Asymmetrical risk reward is the essence of investing in stocks, and is also essential for those who want to beat the market.
In today’s article, we’ll discuss what it is, what investment vehicle has the best asymmetrical risk reward opportunities, and how you can apply its benefits to your investments.
- “The essence of portfolio management is the management of risks, not returns.” – Benjamin Graham
- You should rethink your stocks and bond holdings as most have negative asymmetric risk reward.
An asymmetrical risk reward situation can be both positive and negative. A positive one is where you can only lose an amount that is smaller than the potential reward.
Positive asymmetrical risk reward situation.
A negative risk reward situation is one where you can lose more than what the potential positive reward is.
Negative asymmetrical risk reward situation.
Investors usually focus on returns rather than on risk. This is more pronounced during bull markets because it’s in our human nature to forget bad experiences in favor of only remembering the positive ones.
As the last bear market was 7 years ago, many have completely stopped looking at risks and have only focused their efforts on returns. This is why you will often hear discussions and come across scenario elaborations about yields, returns, dividends, coupons etc., but you will rarely come across scenario elaborations that analyze risks in detail.
By focusing both on the risks and returns, you can find asymmetric risk reward situations that will enable you to maximize your returns and minimize your risks.
Current examples of negative asymmetric risk reward situations are stocks and bonds.
Here’s a simple calculation to make: stocks will on aggregate give you a return that is in line with their earnings and economic growth. The current S&P 500 earnings yield is 3.99%. With the economy expected to grow at a rate between 1% and 3%, those earnings aren’t going to grow much in the future. Therefore, we can say that stocks will give you a 5% yearly long term return.
On the risk side, a WSJ survey shows that economists see a 20% chance of a U.S. recession in the next year and those probabilities increase as we increase the time span. Let’s say that there is a 50% chance of a recession in the next 5 years. Then you have a 50% chance of getting the 5% expected yearly return and a 50% chance of seeing your portfolio fall by 50% as it did in the last two recessions. This means that for every $100, you are risking $50 for a potential return of $34 (5% cumulative return on $100 in five years).
Current stock risk reward situation with a 5% earnings yield and a recession coming up.
The situation with bonds is even worse, and we have been warning readers about it regularly on Investiv Daily and you will see why in a moment.
In the last month, the U.S. 30-year treasury rate has gone from 2.11% back in July to its current rate of 2.97%.
This increase in yields has sent bond prices down. The 20-plus year treasury ETF has fallen by 15% since July.
The above isn’t a positive message, but if you don’t like being in a negative asymmetrical risk reward situation you should rethink your stocks and bond holdings for now.
In the long-term, stocks offer you a positive asymmetric risk reward situation as the upside is unlimited and you can only lose what you have invested. This is the essence of long term investing in stocks. It is a valid perspective but at current valuations it might not be the best strategy to follow right now.
This is much easier said than done, but given that you can invest all around the world in thousands of companies, you also have the opportunity to discover investments that have limited downside risks and huge upside potential. Indicators can be fundamental, where the book value, stable cash flow, cash per share really limit the downside while high potential earnings increase the upside.
The other factor to look at is growth. A company that has a high probability of long term sustainable growth due to positive industry circumstances, macro or demographic trends, will potentially deliver much higher returns than companies with relatively high debt burdens constrained by a slow growing economy like many constituents of the S&P 500.