Risk and Reward Analysis in Investment

There is always risk involved in any investment. The most effective way to mitigate risk is to educate yourself on investments and have a diverse portfolio. Quantitatively measure your own risk tolerance. Risk tolerance depends on many parameters such as the psychology of the investor, duration of investment, investment goals, investor's net worth, and retirement age. Younger people with higher net worth can afford to take more risks. There is a statement that higher risk results in higher returns. However, there is a great chance of losing capital than making a big profit with riskier investments.

It is important to understand and calculate how much risk you can tolerate without losing sleep over your investment. Also, it is crucial to know different classes of investments (bonds, stocks, real estate) and differentiate the risk involved in each class. For example, stocks are a great investment because of their high annual returns. However, the level of risk that you take is different in a small-cap, less established company than a large-cap, more established company that pays you dividends. Furthermore, understand different types of stocks such as value stocks, growth stocks, and dividend stocks and the risk associated with each of them. In the end, accept if you realized at any point that you have made mistake with your investment. Use a stop-loss strategy by defining a minimum price that you are willing to exit to prevent further losses.

To calculate the risk and reward ratio, divide the reward (net profit) by the risk (capital invested). There is a logical loop that can suggest whether an investment is within your risk tolerance. Identify specific stock with rigorous research and knowledge. Define the lower and higher price target by fundamental analysis. Calculate the risk and reward ratio by the formula mentioned above. Is the calculated value close to the threshold that you set for your investment (your risk tolerance)? If yes, proceed with the investment.

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