Risk-Reward Ratio — Risk to Profit Ratio
What is risk-reward ratio, how to calculate it, and how to use it when making investment decisions. Practical guide with examples.
Definition
Risk-reward ratio (risk to profit ratio) is an indicator comparing potential loss with potential gain from an investment. It's expressed as a proportion, e.g., 1:3 means that for every PLN of risk, there's 3 PLN of potential profit.
Formula
Risk-reward ratio = Potential loss / Potential gain
Or inversely (reward-to-risk): Potential gain / Potential loss.
Note: Conventions differ. 1:3 usually means "risk 1 to gain 3" — that's a favorable ratio.
Example
You buy stocks at 100 PLN. You set:
- Stop-loss at 90 PLN (potential loss: 10 PLN)
- Take-profit at 130 PLN (potential gain: 30 PLN)
Risk-reward ratio: 10:30 = 1:3
Even if you're right only 40% of the time, with a 1:3 ratio, you come out ahead.
Why is this important?
Risk-reward ratio forces thinking before buying, not after. Instead of "how much can I earn?", you also ask "how much can I lose?". This is a fundamental shift in perspective.
Table: minimum success rate for different ratios
| Risk-reward ratio | Minimum accuracy to break even |
|---|---|
| 1:1 | 50% |
| 1:2 | 33% |
| 1:3 | 25% |
| 1:5 | 17% |
The better the ratio, the more times you can be wrong and still profit.
Practical application
Long-term investments
For ETFs and long-term portfolios, risk-reward ratio works at the asset allocation level. The question is: how much volatility (risk) do I accept for expected return?
Trading
In trading, ratio is crucial for every transaction. Professional traders rarely enter positions with ratios worse than 1:2.
Life decisions
Risk-reward thinking also works outside the stock market: career change, investment in education, starting a business — what do you risk vs. what can you gain?
Limitations
- "Potential profit" is an estimate, not a guarantee
- Doesn't account for probability — a 1:10 gain won't help if the chance of success is 1%
- Requires honest risk assessment — people tend to underestimate losses
How Freenance can help
Freenance helps assess your portfolio's risk profile — you see volatility, drawdown, and expected return. This is the data you need for conscious risk-reward assessment of your investments.
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