When you make an investment, regardless of the investment vehicle, you’re accepting a risk of loss. In exchange for accepting that risk, your investment has the potential to generate profits.
Beginner investors are often told that the level of risk they accept will determine the potential reward they can expect to achieve.
Unfortunately, that’s not always the case.
Some high-risk investments come with very little upside potential, while some low-risk investments have the potential to generate significant returns.
In order to determine which investments in the stock market offer low risk and higher returns, successful investors use what’s known as the risk-reward ratio as part of their investment strategy.
Understanding the Risk-Reward Ratio
The risk-reward ratio is a mathematical gauge comparing the level of risk an investor takes when making an investment to the expected return of that investment.
For example, let’s say someone asks you to borrow $100 today and promises to give you $110 tomorrow. If you give the loan, you are assuming the risk of losing the $100 you loaned out in exchange for earning $10 in profits. In this case, the risk-reward ratio would come in at 0.1-to-1.
If you trust the borrower, the risk would be worth it, but if you didn’t know the person, you probably wouldn’t risk $100 in order to make $10.
However, if that risk-reward ratio increased to 1-to-1, and the person offered to pay you $200 tomorrow for the same $100 loan, risking the original $100 may be worth consideration. The amount at risk is the same, but the opportunity to double your money will likely be intriguing.
The risk-reward ratio works the same in the stock market.
Let’s say you are following a stock that recently traded at $75 per share but has fallen to $67 per share. Your research suggests that the price will climb back to $75 over the next month or so, and you believe the stock is in line with your investment objectives. So, it may be a good idea to add the stock to your investment portfolio.
In the above example, the potential reward is the high price of $75 minus the low price of $67, or $8. In order to buy the stock, you are risking $67. So, dividing the $8 potential return by the $67 stock price gives you a risk-reward ratio of about 0.119-to-1.
Most savvy investors wouldn’t bat an eye at an investment with such high market risk and minimal potential rate of return. The metrics simply don’t point to a winning investment opportunity.
For most successful investors, a risk-reward ratio of 2-to-1 is acceptable and the goal is to reach 4-to-1. At these ratios, market risk is relatively low compared to the high returns the investor has the potential to achieve.
Using Stop-Losses to Reduce the Risk Profile
Investors generally look for investments that have a strong reward profile and a minimal risk profile.
Although there is nothing you can do to force a stock to rise higher than the stock market will allow, there are tools that allow you to reduce the risk profile of your investments and limit the potential losses associated with any stock market investment.
A stop-loss is a tool that gives investors exposure to the potential investment return they expect to see, while safeguarding them against significant losses, thus reducing the risk profile associated with the investment and shielding them from high levels of market volatility.
You can place a stop-loss order with your broker that will automatically sell all or part of your position in a given security if it falls below a specific price point, thus placing a cap on the potential downside.
For example, say you plan on making an investment in a stock that costs $100 that you expect will rise to $110 in the short term. Risking the entire $100 to make $10 would be an unwise investment decision at a risk-reward ratio of 0.1-to-1. In order to adjust the investment risk, you can put a stop-loss in place at $90.
Should the price of the stock fall to $90, your position will be sold and you will accept a loss of $10. In this case, the loss realized was $10, but the potential gain was $10. As a result, the risk-reward ratio on the investment was 1-to-1, representing a lower risk.
Although 1-to-1 is better than 0.1-to-1, it’s still not the ideal risk-reward ratio. Setting a stop-loss at $95, on the other hand, gives you $10 potential gain for just $5 or potential risk, getting you to a more favorable 2-to-1 risk-reward ratio.
Considering this, when making investments, it’s important that you calculate the risk-reward ratio and adjust the stop-loss on your investments to protect your investment portfolio from wide fluctuations in the stock market.
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Putting the Risk-Reward Ratio Into Perspective
The risk-reward ratio is a comprehensive tool that gives you a clear view of the level of risk you accept when you make an investment.
On the other hand, like any other indicator, the risk-reward ratio isn’t a perfect indication of its target, the level of risk of an investment. Here’s why:
Risk-Reward Ratio Doesn’t Measure Probability
The risk-reward ratio specifically looks only at the amount of money you stand to gain and the amount of money you stand to lose. These factors should never be the sole measures of whether an asset is worth adding to your investment portfolio.
Think about it: Blindly following the risk-reward ratio would tell you that buying a lottery ticket is a low-risk investment with an extremely high reward potential.
However, the probability of your lottery ticket being the jackpot winner is vanishingly low. So, while the investment risk-reward portfolio of a lottery ticket is appealing, a portfolio of lottery tickets isn’t likely to help you achieve your financial goals.
When gauging the risk-reward profile of an investment you’re considering, it’s important to consider other factors to determine whether to pull the trigger. In particular, once you find an investment opportunity that has a favorable risk-reward profile, it’s important to dive into the historic growth of the company.
After all, a history of growth is generally a strong indication of future performance. Look for growth in:
- Revenue. Consistent revenue growth suggests that the company’s sales and marketing efforts are effective and should continue to be so in the future.
- Earnings. Companies that generate positive earnings have a proven ability not only to sell their products but to do so in a profitable way. Consistent earnings growth shows a successful effort to improve margins and increase profitability, which will likely continue ahead.
- Free Cash Flow. Positive free cash flow — meaning that more money is flowing into the business than flowing out — is a sign of financial stability. Growing free cash flow suggests that the company is on track to continue on an upward trajectory.
- Dividend Payments. Finally, as profits grow, dividend-paying stocks should consistently increase the dividend payments they make. This is yet another sign of financial stability and strong potential for future growth.
Your Risk Tolerance Is Uniquely Yours
Every investor has their own level of risk tolerance.
Beginner investors are often told to use investing strategies like diversification and asset allocation to make your level of market risk match your risk tolerance. However, the risk-reward ratio can be used to achieve the same goal.
In general, a risk-reward ratio of 2-to-1 is acceptable, and investors are ultimately looking for 4-to-1 opportunities. However, you don’t have to follow the herd in the stock market.
Your investment decisions are your own and should reflect your unique financial goals and personal risk tolerance.
If you want to walk on the wild side and accept a higher level of risk, that’s completely your decision to make. The opposite is also true. If you’re not comfortable with a 2-to-1 risk-reward profile, adjust your stop-loss upward to match your risk tolerance.
The most important takeaway is that your investment decisions are yours to make. Although financial experts will try to sway your decisions in one way or another, nobody knows you like you.
Don’t get sucked into following the status quo for fear of loss, out of fear of missing out, or in a pursuit driven by blind greed. Always make sure that your investment decisions are your own.
Risk-Reward Is an Objective Measure
The risk-reward ratio is driven by the cold numbers that make it up, nothing else. The calculation is a completely objective measure.
It doesn’t care what products the company represented by the investment sells, it doesn’t care who manages the company, and it reflects nothing about any other fundamental measure. The risk-reward ratio only reflects the largest potential gain and the largest potential loss.
When making investment decisions, it’s important to pay attention to a wide range of fundamental factors, including:
- Financial Data. Before making an investment, prospective investors should look into the company’s financial data, specifically paying attention to price-to-earnings ratio, price-to-sales ratio, revenue, debt, net assets, operating costs, cash and cash equivalents, and free cash flow.
- Product. Take time to research the company’s product or service. What problem does it solve? Is there already an established market for the product or service? Does the product offer something that no other product on the market can provide? These questions should be answered before making any investment decisions.
- Competition. Competition can greatly hamper a company’s ability to generate sales. Before making a decision to invest, do some market research to get an understanding of the competition the company is up against and get an understanding of where the company stands within its market.
- Innovation. The best investments tend to be fueled by innovation. Ultimately, the leader of a market today may not be the leader tomorrow. Companies like Google, Apple, and Facebook have maintained leadership positions through consistent innovation.
- Economic Moat. Investor Warren Buffett often talks about an economic moat. Essentially, this is a company’s durable competitive advantages and intellectual property that make it impossible for competitors to compete. A company with a strong economic moat has a product that offers features nobody else can provide. For example, according to Techcrunch, Apple has more than 2,400 patents, building an economic moat that even the corporate equivalent of a battleship couldn’t breach.
- Market Size. It takes more than a great product and an economic moat to be successful. For example, a company may sell the best lead balloon on the market, but there’s not much demand for those, so that company isn’t going to be very successful. Before making an investment decision, make sure that the target market addressed by the company is large enough to support significant growth.
Risk-reward ratios are a great way to gauge an investment’s risk and its potential to put money into your pocket. They also provide investors with a valuable tool when setting stop-losses on their investments.
However, gauging the risk-reward profile is far more intensive than simply looking into the risk-reward ratio. Because the ratio is an objective measure of the level of risk an investment comes with, it doesn’t take fundamental factors or your probability of being right into account.
As a result, in order to get a true understanding of the market risk associated with an investment you make, whether short-term or long-term, it’s important to perform detailed research, including various fundamental factors.
Nonetheless, by paying close attention to the risk associated with the investments you make and comparing them to the potential profits you may achieve from the investment, you’ll make wiser, more educated investment decisions.
As is always the case, educated investment decisions have a much higher probability of success.