If you are an investor in a stock market, chances are you would describe yourself as a risk taker, as risk is something that comes with the job. One of the thrills associated with the stock market is the accumulation of enormous rewards generated on your investments despite the risks of the market. Each stock market trade comes with a certain amount of risk. Although, from a generic point of view, risks are a part of everyday lives and exist in all social or professional interactions. A business-minded individual always tends to make a pros and cons list when it comes to getting an idea of the risk vs reward involved in any situation. The risk/rewards ratio allows stock market investors to make a risk-adjusted investment. It can be simplified as a more calculative and decisive version of a pros and cons list, if you may.
What is the Risk vs Rewards Ratio?
The risk versus rewards ratio is essentially the expected reward that an investor may earn on every rupee the investor risks on a particular trade or investment. Investors often use the risk versus rewards ratio in order to get an idea of the expected returns an individual may get on a particular investment beforehand. Basically, the amount of risk an investor must partake in to gain a return on a particular trade. For instance, in a risk vs rewards ratio of 2:5, an investor is willing to risk a total of 2 rupees in order to gain a potential reward of 5 rupees.
In any particular trade, the investors are bound to take a certain level of risk. In order to expect a certain level of return/rewards, the investors are obligated to undertake some percentage of risk. A specific risk versus rewards ratio is decided by several contributing factors, which may include the number of years till retirement and the amount of time needed in order to earn back the losses that may or may not be faced by an individual.
How Does It Work?
All the deciding factors that contribute to the risk versus rewards analyses are taken into consideration by bankers and individual investors beforehand in order to determine the final investment. They also consider their personal portfolio and take into account if their portfolio pertains to a balanced mixture of blue chip stocks that are low on risk, and high-risk stocks, which may have an adverse effect but also are a high return investment.
Depending on an investor’s portfolio, they decide if the investment in question would be too much of a threat or a risk. The methods that help analyze an investor’s portfolio include methods like the Sharpe ratio, standard deviation, beta, alpha, R-squared etc. All these deciding factors, such as the stock market volatility and market failure, are prominent risk factors regardless of the risky trade-off. Still, the above techniques help ease the decision process and filter out other risks.
How to Calculate Risk vs Rewards Ratio of an Investment?
Investments in any trade, even mutual funds, are considered to be a risk. But the profit potential that is inherent in any trade is what drives investors to make a trade or investment even with the potential risk involved with those trades. The risk versus rewards ratio helps the traders make a calculated trade in order to limit their losses. In order to calculate the risk versus rewards ratio, follow the steps below:
- Analyze the potential profit and loss an investment could bring in and follow this formula:
R/R Ratio= (Entry Price-Stop Loss Price)/Target Price-Entry Price)
- Say an investor is buying 1000 shares of a company at INR 7000. Book the loss at INR 6900 and the profit at INR 7200. This shows that at each buyout, an investor will face a potential loss of INR 100 and a profit of INR 200.
- Replacing these values in the risk versus rewards formula, we get-
R/R Ratio= (7000-6900)/(7200-7000)
R/R Ratio= 100/200
R/R Ratio= ½
Therefore, the final risk versus rewards ratio of this particular investment would be 1:2.
Every experienced investor never faces a total loss. All investors set a stop loss price. Which in this case was INR 100. As soon as the loss reaches beyond INR 100, the investor sells the share immediately and looks for other profit opportunities. A 1:2 risk versus rewards ratio is considered to be an acceptable ratio in order to make a secure investment.
Once an investor starts calculating and incorporating the risk versus rewards ratio in their trades, they tend to become more meticulous and precise, which works in their favor as it heightens their chances of investing in trades that will more likely give them a profit instead of a loss.
From the aforementioned information, we can conclude that any trade or investment in a stock market comes with preexisting risks and a negative likelihood. Any of these inherent risks cannot be eliminated entirely; therefore, investors are bound to take risks while entering the stock market industry. However, these risks also come with some amount of return on investment if the trade is done right. In order to make a well-calculated risk, traders must analyze their profit and loss by utilizing the risk versus rewards ratio. A well-calculated risk versus rewards ratio can help a buyer make a calculated trade and also have some peace of mind while making that particular trade. To learn more about safety measures and make secure investments or stock market trade, visit Bhive Alts.