Risk vs Reward

Risk versus Reward

In the financial world, risk means uncertainty and the possibility of loss. The reward is the profit returned from an investment.

Risk, in itself, is not a bad thing. The general rule of thumb is that you shouldn't take a great risk without the potential for a great return.

Defining the risk vs reward ratio: how it is used to improve investment performance

When you make an investment, regardless of the investment vehicle, you accept the risk of loss. In exchange for accepting that risk, your investment has the potential to generate profits.

Beginning investors are often told that the level of risk they accept will determine the potential reward they can hope to achieve.

Unfortunately, that is not always the case.

Some high-risk investments have very little potential for improvement, while some low-risk investments have the potential to generate significant returns.

To determine which investments in the stock market offer low risk and higher returns, successful investors use what is known as the risk-reward ratio as part of their investment strategy.

Understanding the risk-reward relationship

The risk-reward ratio is a mathematical indicator that compares the level of risk that an investor assumes when making an investment with the expected return on that investment.

For example, let's say someone borrows $100 from you today and promises to give you $110 tomorrow. If you make the loan, you are taking the risk of losing the $ 100 you loaned in exchange for earning $10 in profit. In this case, the risk-reward ratio would be 0.1 to 1.

If you trust the borrower, the risk will be worth it, but if you didn't know the person, you probably wouldn't risk $100 to earn $10.

However, if that risk-to-reward ratio increases to 1 to 1, and the person offers to pay you $200 tomorrow for the same $100 loan, it may be worth considering risking the original $100. 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're following a stock that recently traded at $75 a share, but has fallen to $67 a share. His research suggests that the price will climb back to $75 over the next month, and he believes the stocks are in line with his investment goals. Therefore, it may be a good idea to add stocks to your investment portfolio.

In the example above, the potential payoff is the high price of $75 minus the low price of $67 or $8.00 To buy the stock, you are risking $67.00 So, divide the potential return of $ 8 by the price of the shares. Shares of $67 gives you a risk-reward ratio of approximately 0.119 to 1.

Most savvy investors would not flinch from an investment with such high market risk and minimal potential rate of return. The metrics just don't point to a winning investment opportunity.

For the 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, the market risk is relatively low compared to the high returns that the investor has the potential to achieve.

Putting the risk-reward ratio in perspective

A risk-reward ratio is a comprehensive tool that gives you a clear view of the level of risk you accept when making an investment.

On the other hand, like any other indicator, the risk-reward ratio is not a perfect indication of your objective, the level of risk of an investment. This is why:

The Risk-reward ratio does not measure the probability

The risk-reward ratio is specifically fixed only on the amount of money you can earn and the amount of money you can lose. These factors should never be the only measure 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 extremely high reward potential.

However, the probability that your lottery ticket will be the winner of the jackpot is extremely low. Therefore, while the risk-reward investment portfolio of a lottery ticket is attractive, a portfolio of lottery tickets is unlikely to help you achieve your financial goals.

When evaluating the risk-reward profile of an investment you are considering, it is important to consider other factors in determining whether to pull the trigger. In particular, once you find an investment opportunity that has a favorable risk-reward profile, it is important to dive into the historical growth of the company.

After all, a growth story is generally a strong indicator of future performance. Look for growth in:

• Income. Steady 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 profits have a proven ability not only to sell their products but to do so profitably. Steady earnings growth shows a successful effort to improve margins and increase profitability, which is likely to continue.

• Free cash flow. Positive free cash flow, meaning more money comes into the business than it goes out, is a sign of financial stability. The growing free cash flow suggests that the company is on track to continue on an upward trajectory.

• Dividend payments. Finally, as earnings grow, dividend-paying stocks should steadily increase the dividend payments they make. This is yet another sign of financial stability and strong potential for future growth.