Investments are made with the expectation that there will be some return on the money risked. Return is the amount of profit made on a specific investment in a specific period of time. Risk is the amount of money the investor is willing to lose before pulling out of an investment. Risk versus return can be calculated as a ratio. When the ratio is high, a lot of money was risked for a small return. When the ratio is low, a lot of money was made on low risk. Investors would prefer to keep the ratio low. Calculating a risk versus return ratio is not difficult.
Write the formula: Risk/Return. Read it as "Risk divided by Return."
Determine the risk on the investment you wish to analyze. For example, if you have invested $5,000 in Stock X, your risk is $5,000 because the company could go bankrupt and the value of Stock X could fall to zero. As an aside, most investors would have a predetermined exit point if Stock X began to fall; they would sell the stock if the value of the investment fell to, say, $4,000, thus reducing their risk.
Determine the return on your investment by subtracting the present value from the value originally invested. If after one year, the value of your $5,000 investment has increased to $5,500, you have earned a return of $500.
Plug your risk and return values into the formula to calculate the ratio. In our Stock X investment example, the formula would be: $5,000/$500 = 10, or 10:1 expressed as a ratio—read it "10 to 1." This means that in your investment you are risking $10 for every $1 made. Hopefully, you have a lot of trust in the company behind Stock X.