No risk, no reward. I’m sure you’ve heard this before. And when it comes to investing, I do believe there is some truth to that. As long as you’re taking calculated risks, which are the only kinds of risks you should ever take.
But there’s a big difference between taking a calculated risk and just taking a risk.
So what makes a risk worth taking?
Keep reading to learn more about exactly how I determine whether or not a trade is worth taking given the potential rewards and risks involved.
What Is Risk Reward Ratio?
The risk reward ratio refers to the size of the reward compared to the size of the risk in any given investment. Generally speaking, if an investment has a higher risk/reward ratio, it will be considered to have less potential for growth than one with a lower ratio.
For example, if Investing A has an expected return of 20% with an expected loss of 10% and Investing B has an expected return of 10% with an expected loss of 5%, Investing B would be considered safer than Investing A because it has a lower risk/reward ratio (10/5 = 2 vs. 20/10 = 2).
The risk-reward ratio is one of the most important and most overlooked metrics in a business.
Why It Is So Often Overlooked
One of the reasons why it is so often overlooked is because it is so hard to quantify. It comes down to a gut feeling, which is hard to describe.
The risk-reward ratio is a metric that you should use when you are weighing the pros and cons of an opportunity.
The potential upside and downside of the opportunity should be quantified as best as possible. The risk-reward ratio formulas could look like this:
Risk reward ratio = Upside / Downside
You have an opportunity for $100,000 in sales at a 10% profit margin (profit will be $10,000) or an opportunity for $50,000 in sales at a 20% profit margin (profit will be $10,000).
Risk Reward Ratio for option 1 = 100k / 10k = 10x
Risk Reward Ratio for option 2 = 50k / 10k = 5x
In this example, option 1 has a better risk-reward ratio. If you choose option 1 and lose out on the deal you will have lost more money than if you had chosen option 2. However, the upside potential is much higher with option 1.
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