How to Calculate Investment Risk
Dear Rich Lifer,
If a friend asked to borrow $100 and said he’d pay you back $120 in two weeks, would you take that deal?
What if instead of $120 this friend offered you $200?
That’s a 2:1 risk/reward — a ratio where a lot of professional investors start to pay attention.
My observation has been that most investors have no clue how to use risk/reward ratios correctly.
Or worse, they focus only on win/loss ratios and completely ignore risk/reward altogether.
Here’s something that might surprise you…most investors have win rates of more than 50%, but they still lose money.
How can that be?
If your trades aren’t profitable, it’s likely because your risk/reward ratio is off.
Today I’m going to show you how to fix that.
What is the Risk/Reward Ratio?
The risk/reward ratio is the profit potential of a trade relative to its loss potential.
For example, assume you found a stock you like called XYZ. You notice XYZ stock is trading at $20 a share, down from a $25 high.
If you buy now, your research tells you XYZ stock should climb back up to $25. Let’s say you have $1,000 to invest, so you buy 50 shares.
What’s your risk/reward ratio?
Before I show you how to calculate your risk/reward, it’s important to understand that risk/reward is not the same as probability.
If you took your $1,000 and played the lottery, you’d be risking $1,000 for a potential upside of winning millions.
That would be a much better risk/reward ratio than this hypothetical stock. However your probability of winning the lottery is a lot worse than playing the stock market.
So how do you calculate risk/reward?
To calculate risk/reward, you divide your net profit by the price of your maximum risk.
Going back to our example, if your stock went up to $25 per share, you’d make $5 for each of your shares for a total of $250.
Your initial investment was $1,000, so you would divide 250 by 1000 which gives you 0.25. Therefore your risk/reward for this investment would be 0.25:1.
With a low risk/reward ratio like this, most experienced investors wouldn’t give this opportunity a second look. But is it really that bad?
How to Limit Your Risk
Unless you’re an inexperienced investor, you would never expose all of your $1,000 investment.
To limit your risk, you should have a stop-loss order in place. If you set a $25 sell limit price as the upside, you might set $16 as the maximum downside.
When your stop-loss order reaches $16, you sell. Since you’ve now limited your downside, this changes your risk/reward calculation.
Your profit stays the same at $250, but your risk is now only $200 ($4 maximum loss multiplied by the 50 shares you own), or 250/200 = 1.25:1. Depending on your win/loss ratio this could be a profitable trade.
But you can limit your risk even more by raising your stop-loss price higher. If your maximum downside is $18, then you’re now only risking $2 per share or $100 loss in total.
So, 250/100 is 2.5:1, which is a good risk/reward ratio for any investor with a win/loss ratio of at least 30% or more.
Of course, this all depends on how much risk you’re willing to take. Notice I never told you to adjust the top number.
If you did your research and found that the maximum upside is $25, that’s where your upper limit should stay. Changing the top number in order to achieve a more favorable risk/reward ratio is a losing strategy.
Bringing It All Together
I hope that clears up some confusion around risk/reward ratios. To start using risk/reward calculations in your research, here’s what you do:
- Choose a stock based on your research method
- Set the upside and downside limits based on the entry price
- Calculate the risk/reward (potential profit/potential loss)
- If your risk/reward ratio is below your threshold, increase your downside target
- If you can’t achieve the ratio you want, pick a different stock
Once you run through this exercise a few times, you’ll see that finding good trades is both art and science. Professional investors sometimes spend hours combing through charts every day looking for trades that fit their risk/reward profile.
The more thorough you are with your research, the better your odds are of trading profitably. Lastly, sometimes the upside target will change as you’re holding a stock. If this skews your risk/reward outside of your comfort zone, don’t hesitate to exit the trade. Use your risk/reward calculation to your advantage.
To a richer life,