Risk reward

Risk Reward

Risk reward, often referred to as the risk/reward ratio, is a fundamental concept in investment analysis that quantifies the prospective return an investor might achieve for every unit of risk undertaken. It is a critical metric used by investors and traders to evaluate the attractiveness of an investment decision by comparing the potential for profit against the potential for loss. This ratio helps market participants make informed choices that align with their individual risk management strategies and objectives.

History and Origin

The conceptualization of balancing risk and reward has existed informally in financial dealings for centuries, often summarized by adages such as "high risk, high reward." However, the formal mathematical framework that underpins modern risk and reward analysis emerged in the mid-20th century. A pivotal moment came with the work of economist Harry Markowitz, whose 1952 paper, "Portfolio Selection," introduced Modern Portfolio Theory (MPT). Markowitz's theory provided a quantitative method for selecting portfolios that maximize expected return for a given level of risk, or minimize risk for a given expected return. This groundbreaking work, for which he later received the Nobel Memorial Prize in Economic Sciences, established that an asset's risk and return should not be assessed in isolation but rather by its contribution to a portfolio's overall risk and return.⁴ Markowitz's insights laid the groundwork for understanding the inherent tradeoff between the two, formalizing the analytical approach to risk reward that is widely used today.

Key Takeaways

The risk reward ratio assesses the potential profit of an investment against its potential loss.
It is a core metric for evaluating investment attractiveness and aligns with various investment strategy objectives.
A lower ratio (e.g., 1:3) generally indicates a more favorable trade, implying higher potential reward per unit of risk.
Proper application requires defining clear entry, stop-loss, and take-profit points for an investment.
While a valuable tool, the risk reward ratio does not guarantee outcomes and should be used alongside other analytical methods.

Formula and Calculation

The risk reward ratio is typically expressed as the potential loss an investor is willing to take versus the potential gain they aim to achieve. While commonly stated as "reward to risk" (e.g., 3:1), the mathematical calculation for the ratio value usually involves dividing the potential loss by the potential gain.

\text{Risk/Reward Ratio} = \frac{\text{Potential Loss}}{\text{Potential Gain}}

Variables Defined:

Potential Loss: The maximum amount an investor is willing to lose on a trade, often determined by a stop-loss order. This represents the difference between the entry price and the stop-loss price.
Potential Gain: The target profit an investor aims to achieve, often defined by a take-profit order. This represents the difference between the entry price and the target price.

For example, if an investor plans to risk $100 (potential loss) to gain $300 (potential gain), the calculation would be:

\text{Risk/Reward Ratio} = \frac{\$100}{\$300} = 0.33

This results in a ratio of 0.33, often expressed as 1:3, signifying that for every $1 of risk, there is a potential $3 of reward.

Interpreting the Risk Reward

Interpreting the risk reward ratio involves understanding what different values signify in terms of an investment's attractiveness. A ratio of 1 or higher (e.g., 1:1, 2:1) suggests that the potential loss is equal to or greater than the potential gain, which is generally considered unfavorable for most investments. Conversely, a ratio less than 1 (e.g., 0.5 or 1:2, 0.33 or 1:3) indicates that the potential gain outweighs the potential loss, making the investment potentially more attractive.

Most traders and investors aim for a favorable risk reward ratio, commonly striving for at least 1:2 or 1:3, meaning they are willing to risk $1 to make $2 or $3, respectively. This approach implies that even if not every trade is profitable, a positive overall outcome can still be achieved if the winning trades sufficiently compensate for the losing ones. A favorable ratio can contribute to capital preservation by ensuring that when losses occur, they are contained relative to potential gains. This metric is instrumental in developing a disciplined trading approach.

Hypothetical Example

Consider an investor analyzing a stock currently trading at $50 per share. The investor believes the stock could rise to $65 per share within a reasonable timeframe due to positive company news (potential gain of $15 per share). To manage downside risk, the investor decides to place a stop-loss order at $45 per share, limiting potential losses to $5 per share.

Here's how to calculate the risk reward ratio:

Potential Gain: Target Price ($65) - Current Price ($50) = $15
Potential Loss: Current Price ($50) - Stop-Loss Price ($45) = $5

Using the formula:

\text{Risk/Reward Ratio} = \frac{\text{Potential Loss}}{\text{Potential Gain}} = \frac{\$5}{\$15} = 0.33

This represents a risk reward ratio of 1:3. This ratio suggests that for every $1 of risk, the investor stands to gain $3. This favorable ratio might encourage the investor to proceed with the trade, as it offers a substantial return on investment relative to the potential downside.

Practical Applications

The risk reward concept is widely applied across various financial disciplines, serving as a cornerstone for disciplined decision-making. In portfolio management, investors use it to construct balanced portfolios by assessing how different assets contribute to the overall risk and return profile. This involves strategic asset allocation to ensure that the aggregate risk exposure aligns with the desired return objectives.

For individual securities, especially in active trading or speculation, the risk reward ratio helps define entry and exit points. Traders often set predefined stop-loss orders to cap potential losses and take-profit targets to secure gains, directly implementing their desired risk reward profile. Regulatory bodies also emphasize the importance of understanding risk. For instance, the U.S. Securities and Exchange Commission (SEC) frequently highlights the need for investors to diversify their risk across various investment stages and types of assets to mitigate potential shortfalls.³ This approach implicitly leverages the risk reward principle by aiming to maximize overall portfolio returns while minimizing concentrated risk.

Limitations and Criticisms

While the risk reward ratio is a powerful tool, it has limitations and faces criticisms. One primary challenge is that it relies on potential gains and losses, which are subjective estimates. Accurately forecasting future price movements and setting realistic profit targets and stop-loss levels can be difficult, particularly in volatile markets. External factors, unforeseen events, or rapid market shifts can quickly invalidate initial risk reward assumptions.

Furthermore, the ratio itself does not account for the probability of achieving the potential gain or incurring the potential loss. A trade might have an attractive 1:3 risk reward ratio, but if the likelihood of reaching the profit target is very low, the trade may still be unprofitable in the long run. Critics also point out that the traditional risk reward framework, especially when applied in isolation, may overlook the complexities of market behavior and investor psychology. For example, investor behavior is often influenced by cognitive biases, such as loss aversion, where the pain of a loss is felt more strongly than the pleasure of an equivalent gain, potentially leading to irrational decisions despite a favorable theoretical risk reward.² FINRA emphasizes that while a higher potential return generally correlates with greater risk, this relationship is not always straightforward, and historical data should not mislead investors into thinking that there is no risk in long-term investments.¹

Risk Reward vs. Risk-Adjusted Return

While both "risk reward" and "risk-adjusted return" are vital in financial analysis, they represent distinct concepts.

Risk Reward
The risk reward ratio is a forward-looking metric that quantifies the potential upside relative to the potential downside of a specific investment or trade. It helps investors decide whether to enter a position and how much to risk, based on pre-defined price targets and stop-loss levels. It's a simple, intuitive measure focused on the proportional relationship between a planned loss and a planned profit. For example, a 1:3 risk reward ratio for a stock trade indicates that for every $1 risked, the investor aims for a $3 profit.

Risk-Adjusted Return
In contrast, risk-adjusted return is a backward-looking metric that measures an investment's historical return in relation to the amount of volatility or risk taken to achieve that return. It provides a more comprehensive view of investment performance by penalizing returns for higher levels of risk. Common risk-adjusted return measures include the Sharpe Ratio, Sortino Ratio, and Treynor Ratio, which use metrics like standard deviation to quantify risk. These ratios help evaluate the efficiency of an investment or portfolio over time, indicating how much return was generated per unit of risk taken.

The primary confusion between the two often arises because both terms relate to "risk" and "return." However, risk reward focuses on the prospective payoff for a single decision, while risk-adjusted return evaluates past performance by factoring in the actual risk endured.

FAQs

What is a good risk reward ratio?

A "good" risk reward ratio is subjective and depends on an investor's financial planning, strategy, and win rate. However, many traders aim for a ratio of 1:2 or 1:3, meaning they are willing to risk $1 for every $2 or $3 of potential gain. This allows for a higher probability of overall profitability even if not every trade is a winner.

Why is risk reward important in investing?

Understanding risk reward is crucial because it helps investors make disciplined decisions by quantifying the potential profitability of an investment relative to its downside. It encourages a systematic approach to diversification and managing capital, rather than making impulsive choices driven by emotion.

Does the risk reward ratio guarantee profit?

No, the risk reward ratio does not guarantee profit. It is a planning tool based on potential outcomes and estimates. Actual market movements can differ significantly from expectations, leading to losses even with a theoretically favorable ratio. It should be used as part of a broader analytical framework.

How does the risk reward ratio relate to Modern Portfolio Theory (MPT)?

The risk reward ratio aligns with the core principles of MPT by emphasizing the trade-off between risk and return. MPT, pioneered by Harry Markowitz, formalizes the idea that investors should seek to maximize expected returns for a given level of risk or minimize risk for a given expected return. The risk reward ratio is a practical application of this principle at the individual investment level.