The risk-reward ratio is a measure that compares the potential for losses to the potential for gains for a particular action. Risk management aims to optimize this ratio, taking into account an organization’s risk tolerance, rather than necessarily eliminating all risk. The goal is often to minimize the risk relative to the potential reward. The following are a few examples of a risk/reward ratio.
Investing
Based on a proprietary estimation, an investor guesses that the S&P 500 has equal chance of going up 20% or going down 5% in the next year. The investor sees the risk/reward of 1:4 as attractive and buys into the index.
Product Development
An electronics company is considering launching a line of 3D printers. The development costs are significant and the company estimates there is an equal change of net income of $3 billion or a net loss of $2 billion from the product within the first 5 years. The company views the risk reward of 2:3 as unattractive and decides not to develop 3d printers.
Marketing
A luxury hotel is considering changing their pricing strategy to add a resort fee of $33 a day. They know that such fees are unpopular and the hotel has recently experienced declining ratings on popular travel review sites. They calculate that the price change will generate revenues of $1 million dollars but that there is a 50% chance of a customer backlash that will cost $12 million dollars in lost revenue due to a lower occupancy rate. The resulting risk/reward ratio is 6:1 meaning that the price increase is a risky proposition that’s unlikely to payback.
Types of Risk/Reward Ratio
The risk-reward ratio is a simple mathematical equation: risk / reward that can be used to evaluate strategies, tactical actions and processes for their potential payback. For simplicity, the ratio is often expressed as gains and losses that are estimated to have equal probability. More accurate methods model risk as a risk matrix or probability distribution.
