Risk vs Reward Ratio
Imagine for a moment you found a way to make 100% per year in the stock market. If you could just do it seven times, did you know that $10,000 would grow to $1 MILLION DOLLARS?
How much risk would you be willing to accept in order to achieve the million dollar goal? If things went bad when do you say enough is enough?
As an investor/trader we must all weigh how much risk we are willing to take to achieve the kind of returns we want. Here at Stocklocater.com I have developed an Index Trading Strategy which has averaged 60% annually (Dec 2008 thru Dec 2020), but it does come with some risk. Is the risk too risky for the reward? The Risk Reward Ratio will tell you.
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.
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.
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 10%. Using the Risk Reward Ratio we now know that we should never risk more than 5% of our funds to achieve that annual return of 10%.
If you look at the results of the S&P 500 and SPY, you’ll find in any given year, you have had to risk more than 5. Even worse, about once every three years you have to risk 20% of your portfolio to make 10% annually.
According to the Risk Reward Ratio, this popular ETF is way too risky for investors and should be avoided.
Then you have a trading strategy like my Index Trading System. With an average 74% annually (based on the most recent 3 year period). According to the Risk Reward Ration you should NEVER have to risk more than 37% of your portfolio.
The Index Trading Systems biggest drop in the last three years was only 29%, well within the ratio making this a better return on your investment.
Risking 20% to gain 10% or risk 29% to gain 74%. Big difference in returns, not mush different in risk. Now you can use the Risk vs Reward Ratio to make smarter trading decisions.