Risk vs Reward: Strategy Explained

Understanding the relationship between risk and reward is a cornerstone of smart investing. Investors often walk a tightrope between chasing high returns and protecting their capital, and understanding how risk and reward interact provides perspective on long-term outcomes. This guide explores how risk vs reward works in investing, its relevance to different strategies, and how you can apply this concept to make disciplined investment decisions.

Let’s start with the basics of the concept:

Risk refers to the potential of losing some or all of your invested capital. Reward, on the other hand, is the potential gain or profit you expect from an investment. In financial terms, the two are intrinsically linked: the higher the potential reward, the higher the risk usually involved.

In the investment world, “risk vs reward” is a principle that helps investors assess whether a given investment is worth pursuing. It offers a way to quantify how much risk you are taking on in pursuit of a desired return, helping you evaluate trade-offs before committing your money.

To quantify this balance, we use a basic but powerful formula:

• Risk-Reward Ratio = (Potential Loss) / (Potential Gain)

Here’s how to calculate it:

• Determine your entry price (where you plan to buy the stock)
  

• Set your stop-loss (the price at which you’ll exit if the stock falls)
  

• Set your target price (the level at which you’ll book profits)

Example:

Suppose you buy a stock at ₹100, set a stop-loss at ₹95 (₹5 loss), and target price at ₹115 (₹15 gain). The risk-reward ratio would be:

Risk-Reward Ratio = 5 / 15 = 1:3

This means you are risking ₹1 for every ₹3 you could potentially earn.

The real use of this concept lies in its ability to guide smarter, more disciplined investment decisions:

• Capital protection: By limiting downside through stop-losses, investors protect capital.
  

• Mathematical edge: With a 50% win rate, a 1:2 or 1:3 risk-reward ratio may still result in profitability.
  

• Objective decision-making: This framework removes emotion and encourages data-driven actions.
  

• Improved consistency: This framework supports consistency in decision-making over time.

There is no universal rule for the risk–reward ratio, but market participants often use the following reference points:

• 1:2 ratio – commonly used as a baseline, meaning for every ₹1 at risk, the potential reward targeted is ₹2.
  

• 1:3 ratio or higher – often applied in volatile market setups where wider movements are expected.
  

• Below 1:1 ratio – generally viewed as unfavourable since the potential loss outweighs the potential reward, though some strategies with high win rates may still use it.
  

Factors that influence commonly used risk-reward ratios include:

• Market volatility
  

• Asset type (stocks vs bonds vs derivatives)
  

• Your own risk tolerance and strategy

Here’s how investors can define these levels more effectively:

• Use support and resistance zones: Historical price points where the asset has bounced or dropped before.
  

• Factor in volatility: Use indicators like Average True Range (ATR) to buffer stop-losses.
  

• Maintain logical distance: Avoid tight stops that get hit easily or far-off targets that are rarely achieved.
  

Arbitrary numbers may be less effective; many investors instead look at market structure.

Risk-reward should be embedded in every part of your investment or trading approach:

• Trade selection: Filter only trades with favorable risk-reward setups.
  

• Position sizing: Adjust quantity based on the amount you are willing to lose (Some investors manage exposure by limiting the size of individual trades relative to their overall portfolio).
  

• Portfolio planning: Allocate across asset classes with varying risk-reward dynamics — e.g., equity for higher risk-reward, debt for lower.
  

This approach is often used to bring structure and consistency, even during volatile times.

Risk vs reward plays a key role across various asset types:

• Stocks: Targets and stop-loss levels are commonly used in stocks trading.
  

• Mutual Funds: Evaluate fund performance vs benchmark risks.
  

• Options Trading: Focus on high payoff setups with limited downside.
  

• Forex: Manage tight spreads with well-defined risk-reward thresholds.
  

Using it consistently helps navigate even complex markets.

While useful, this ratio is not foolproof:

• Ignores probability: A high reward doesn't matter if odds of success are low.
  

• Assumes linear movement: Real markets are dynamic and unpredictable.
  

• Volatility risk: Unexpected price spikes can hit stop-losses before rebounding.
  

Hence, it must be used with complementary indicators like win rate, Sharpe ratio, or drawdown analysis.

Here are additional tools to help improve decision-making beyond just the basic ratio:

• Sharpe Ratio: Adjusts returns for volatility, offering a clearer picture of risk-adjusted performance.
  

• Diversification: Don’t rely on a single trade or asset.
  

• Position correlation: Avoid overlapping exposures in your portfolio.
  

• Market sentiment: Understand macro indicators that affect risk levels globally.
  

These additions bring a more holistic understanding to your investment risk framework.

Understanding and applying the risk vs reward ratio empowers you to make informed, disciplined, and results-oriented decisions. While the concept is simple, its impact on your success as an investor is profound — especially when used alongside other strategic tools. Whether you’re a beginner or a seasoned trader, applying the risk vs reward principle can help bring structure and discipline to financial decision-making.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.