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.
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?
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.
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.
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.