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

You May Also Be Interested In:

The Bankers’ Beatings Begin

All of America’s banks’ profits have been hit hard. As the Fed tightens, banks should make higher net interest margins. But even as trading has thrived, investment banking is hurting. Happy Tuesday. As I was driving from Newark Airport to the Big Apple, I noticed whoever put Hudson Yards up has blocked the view of...

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...

View More By Nilus Mattive