What is the risk-reward ratio?
The risk-reward ratio is a mathematical calculation used by investors to measure the expected gains of a given investment against the risk of loss.
Risk-reward ratio is typically expressed as a figure for the assessed risk separated by a colon from the figure for the prospective reward. Usually, the ratio quantifies the relationship between the potential dollars lost should the investment or action fail versus the dollars realized if all goes as planned (reward). A risk-reward ratio of 1-to-3, for example, would signify that for every dollar risked, there's a $3 potential profit or reward.
Investors use risk-reward ratios to help them determine which investments to make. Specifically, investors use the risk-reward ratio to determine the viability of a given investment. The risk-reward ratio can also help investors measure one potential investment against another, comparing the amount of risk they assume for each investment against each investment's expected returns.
While the acceptable ratio can vary, trade advisers and other professionals often recommend a ratio between 1-to-2 and 1-to-3 to determine a worthy investment.
It's important to note that some use the ratio in reverse, that is, depicting a reward-risk ratio. It similarly calculates the potential reward (net profit) against the potential risk (amount that could be lost). And it presents those as a mirror image of the risk-reward ratio: A reward-risk ratio of 3-to-1 indicates a $3 potential reward for every $1 risked.
Who uses the risk-reward ratio?
The risk-reward ratio is most commonly used by stock traders, investors and others in financial services to evaluate financial investments such as stock purchases. They sometimes limit risk by issuing stop-loss orders, which trigger automatic sales of stock or other securities when they hit a specific value. Without such a mechanism in place, risk is potentially unlimited, which renders the risk-reward ratio incalculable.
The ratio is also used by project managers and others involved in project portfolio management (PPM).
The risk-reward ratio is used in PPM to quantify the potential risks and benefits of a project. Project leaders use the ratio to assess the feasibility of the project as a whole, as well as for assessing specific components of the project.
Project management leaders also use a risk-reward ratio to choose one investment over another. A project that has the same expected return as another project but has less risk is usually deemed the better choice.
Risk vs. reward
Nearly all investments come with some level of risk; few, if any, can guarantee a return (or reward). The same is true of projects, which require an investment of resources to complete a task or endeavor that offers potential profits or benefits upon completion.
In a risk-reward ratio, risk is the amount of money that could be lost in the investment. In a stock purchase, that amount is the actual capital value, or the actual dollar amount, that could be lost.
In a project scenario, risk represents the value of resources being put toward the project. The reward is the monetary value of the gains that could be reaped from completing the project.
How does the risk-reward ratio work?
As previously stated, the risk-reward ratio allows investors to evaluate the level of risk they must accept against the potential returns they could achieve.
In this way, the risk-reward ratio gives investors a level of visibility into each investment's potential for loss against its potential for gains.
So, a risk-reward ratio of 1-to-1 indicates that the investor faces the possibility of losing the same amount of capital that they stand to gain through positive returns.
Each investor can set their threshold for acceptable risk. A more risk-tolerant investor may be willing to accept a ratio that indicates a higher level of risk for the same level of reward, while a risk-averse investor may consider a 1-3 ratio as not worth the investment.
Win rate and the risk-reward ratio
Among stock traders, a win rate reflects how many of the total number of trades made during a prescribed period of time are profitable. For example, if you have 15 profitable trades out of a total of 20 trades a day, your daily win rate is 15 out of 20, or 75%. According to authorities such as Investopedia, a win rate above 50% is usually considered good. A high win rate, however, does not necessarily indicate you've made money, as the losses of the bad trades could exceed the profits from the winning trades. That is where the risk-reward ratio comes in: It calculates your trades' potential loss versus the potential profit.
How do you calculate risk and reward?
Here's how to calculate a risk-reward ratio: Divide the amount you could profit (that's the reward) by the amount you stand to lose (that's the risk).
So if you bought a stock for $100 and plan to sell it when it hits $200, the net profit would be $100. If you are willing to risk the entire investment, then the value of your risk is $100. So 100 divided by 100 is 100/100 or 1-to-1 -- meaning the risk and reward are equal.
Consider the same investment with a stop-loss at $50, but with the same expected profit of $100. You are willing to risk $50 to make double that. That's 50 for the risk, 100 for the reward, or 50/100, which is .5-to-1. However, risk is typically represented as 1 in the risk-reward ratio, so .5-to-1 is expressed as 1-to-2.
Examples of the risk-reward ratio in use
Stop-loss order. As noted above, a stop-loss order is an automated trigger often used in making a risk-reward calculation. The investor puts it in place, with the order to sell the investment if it falls to a specific value. A stop-loss order essentially puts a floor on the amount of loss an investor is willing to take before selling an investment.
When using a stop-loss order, the amount of the loss the investor is willing to take is the amount used to calculate the risk-reward ratio rather than the full dollar amount invested.
Probability. The risk-reward ratio does not take into account other factors that impact investment decisions. Most notably, the ratio does not consider the probability of an investment paying off.
Take, for example, a $1,000 investment that could return a $1,000 gain, but the chances of that investment successfully delivering any returns is very low (perhaps there's only a 10% chance). The risk-reward ratio at 1-to-1 may indicate a low risk, but the risk is much higher when considering the probability.
Similarly, some projects may have a low probability of failing but are coupled with a low potential return on investment (ROI). Projects with more unknown factors may have a higher probability of failure but at the same time offer a significantly higher return if they are successful. Companies typically distribute their risk by investing in projects that fit in both categories. The ideal is a project with a low risk-reward ratio -- little risk of failure and a high potential for reward. However, that type of project tends to be rare.
Benefits and limitations of using risk-reward ratio
The risk-reward ratio helps investors (as well as project leaders) with risk management by doing the following:
- Manage their risks by giving them a tool to evaluate and express the potential risk.
- Evaluate risks and rewards in an objective manner, as the risk-reward ratio -- a mathematical calculation -- removes subjective elements from the evaluation.
- Quickly recalculate risks against rewards if dynamics -- and values -- change.
The following are some drawbacks of the risk-reward calculation:
- It does not consider probability.
- The ratio depends upon the quality of the investor's research and ability to gauge risk.
- The risk-reward ratio does not incorporate other potential factors and calculations including, for example, the possibility in making trades that the stock does not fluctuate.
So while the risk-reward ratio can help calculate and compare investment risks, the figure in and of itself is not considered adequate for determining worthwhile investments.