Risk-reward ratio is a formula used to measure the expected gains of a given investment against the risk of loss.
Risk-reward ratio is typically expressed as a figure for the assessed risk separated by a colon from the figure for the prospective reward. While the acceptable ratio can vary, trade advisers and other professionals often recommend a ratio between 2:1 and 3:1 to determine a worthy investment. Typically, the ratio quantifies the relationship between the potential dollars lost, should the investment or action fail, versus the dollars realized if all goes as planned.
Investors use the risk-reward ratio to determine the viability or worthiness of a given investment. They sometimes limit risk by issuing stop-loss orders, which trigger automatic sales of stock or other securities when they hit a specific value. Without such a mechanism in place, risk is potentially unlimited, which renders the risk-reward ratio incalculable.
In project and portfolio management (PPM), risk management is integral to the success of any project. The risk-reward ratio is used to quantify the potential risks and benefits to assess the feasibility of the project as a whole as well as components of the project. Essentially, the risk-reward ratio should be calculated for each significant PPM investment.
Some projects may have a low probability of failing but coupled with a low potential return on investment (ROI). Projects with more unknown factors may have a higher probability of failure but at the same time offer a significantly higher return if they are successful. Companies typically distribute their risk by investing in projects that fit in both categories. The ideal is a project with a low risk-reward ratio – little risk of failure and a high potential for reward. However, that type of project tends to be rare.