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Risk to Reward Ratio

  • November 13, 2020
  • Team Kalkine

What is the Risk to Reward Ratio?

In any form of investment, there are primarily two parameters which an investor needs to look at before coming to a sound decision. These two parameters are:`

  1. How much risk is there in the investment?
  2. How much potential reward can be expected?

Every form of investment, especially in the stock market, incorporates a risk factor and does not come with a guaranteed return, no matter how safe an investment sound. Therefore, an investor always needs to access the risk before putting his money on stake. Although depending upon numerous variables, the degree of risk may vary from one investment opportunity to another.

Another parameter is the potential reward that an investor expects out of his investment. The potential reward also varies with many factors and generally goes hand in hand with the risk. This means lower the risk; lower would be the potential reward and vice versa.

While making an informed investment decision, an investor needs to look at both the risk and reward to spot investment opportunities that match his/her risk profile and also satisfies his return expectations.

This comparison of risk with the reward through a mathematical calculation is called Risk to Reward ratio.  


How to calculate Risk to Reward ratio?

First, one needs to determine the risk and the reward quantitively in order to calculate the Risk to Reward ratio. There are many ways to determine these two parameters using technical analysis, fundamental analysis or any other method.

Let's assume the determined risk is $100, and the reward is $200. Now dividing risk with reward gives the ratio between the two.

In our example, it would be $100 (risk) /$200 (reward) = ½ or 1:2. The is interpreted as $1 of risk is needed to be taken in order to make $2.

Higher the Risk to Reward ratio, better would be the investment/trading opportunity.

How is Risk to Reward ratio used in the stock market?

Let's assume an investor B has two investment opportunities and wants to invest in any one of them. He may use the Risk to Reward ratio as a parameter to qualify an opportunity for his investment.

Investment opportunity – 1

An investor B is looking at a company’s share price, which is trading at $100. After his extensive analysis, he determines the intrinsic value of the company’s shares comes at $160. That’s an upside potential of $60 from the current market price of $100. Now, the reward of $60 per share ($160 - $100) has been determined.

He also assumes that there are chances that the stock might drop to $70 instead of moving up. Therefore, he pre-determines his decision to exit the stock below $70 (if it drops) as he is not willing to take more risk than $30 per share. With this decision, he has capped his max risk to $30 per share ($100 - $70).

Combining both the parameters, B is willing to risk $30 ($100 - $70) in order to make a potential profit of $60 ($160 - $100). That gives him the Risk to Reward ratio of 1:2, which means, he is willing to risk $1 for making a potential profit of $2.

Investment opportunity - 2

The same investor B has another company in mind which is trading at $200, and his analysis states an intrinsic value of the company’s shares at $230. In case the stock does not move as expected and turns towards south, B decides to hold till $140 and not below that.

If the stock moves in favour of B, he can make a profit of $30 per share ($230 – $200). However, if the stock falls, against the expectations, then B will book the loss of $60 per share ($200 - $140). Combining both the parameters, B is willing to lose $60 per share in order to make only $30 per share, giving him a risk to reward ratio of 1:0.5. This means he is ready to earn only $1 for every $2 of risk.

Comparing both the investment opportunities together, it is evident that investment in the 1st opportunity is a sound decision than going for the 2nd option.

In the 1st opportunity, if B loses his money, he would be losing only $30 per share but would make $60 per share if he is right. In the 2nd option, B will lose $60 per share if his analysis goes wrong but would be making only $30 per share if the stock moves as expected.

How does higher risk to reward ratio compensates for the lower accuracy?

In order to succeed in the stock market, apart from high risk to reward ratio, an investor also needs to have a decent accuracy. Accuracy of investment/trade is different from the risk to reward ratio, but both are required in order to gauge the overall performance of the portfolio. Accuracy defines how much trades/investment decisions generally goes right. An accuracy of 70% means 7 trades out of 10 hit the target price, and the remaining 3 yields loss.

For example, if a person has a risk to reward ratio of 1:1, meaning he is willing to lose $1 to make $1. He has an accuracy of 50%, meaning out of 10 trades his 5 trades go wrong and the other 5 go right.

After putting it all together, he would stand at break-even after 10 trades, as in 5 trades he would be losing $5 and would make $5 in the other 5 trades.

Now if the risk to reward ratio is increased to 1:2 he would make a decent profit even with the same accuracy of 50%; He would be losing $5 in 5 trades but would be making $10 in the remaining 5 trades, giving him a net profit of $5.

What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others.  The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors.  For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel.  How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages.  Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage.  Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade.  Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries.  What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another.  The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services.  Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour.  Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television.  It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured.  Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power.  The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play.  It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability.  What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects.  The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers.  Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.

Difference between actual and an expected return. For example, if a stock increased by 7% because of some update, but the average market only increased by 3% and the stock has a beta of 1, then the abnormal return was 4% (7% - 3% = 4%)

Ability-to-Pay Taxation The neoteric trending concept in which the tax is levied as per the taxpayer’s economic ability to pay. It is based on the concept that a person who earns more should pay more taxes and the one earning less should pay less.  

Refers to most commonly the realty sector and indicates the rate of sale of homes in a certain market during a given period of time. It is calculated as the ratio of the average number of sales in a month by the total number of available homes.

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