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: 

  1. Choose a stock based on your research method
  2. Set the upside and downside limits based on the entry price
  3. Calculate the risk/reward (potential profit/potential loss) 
  4. If your risk/reward ratio is below your threshold, increase your downside target
  5. 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,

Nilus Mattive

Nilus Mattive

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Nilus Mattive

Nilus is the editor for the daily e-letter The Rich Life Roadmap and a Paradigm Press analyst.

Nilus began his professional career at Jono Steinberg’s Individual Investor Group, where he published his original research through a regular investment column. Later, he worked for a private equity business and spent five years editing Standard and Poor’s...

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