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The risk-reward ratio is a calculation made by investment traders to assess how risky a transaction is before buying into it. Calculating the ratio is usually rather straightforward, requiring only the amount of money at stake, the expected reward, and the potential losses. The main goal of the ratio is to provide investors with a numerical representation of whether potential investments are worth the cost. Investors who take to the time to make the calculation can avoid transactions that may seem good on the surface, but are likely to lead to great losses over time.
Understanding the relative risk of a financial transaction is generally considered essential to success in the investment market, whether in stocks, bonds, or indexed funds. While some investors have luck blindly selecting transactions, this practice is more akin to gambling than reasoned investing. Savvy investors universally seek to understand how the projected reward compares to the risk required to get there. This is the goal of the risk-reward ratio.
The risk-reward ratio is usually expressed numerically, based on currency units. For example, $100 US Dollars (USD) invested into a fund with a potential $200 (USD) return would be expressed as 100:200, or 1:2. A 1:2 ratio is usually considered the lowest possible “safe” ratio by most of the world’s major financial advisers. The higher the reward, the better the ultimate investment. That same $100 (USD) invested in an account with an expected $500 (USD) return would yield a 1:5 risk-reward ratio, for instance, which is much more favorable.
It is usually hardest to calculate the “reward” portion of the risk-reward ratio. Anticipated reward is usually determined by close analysis of stock charts and prior trends. There is some science involved — mostly statistical and standard deviation calculations — but a lot of reasoned predictions and probability accounting are also required. Financial tracking software and technological trends predictors can be helpful in coming up with these numbers. Investors also spend time reading and studying the market’s health in target sectors.
There is usually some flexibility with risk, too. Beginning risk need not always be the starting amount of money. Investors often elect to purchase their investments with attached “stop loss” orders. These orders essentially withdraw the funds and stop the trading once losses hit a certain bottom. Investors can play with their stop-loss floor to change the ratio, which can help determine the contours of the ultimate investment.
Even a risk-reward ratio that puts the potential rewards as high as 500% does not guarantee high returns. Market volatility changes and prices drop in unexpected ways all the time. All that the risk-reward ratio says is that the investment is more likely than not to yield a favorable return. This means that it is a good bet for an investor, but nothing is ever a sure deal.