How to Use the Risk-Reward Ratio in Investing

In the investment world, a reward-to-risk ratio indicates how much money an investor stands to 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.

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.

What Is the Risk-Reward Ratio?

As noted, the reward-to-risk ratio indicates how much money an investor stands to gain levied against how much they’re risking in order to generate that potential gain. This 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 money one invests — such as in high-risk stocks — the more ample the reward if the investment turns out to be a winner. On that note, it may be beneficial to review a guide to high risk stocks, too. Conversely, 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 savings account at a bank, 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.

In other words, using a savings account to accrue interest is a fairly safe investment.

Likewise, the potential 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 in interest on the deposit. If savings accounts were somewhere on an investment risk pyramid, they’d be among other relatively safe investments — low risk, but low potential returns.

Compare that scenario to a stock market investor, who has no guarantees that the money she steers into a stock transaction will be intact in the future. 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 taken when 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.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

How To Calculate Risk-Reward Ratio

The reward-to-risk ratio formula is a fairly straightforward calculation, and involves following a formula.

Risk-Reward Ratio Formula

To calculate risk-reward ratio, divide 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 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.

As an aside: A stop loss order is a type of market order in which the order that 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.

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 get a sense of whether their strategy makes sense. In that sense, it can be very useful with some basic risk management when tinkering with a portfolio.

On the other hand, it’s a relatively simple formula and calculation that may not be terribly accurate, and doesn’t necessarily deliver a whole 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.

Recommended: Guide to Risk Neutral Probability

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.

Typically, there are three different types of investor when it comes to risk:

•   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.

•   Aggressive investors. This type of investor may completely bypass conservative investments and elect to 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 more.

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), she takes on the small risk that the bond will default, and the principal and interest on the bond disappears.

An aggressive investor understands that by placing money in a high-risk stock, he is potentially risking some or all of his 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.

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 at all, and taking both risk and reward out of the equation, the investor won’t see their investment portfolio appreciate in value, and risk losing ground as economic realities like inflation, taxes, and stagnation eat into their wealth.

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Investing With SoFi

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 can 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.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

What is a good risk-reward ratio?

Generally speaking, a good risk-reward ratio is one that skews toward reward, rather than risk. If the ratio is calculated, a ratio below 1 is better, as it indicates that an investment has a bigger potential reward compared to risk.

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.

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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