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?

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.

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?

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)
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

How Live in Luxury AND Save Money

Lifestyle creep can be an unnoticed, slow moving poison in your finances. You come into some money, or get a raise, and you want to live a little! Little luxuries are fine and dandy, but can consume you if you aren’t careful and don’t have a plan to deal with them. Not to worry, I have a solution!

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...