This can also be referred to as the phenomenon of asymmetric risk. If in any situation one type of outcome has orders of magnitude greater consequence than another type of outcome, that would be an example of asymmetric risk, and it's not just the crazy things like skydiving or running with the bulls that pose asymmetric risk. In fact, asymmetric risk is not always tilted to the negative, though we do spend a bit of time hedging against it.
In the world of investing, we seek to protect our clients from negative asymmetric risk, or the portfolio equivalent of playing Russian roulette. We don't want to get them in a situation where positive outcomes, though statistically likely, come at the risk of negative outcomes that are catastrophic or game-ending. In their book great by choice, Jim Collins and Morton T. Hanson describe this as “leading above the death line”.
As you might imagine, the places to find positive asymmetric risk in the world of investing are few and far between. Often, investors searching for such unfair advantages get burned. Although rare, such opportunities for positive asymmetric risks exist, and when understood correctly and employed prudently, work to your advantage. But correct understanding and prudent implementation are fundamental to this process.
To better understand asymmetric risk and how to hedge against it, I want to share a story of a banker, friend of mine. He described to me the process of underwriting a hotel construction in 2019. When they did the stress tests, they tried to imagine the worst case scenario of occupancy rates. They said, "What if it got really bad, and they can only fill 50% of the rooms on a regular basis?" As he described this story to me, he laughed, and then went on to show how COVID fundamentally changed their risk assessment. "Try 5% occupancy," he chuckled. "See what that does to your risk profile."
Your investment decisions might not involve building a hotel that could be subject to Covid lockdowns at a moment's notice. But it might be wise to see as you are making investment decisions, how bad of a loss can you afford? Before you commit capital for a period of time, ask yourself if you can stand seeing that value deteriorate rapidly before recovering. If it went to zero, would that ruin you? Hint: if the answer is yes to that last question, you're in too deep.
"But I want to make money," you say. Yes, we all do. And to do so, it's helpful to remember that risk is the fee that we pay to be in the investment game. It's not a fine for doing something wrong. (Nod to Morgan Housel for this observation).
If you can manage that risk, emotionally and psychologically, as well as financially, then you might be clear to proceed. If not, it's helpful to recheck things. But whatever we do with investment risk, we typically do our best to avoid playing Russian roulette in the market. We recommend you do the same.
Any opinions are those of Tim Weddle and not necessarily those of Raymond James. This information is intended to be educational and is not tailored to the investment needs of any specific investor. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance is not indicative of future results.