Risk vs Reward Ratio
Imagine for a moment you found a way to make 100% per year in the stock market. How much risk would you be willing to accept in order to achieve such a return?
That’s where the Risk Reward Ratio (or RRR) comes into play. RRR is a concept used in finance, investing, and decision-making to assess the potential return of an investment or action relative to the associated risks involved. It is a quantitative measure that helps evaluate the potential gains against the likelihood of losses.
Suppose you had two investments under consideration. Both offering the same annual return. The Risk Reward Ratio will inform you which of the two is the safer investment. As an investor/trader we must all weigh how much risk we are willing to take to achieve the kind of returns we want.
To calculate the Risk vs. Reward you will need two numbers. The annual return of the investment being considered, and the maximum drawdown for that investment. Your annual return should be at a minimum, twice what the potentil loss is.
The Risk Reward Ratio is typically expressed as a ratio or a percentage. The numerator represents the potential gain, while the denominator represents the risk or potential loss. A higher ratio indicates that the potential reward is greater relative to the risk, whereas a lower ratio suggests that the risk outweighs the potential reward.
Let’s use the popular ETF, SPY that tracks the S&P and should achieve close to the same return as the S&P 500.
The average annual return on the S&P 500 has been a little over 7% per year. Using the Risk Reward Ratio (loss needs to be no more than 1/2 the gain) we now know that we should never risk more than 3.5% of our funds to achieve that annual return of 7%.
If you examine the results of the S&P 500 and SPY, you’ll find in any given year, you have had to risk more than 3.5%. Even worse, about once every three years you have to risk 20% of your portfolio to make 7% annually.
According to the ratio, this popular ETF is way too risky for investors and should be avoided. This assumes you can’t handle the drop in price and end up selling. The stock market has always gone back up (unlike stocks which can fold). As long as you hold and don’t give into fear, your risk goes down.
That brings up my next point. It’s important to note that the ratio is just one factor to consider when making investment decisions. Other factors such as market conditions, investment goals, time horizon, and individual risk tolerance should also be taken into account.
Investors and traders often use the ratio to determine if a trade is worth taking. A favorable ratio suggests that the potential reward justifies the potential risk, making the trade more appealing. In contrast, an unfavorable ratio may indicate that the potential reward is not sufficient to offset the potential risk, leading to a decision to avoid the trade.
For more ways to reduce risk, check out our “4 Tips To Reduce Risk“.
