Risk vs Reward

Learn how risk and potential return are connected in investing, and how to evaluate whether an investment makes sense for your goals.

Advanced25 minLesson

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Definition

Risk in investing refers to the uncertainty of returns - the possibility that you could lose money or earn less than expected. Reward is the potential gain or return on your investment.

The fundamental principle of investing is:

Measuring Risk: Standard Deviation

Risk is often measured using standard deviation (), which tells us how much returns vary from the average:

A higher standard deviation means more volatility - the investment's value swings more dramatically.

Risk-Reward Ratio

The risk-reward ratio compares potential gain to potential loss:

A ratio of means you could gain 3 dollars for every 1 dollar you risk.

Try it now

If an investment has high potential returns, what can you generally expect about its risk?

Worked Examples

Investment A has an expected return of 12% with a standard deviation of 20%. Investment B has an expected return of 6% with a standard deviation of 8%. Which has a better risk-adjusted return?

Calculate the return per unit of risk for Investment A

→ 0.60 return per unit of risk

Calculate the return per unit of risk for Investment B

→ 0.75 return per unit of risk

Compare the ratios

, so Investment B provides more return for each unit of risk taken → B has better risk-adjusted return

Answer: Investment B has a better risk-adjusted return (0.75 vs 0.60). Even though A has higher potential returns, B gives you more return for each unit of risk you take.

Common Mistakes

Thinking high returns guarantee high risk is worth taking

Why it's wrong: Expected returns are not guaranteed. A volatile investment might have great returns on average but could lose significantly in any given year.

Correct: Compare risk-adjusted returns. Ask: 'How much return am I getting per unit of risk?'

Assuming low-risk investments are always the best choice

Why it's wrong: Very safe investments (like savings accounts) may not keep pace with inflation, meaning your money loses purchasing power over time.

Correct: Match your risk level to your time horizon and goals. Long-term investors can often afford more risk.

Confusing volatility with permanent loss

Why it's wrong: A stock dropping 20% isn't a loss until you sell. Volatility is short-term price swings; actual loss only occurs when you realize it.

Correct: Understand that volatility is normal. Long-term investors can often ride out short-term drops.

Interactive Visual

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Part A(25%)

Part B(35%)

Part C(20%)

Part D(20%)

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Slope (m)1

Y-Intercept (b)0

run

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Practice Problems

16 problems

Problem 1 of 16

Easy

If an investment has high potential returns, what can you generally expect about its risk?

Why It Matters

Understanding risk vs reward is essential for making smart financial decisions:

Choosing investments: Should you buy stocks, bonds, or keep money in savings?
Setting expectations: Higher potential returns always come with higher risk
Avoiding scams: If something promises high returns with no risk, it's likely too good to be true
Long-term planning: Young investors can often afford more risk; those near retirement typically want less

Every financial decision involves weighing what you might gain against what you might lose.

Real World Applications

Choosing Between Savings Account and Index Fund

A savings account might offer 2% return with virtually no risk, while a stock index fund might average 8% but with significant year-to-year variation.

Example:

Over 10 years, 1000 dollars at 2% becomes about 1219 dollars. At 8%, it becomes about 2159 dollars - but with years of gains and losses along the way.

1Try It Yourself

You have 5000 dollars to invest. A savings account pays 2% guaranteed. A stock fund has returned an average of 10% but with a standard deviation of 15%.

What is the risk-adjusted return ratio for the stock fund?

Step 1: Write the mathematical expression

Divide expected return by standard deviation:

Evaluating a Trading Opportunity

Day traders constantly evaluate risk-reward ratios before entering trades. A good trader rarely takes a trade with less than a 2:1 reward-to-risk ratio.

Example:

If a trader risks 100 dollars on a trade, they should aim to gain at least 200 dollars to make the trade worthwhile over time.

2Try It Yourself

You're considering buying a stock at 50 dollars. You set a stop-loss at 45 dollars (5 dollars risk) and a target price of 65 dollars.

What is the risk-reward ratio of this trade?

Step 1: Write the mathematical expression

Potential gain divided by potential loss:

Key Takeaways

1Risk and reward are directly connected: higher potential returns require accepting higher risk
2Standard deviation () measures how much returns vary from the average (volatility)
3Risk-reward ratio = Potential Gain / Potential Loss; ratios above 2:1 are generally favorable
4Risk-adjusted return compares return per unit of risk, helping compare different investments fairly
5Your appropriate risk level depends on your time horizon, goals, and ability to handle losses

Frequently Asked Questions

Most professional traders aim for at least 2:1 (gaining 2 dollars for every 1 dollar at risk). A 3:1 ratio is even better. Below 1:1 means you're risking more than you could gain.

Glossary

Risk: The uncertainty of investment returns; the possibility of losing money or earning less than expected
Reward (Return): The gain or profit from an investment, usually expressed as a percentage
Standard deviation: A statistical measure of how much values spread from the average; higher values indicate more volatility
Volatility: The degree to which an investment's price fluctuates over time
Risk-reward ratio: The potential profit divided by the potential loss; helps evaluate if a trade is worth taking
Risk-adjusted return: Return divided by risk (standard deviation); allows fair comparison of investments with different risk levels
Risk tolerance: An investor's ability and willingness to accept potential losses in exchange for potential gains