How the Risk/Reward Ratio Works

In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.

The risk/reward ratio is often used as a measure when trading individual stocks. The optimal risk/reward ratio differs widely among various trading strategies. Some trial-and-error methods are usually required to determine which ratio is best for a given trading strategy, and many investors have a pre-specified risk/reward ratio for their investments.

Note that the risk/return ratio can be computed as one's personal risk tolerance on an investment, or as the objective calculation of an investment's risk/return profile. In the latter case, expected return is often used in the denominator and potential loss in the numerator. Expected return can be computed in several ways, including projecting historical returns into the future, estimating the weighted probabilities of future outcomes, or using a model like the capital asset pricing model (CAPM).

To estimate the potential loss, investors may use a variety of methods, such as analyzing historical price data with technical analysis, using the historical standard deviation of price action, assessing company financial statements with fundamental analysis, and models like value-at-risk (VaR). These methods can help investors identify factors that could impact the investment's value and estimate the potential downside.

Estimating the expected return and potential loss is not an exact science, and the actual amount of risk and return may differ from your estimates. Investors should also consider their own risk tolerance when evaluating the potential risk of an investment, as the amount of risk they are willing to take on can vary depending on their personal circumstances and investment goals.