Investing in any asset will always carry some kind of risk, which is why the risk/reward ratio is so popular with traders and investors in assessing the best investments for their specific situation.
Whatever type of asset you choose to invest in, there is always risk associated, you just need to make sure you get paid for the risk you take.
What is risk vs reward?
In the investment world, risk describes the potential for a financial loss, whilst reward refers to the financial return an investor receives, typically in the form of “yields” or “capital gains.”
These two concepts are innately intertwined, through what is known in the financial industry as Risk vs Reward or Risk vs Return. The riskier an investment is, the more likely you are to lose money and therefore investors expect a higher return when they invest in risky products.
Generally, the riskier the investment, the higher the expected return.
For instance, let’s say you lend someone $100, and they offer to pay you back $150 in two weeks, whilst another offers to pay back $200 in the same time frame. Which person would you loan the money to?
This is the very basic foundation of understanding the risk versus the reward. You might be tempted to choose to lend to the Person B who is offering a repayment of $200, however, the most important part will be assessing which of these two people are more likely to repay.
The risks and returns of bonds vs shares
Comparing the returns of fixed income and shares/equities highlight the risks versus rewards of these higher and lower risk asset classes.
Specifically, the Vanguard data from the twenty years to 2022 shows how shares can be a more volatile investment (with higher losses and higher returns).
As a more volatile investment class, Australian shares saw both exceptionally high losses (-40.4%) and returns (+40.5%), while bonds and fixed income, saw lower returns (+18.6%) but also smaller losses (-9.7%) over the same period.
Higher-risk investments (like shares) will not always generate a high return, despite what past performance may suggest. Some investors who choose higher risk assets will encounter a loss, which is why many investors choose to include assets like bonds and fixed income investments into their portfolios. This is evidenced by AustralianSuper reporting a 7% loss across their typically strong property portfolio in the last fiscal year.
Therefore, it’s crucial to carefully assess all the potential risks, and rewards, of assets you’re considering investing in, to ensure you get “paid” for the risks you take.
How do you calculate risk vs reward?
Calculating the risk versus the reward of a financial investment is complex, as it’s not just the asset that holds risk. Every trader or investor will have a different risk profile, as everyone has different personal financial situations, and almost every investment is impacted by economic and market factors outside the investor’s control.
However, despite the various different types of risk involved in investing, there is a popular method among traders and investors that is used to calculate risk vs return, the risk/reward ratio.
What is the Risk/Reward or Risk/Return Ratio?
The risk/reward ratio (also known as the risk/return ratio) is a key investment metric that measures the tradeoff between the risk an investor takes, and the reward they expect to receive for taking that risk.
It’s calculated by dividing the risk by the reward and is expressed as a ratio.
For instance, a risk/reward ratio of 1:2 means you are willing to risk $1 to make $2 (and $100 to make $200, or $1,000 to make $2,000), and a 1:5 risk/reward ratio means you are willing to risk $1 to make $5 (and $100 to make $500 or $1,000 to make $5,000).
The closer the two numbers in the ratio are to one another, the more risk you are willing to take.
Calculating the Risk/Reward Ratio
The risk vs reward risk/reward ratio is determined by the risk of an investment relative to each dollar invested. It is the risk divided by the reward.
To calculate the ratio, you need to find a figure for the potential reward of an investment, and your “stop loss” point (the lowest value you can afford for your investment to reach before you need to pull your money out by closing the investment account or selling your assets.
In its most basic form, excluding any further complex analysis of the risks and rewards involved, this ratio can be calculated by dividing the maximum potential profit, by the maximum potential loss.
Risk/Reward Ratio Example
Let’s say Rachel buys 100 shares from Company Z, at a cost of $50 each. Rachel has a “stop loss” order of $35, as she cannot afford to lose any more than $15 per share.
Rachel thinks (based on market analysis) that Company Z shares will increase to $80 over the next few months and plans to sell when it reaches that position.
This is how you would calculate Rachel’s Risk/Reward Ratio (ensure you put a – before the current price to ensure the ratio calculates correctly):
RISK = -$5,000 + $3,500 (-Current Price + Stop Loss) = -$1,500
REWARD = –$5,000 + $8,000 (-Current Price + Potential Reward) = +$3,000
From these calculations, we can see that Rachel is willing to RISK $1,500 to make a REWARD of $3,000, and therefore the risk/return ratio is 1,500 : 3,000 OR 1:2.
Rachel is willing to risk $1 to make $2.
What does the risk/reward ratio mean for fixed income investors?
When it comes to fixed income and debt securities, the risk/reward ratio is less applicable than it is in the equities market. This is because while bond and debt security prices are influenced by market factors and volatility, the face value of the security (if held to maturity).
For example, let’s say you pay $100 for a debt security with a face value of $100, with a 7.5% per annum coupon and a maturity date in three years’ time. If interest rates rise, and the price of the debt security drops to $93, however, you will still receive the $100 face value and a 7.5% coupon in return if you hold the security until the maturity date (and the security issuer does not default, and no credit events occur)
Essentially, rather than having to calculate the risk/reward ratio, fixed income investors can evaluate the credit risk, interest rate risk and market risk (on bond/debt security prices) to decide on whether the yield (coupons paid plus any capital gains) on the investment is ‘worth’ the risk.
Types of risk involved in investing
Before investing in shares, bonds or other securities, make sure to seek the advice of a financial adviser, as insolvency law is complex and dependent upon different factors that can impact the outcome in a credit default or insolvency event.
RISKS* | Corporate bonds and Fixed income securities | Shares (Stocks/equities) |
Credit | There is always risk of default or a credit event. | There is always risk of default or insolvency. |
Interest Rates | If interest rates rise, corporate bondholders can miss out on opportunities to earn higher coupon rates. If not held to maturity (and you choose to sell) changing interest rates can determine whether you make or lose money when you sell the bond. | When interest rates are high, stock markets generally decline in value. When interest rates are low, they typically increase in value. However, as all interest rate changes impact investor sentiment, there is no guarantee on how share markets will react to changing interest rates or how this will influence share prices. |
Volatility | Bond prices and coupon rates are influenced by economic and market factors. However, if you buy the bond and hold it to the maturity date, the agreed coupon rate and principal value remain the same. | As shares are part ownership in a company, the value of the share is tied to the financial market and is highly volatile. The value of a share is influenced easily by investor sentiment and there is no agreed rate of return. |
*This list is not intended to be exhaustive, nor comprehensive. Various other risks apply depending on the investment made and various other factors. Before investing you should ensure you fully understand the risks associated with the investment and speak to a qualified financial adviser. | ||
The following investment risks have been sourced from the Australian Securities and Investments Commission (ASIC) MoneySmart website, which you can access here.
Interest rate risk | Changes in interest rates can reduce returns or cause financial loss. This is a key risk for fixed income investments. |
Market risk | Economic changes or other events that affect the entire market can cause an investment to fall in value. |
Sector risk | Events in a specific industry sector can cause an investment to fall in value. |
Currency risk | A key risk for overseas investments, currency movements can impact your returns. This impacts Australian companies with overseas operations and investments that have foreign currency in them. |
Liquidity risk | There is always a risk that you won’t be able to sell your investment and get your money back when you need, without impacting the price in the market. |
Credit risk | When you invest in debt or credit cycles, there is a risk that the company or government will default on the debt and be unable to make the repayments. |
Concentration risk | If your investments aren’t diversified, poor performance in one investment or asset class can significantly affect your portfolio and increase your risk of loss. |
Inflation risk | There is a risk that the value of your investments doesn’t keep pace with inflation, that is, you will lose the “real value” of your investment as inflation increases. |
Timing risk | The timing of your investment decisions can expose you to risk of lower returns or a loss of capital. |
Gearing risk | When you use borrowed money to invest, you risk increasing your losses. Even if your investments fall in value, you still have to pay the remaining loan balance and interest. |
Disclaimer: This information has been prepared by Australian Bond Exchange Pty. Ltd (ABN 73 605 038 935, AFSL 484453) is of a general nature only. It has been prepared without taking into account your particular financial needs, circumstances and objectives. No representation or warranty is made as to the accuracy, completeness or reliability of any estimates, opinions, conclusions or other information contained in the document. The document may contain certain forward-looking statements. Forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors, many of which are beyond our control. You should not place reliance on forward-looking statements. To the maximum extent permitted by law, Australian Bond Exchange Pty. Ltd. disclaims all liability and responsibility for any direct or indirect loss or damage that may be suffered as a result of relying on anything in this document including any forward-looking statements. Past performance is not an indication of future performance.