Financial advisers will tell people that they need to analyze an investment in the stock market before choosing what they plan to purchase. They should know whether the investment is worth the risk. You want an investment that will give you a good reward. Novice investors might not know how to do this or whether it is necessary.
Individual investors have to know how to manage risk. Risk versus reward is well-known in financial circles. It means that investing in stock markets carries a great risk, but you should be compensated well if you're going to take that risk. You might not be willing to risk your money if you aren’t going to get much, such as a few dollars. However, if you could double your money, you might be willing to take that risk. Many professional investors begin to invest when the ratio is 2 to 1 risk versus reward.
How does this ratio apply to the stock market?
Let’s start by acknowledging that after you have done your due diligence, you have found a stock you like. The company’s stock is selling at $25, down from a recent high of $29. However, you predict that the stock will rise again and you can sell high. Therefore, you invest $500 in this stock and buy 20 shares. Despite doing your research, you need to know what your risk versus reward ratio is before you purchase those 20 shares.
Before you go all in with your investment, consider behavioral economics. This comes into play when investing. Risk versus reward does not involve emotions. It’s a numbers game, and they don’t lie. Every person has his or her own tolerance for risk. Some might love a lot of risk while others want minimal risks. Knowing the risk versus reward ratio is not the same as knowing the probability of success. You could invest $500 in the lottery with a chance to win millions, but the odds are against you.
How do you calculate risk versus reward?
Divide your net profit by the price of your maximum risk. If you purchased the 20 shares at $25 and the stock rose to $29, you would make $4 per share. Multiply that by the number of shares and you get $80. Because you paid $500 for the stock, you would divide $80 by 500 to arrive at a ratio of 0.16. Your risk versus reward is 0.16:1. This is a low ratio, which might make it a bad choice.
You also can use the Economatica system to determine risk versus reward. The system was used to see the risk versus reward analysis on large-cap equities of the top 25 stocks by market capitalization. Then, you can determine the risk versus reward for a year and plot the numbers on a graph. This system gives you a definitive answer to your basic question of whether it is smart to take on the risk.