. For instance, an investment might not keep up with inflation, meaning the true value of any reward is effectively negated (this possibility is higher for cash equivalent investments, such as treasury or municipal bonds). Similarly, consider the fees or other costs associated with your investments. If these are high, returns will be reduced accordingly.

You should also ponder the purpose of your portfolio. Think about why you are investing and whether the anticipated rewards will be enough to meet that goal. For instance, if you are planning for retirement, make sure you don’t come up short with returns that are insufficient for your future needs.

Finally, reflect on the consequences of losing your principal on an investment: what would it mean to lose everything you ventured? Weighing this up gives a clear indication about the level of exposure you are comfortable with and will help shape your risk strategy.

How to reduce risk

Each person’s risk profile is going to be entirely different based on individual factors including how you feel about the amount at stake. As a bottom line, risk shouldn’t be so large that it keeps you up at night, so only ever venture an amount that you can handle losing.

Also, contemplate how soon you will need your money. With longer-term goals, conservative tactics are likely to suit, while short-term strategies lead inherently to a more risky approach.  

Understanding risk is the key to reducing and managing it. This includes knowing how to use minimisation tools such as the risk/reward ratio while weighing up other individual factors. That way, you’ll be well-armed with information and investing with your eyes wide open.

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