If you're new to investing, you may have heard the term "risk to reward ratio" thrown around. But what does it actually mean, and how can it help you make better investment decisions?
What is the Risk to Reward Ratio?
The risk to reward ratio is a way of measuring the potential reward of an investment compared to its potential risk. It's a calculation that helps investors assess whether an investment is worth pursuing, based on the amount of potential profit compared to the amount of potential loss.
How to Calculate the Risk to Reward Ratio
The risk to reward ratio is calculated by dividing the potential profit of an investment by the potential loss. For example, let's say you're considering investing in a stock that has the potential to increase in value by $20 per share, but also has the potential to decrease in value by $10 per share. The risk to reward ratio in this scenario would be 2:1 ($20 potential profit divided by $10 potential loss).
Examples of the Risk to Reward Ratio in Action
Let's say you're considering two different investments: a high-risk, high-reward stock and a low-risk, low-reward bond. The stock has the potential to increase in value by 50% but also has the potential to decrease in value by 25%. The bond has the potential to increase in value by 5% but only has the potential to decrease in value by 2%.
If you calculate the risk to reward ratio for each investment, you'll get the following:
- High-risk, high-reward stock: 2:1 (50% potential profit divided by 25% potential loss)
- Low-risk, low-reward bond: 2.5:1 (5% potential profit divided by 2% potential loss)
In this scenario, the low-risk, low-reward bond actually has a higher risk to reward ratio than the high-risk, high-reward stock. This means that the bond is a better investment choice if you're looking for a higher potential profit compared to potential loss.
Another example could be if you're considering two stocks: one with the potential to increase in value by $10 per share and the potential to decrease in value by $5 per share, and another with the potential to increase in value by $5 per share and the potential to decrease in value by $1 per share. The risk to reward ratio for each investment would be as follows:
- First stock: 2:1 ($10 potential profit divided by $5 potential loss)
- Second stock: 5:1 ($5 potential profit divided by $1 potential loss)
In this case, the second stock has a higher risk to reward ratio, meaning that it's a better investment choice if you're looking for a higher potential profit compared to potential loss.
The risk to reward ratio is an important concept to understand when making investment decisions. By calculating the potential profit and potential loss of an investment and comparing the two, you can determine whether an investment is worth pursuing. Keep in mind that a higher risk to reward ratio doesn't necessarily mean an investment is better, as it ultimately depends on your investment goals and risk tolerance. However, by using the risk to reward ratio as a tool in your investment decision-making process, you can make more informed choices and potentially increase your chances of success.
