Asymmetrical Payoffs: It’s Not About The Magnitude

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Asymmetrical Payoffs: It’s Not About The Magnitude

Investors seek favourable risk-reward ratios in their investments. A manner in which this is achieved is through asymmetrical payoffs. Many tend to focus on the magnitude of the payoffs and a common rationalisation is that if I stand to earn $20 per share at the risk of only losing $2 per share, there is asymmetrical payoff and hence, a favourable risk-reward ratio. However, a critical factor is omitted and may result in warped expectations and misjudgements.

Short-selling

Here is one way of perceiving it. A commonly known disadvantage, or risk, in short selling stocks is ironically, asymmetrical payoff. Upon short-selling a stock, one profits from any fall in share price. The lowest that any share price can fall to is zero while the highest it can increase to is literally, infinite. In this regard, an investor is susceptible to infinite downside while having a capped upside – asymmetrical payoff. By this logic, the act of buying a stock (where the situation is reversed) naturally comes with favourable asymmetrical payoffs. Then, the corollary would be that an investor is bound to make profits as long as he arbitrarily buys a large number of stocks. No analysis is required. It goes without saying that such a conclusion is erroneous, but why?

Lottery Analogy

A simpler analogy will shed some light. A lottery ticket costs a few dollars, but the payout that comes with winning can amount to a thousand or million times more than the cost of the ticket. Does this mean there is asymmetrical payoff (in the sense of favourable risk-reward ratio)? Every investor worth is salt will know that lotteries are a sure way to lose money in the long term. Little do they know, they may be committing the same erroneous rationale in their investment process.

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The missing ingredient, in evaluating asymmetrical payoffs, is probability. In other words, a favourable risk-reward ratio can only be accurately determined if the payoffs calculated encompasses the likelihood of payoffs. In statistics parlance, this is known as the expected monetary value of a decision.

Final Words

In investments, one can hardly be expected to calculate the precise probability of any event, but one has to pay heed (at least intuitively) to the likelihood of an event. In all fairness, many do, whether they are explicitly aware of it or not. When one makes a call based on an investment thesis, one is implicitly arguing that a specific target price is the most probable one. The main pitfall lies in making statements like the one above – if I stand to earn $20 per share at the risk of only losing $2 per share, there is asymmetrical payoff. It is enticing in its deceptive simplicity, but is ultimately misleading for it does not address the critical factor of likelihood.

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I developed my passion for investment management especially equity research at a relatively young age. My investment journey began when I was 20, at a point in time where markets were still recovering from the Global Financial Crisis. My portfolio started from money I saved over the past years and through working during the holidays. I was fortunate to have a good friend with common investing mentality to began my journey towards value investing. To date, we still research and invest in companies together, discussing valuations and potential risks of a company. To date, I manage a fund with a value investing style. Positions are decided upon via a bottom-up approach or smart speculation (a term I came up with when buying a stock for quick profit due to a mismatch in prices in the market due to takeovers/selling of a subsidiary or associate). Apart from managing my own portfolio, I enjoy sharing my research with family and friends, seeking their opinions and views towards the stock. Reading Economics in London, I constantly keep up with the financial news in Singapore & Hong Kong. Despite my busy schedule, it has not stopped me from enjoying other aspects of life. I enjoy a variety of activities in whatever free time I may have – endurance running, marathons, traveling, fine dining, whiskey appreciation, fashion. Lastly, I enjoy meeting new people, discussing ideas and gaining new perspectives towards issues in the world.

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