In my last two blogs, I’ve talked about the value in making asymmetric bets, bets where the risk of loss is small compared to the possible gain. My theory is that one way to do well in life is by continuously making asymmetric bets that have positive expected outcomes.
So far, most of this discussion has been rather theoretical, so it’s worth discussing some of the real-life ways where such a strategy might apply and some of the challenges in implementing it.
Getting a college education: This strategy might not seem that asymmetric–spending years and thousands of dollars on a college education hardly seems low risk and low cost. But most studies that I’ve seen indicate that a college degree still has a significantly positive economic return, and likely has a return in terms of satisfaction with life, also.
Driving safely: Wearing a seatbelt, signalling, and shoulder checking when doing lane changes have almost no cost, but a huge potential reward for avoiding and reducing the cost of accidents.
Being friendly and polite: There is almost no cost to not alienating people, but the returns can be high, both in terms of happiness and future opportunities.
Investing in value: Buying a stock for less than it’s worth is a low-risk/high reward bet. The stock is unlikely to fall even farther below fair value and the value of your investment can increase not just from growth of the business, but also from the return of the stock to its fair value.
Acquiring stock options: Whether you purchase undervalued stock options on exchanges or negotiate for them as part of your work compensation, stock options often offer an asymmetric risk and reward situation.
Starting a high-upside business: A business like a corner store is high-risk, low reward, but many high tech businesses can be low risk relative to the potential rewards, simply because the rewards are so huge.
Doing hobbies that pay : Hobbies that pay (e.g. making and selling things on Etsy) can be asymmetric, because, if you like the hobby enough that you would do it without being paid, then the marginal cost of the hobby is nothing. That makes for an asymmetric situation–no risk for some reward.
Buying a house: In places where the long-term cost of owning a house is less than or equal to the cost of renting, owning your residence is a low-risk/high rewards bet.
Borrowing to invest: If you don’t have many assets, a reasonable strategy is to borrow as much as possible to invest, since you can make a lot if you win, and declare bankruptcy if you lose. Once you have significant assets, this is a poor strategy, since gambling what you need in order to acquire things you want is stupid.
Acquiring memories rather than products: While money does buy happiness (higher income earners are happier), studies of happiness also show that people tend to gain more happiness from experiences (playing board games with the family) than things (that gargantuan TV). What’s more, experiences are often cheaper, so they are often a low-risk/high reward asymmetric bet.
Held back by your brain
Of all these asymmetric bets, the money-making opportunities are some of the most interesting, because they are so clear cut. The injuries and emotional trauma resulting from a car accident are difficult to quantify. But many of the money-making opportunities are easy to analyse. “Can I bet $1 to earn an expected $2” is a simple, clear-cut proposition.
If that’s the case, it ought to be easy making money from such asymmetric bets. So why doesn’t everyone do it?
I think there are three psychological reasons why people don’t.
The first is the valuation problem that I discussed my last post, the difficulty in deciding whether the expected value of the asymmetric bet is worth the cost. The solution to that issue is to not get hung up on exact valuations, but rather focus on being approximately right with a reasonable margin of safety.
Taking a punch, or a hundred punches
The second reason is that investing in asymmetric opportunities is often a high-variance strategy with a low win rate. Suppose you’re making a bet that has a 100 times payoff, but you only win 5% of the time. This is a good bet to make, since, on average, you’ll make five times your wager.
But you’re going to lose a lot, and that will be hard to take. If you do this bet 1000 times, there is a 99% chance you have a streak of 50 consecutive losses, and almost a 25% chance of having a streak of 100 consecutive losses. Losing so frequently is psychologically difficult, and might be enough to make you doubt your strategy. What’s more, if you don’t manage your bet-sizing well, you could go broke from a single bad streak.
In such cases, I think the key is to do sensible bankroll management to make sure you don’t go broke. Then, go through your analysis again, and, if you’re convinced it’s right, trust it. After all, in those 1000 bets, you also have an 11% chance of winning 3 times in a row.
Greed is good
The third, related reason people don’t win using this strategy is because they are often psychologically more inclined to take the bird in the hand than the sixteen in the bush. With many options, once the bet starts to go in your favor, you can often cash out quickly for a smaller win.
For instance, if you have purchased a stock option and the stock has moved slightly in your direction, you could sell your option immediately for a profit. If you’ve done a sports parlay (betting on multiple games and needing to win all the games to win the wager), you could bet “against yourself” once you’ve won several of the games in order to “lock in” a win.
But doing so is often a bad idea because you need the huge wins in order to make up for the frequent small losses.
Let’s look at a simple example. Suppose that, according to your analysis, a bet has a 20% chance of returning ten times the amount wagered (and an 80% chance of losing everything). On average, you’ll double your money. But then imagine, after the bet has started to swing in your favor, you have the option to “cash out”, doubling your initial investment.
If you do this with all the winning bets, but none of the losing bets, then you’ve effectively changed the proposition from having a 20% chance of winning ten times your bet to a 20% chance of winning two times your bet. This is obviously a terrible idea. The expected return on your initial bet has fallen from a 100% gain to a 60% loss.
So, though it might be psychologically easier to take the “sure win”, it can pay to be greedy. This is particularly true if your analysis indicates that you’re pruning your big wins without also getting rid of most of the losses.
The bottom line
I think that identifying asymmetric risk/reward situations can make you wealthier and happier. If you keep your eyes open to these opportunities and maximize the value you receive from them, you are likely to live a better life. The key is to not be discouraged if a small risk doesn’t pay off. That’s why you are deliberately keeping your risks small. Over a lifetime, the outcomes will approach the expected results, and you will do very well.