How to Win in Stock Market | Stock Market for Beginners (Part 2) | Lumovest
For those of us who are familiar with the hit TV-series Friends, there’s a scene where Joey and Rachel play coin tosses. The rule of the game is that heads Rachel wins and tails Joey loses. Of course it’s rigged, because if the coin lands on the head, Rachel wins and if it lands on the tail, Joey loses, which means Rachel wins anyways. So regardless which face the coin lands on, Rachel wins and Joey loses. And surprise, Rachel won 57 times in a row. As innocent as this game might be, it demonstrates a key concept that underpins successful investing. Heads, we win. Tails we don’t lose, or at least we don’t lose that much. As investors, we want to seek out opportunities with similar dynamics as this coin toss game. In the Upside Case, where everything goes the way we wanted, we make a lot of money. But even if the key risks were to play out, we don’t lose money or at least we don’t lose a lot of money in the Downside Case.
Suppose for example, we’re considering an investment into a pharmaceutical company. Its stock price is really depressed because the market believes the company’s drug will get rejected by the US government. Now suppose we buy this stock. In the Upside Case, where the drug is approved by the US government, the stock price will spike through the roof and we would make an incredible amount of profit. But even in the Downside Case where the drug is in fact rejected by the US government, the stock price won’t decline much anyways because the market was already pricing the stock with the expectation that it won’t get approved. See? Heads, drug gets approved by the US government, stock price jumps and we make a ton of money. Tails, drug gets rejected by the government, but the stock price was already reflecting the expectation that it won’t get approved anyways, so it stays flat and we don’t lose money. This is known as Asymmetric Risk Reward dynamics.
It characterizes situations where the potential for gains and the potential for losses are uneven. We want to look for investment opportunities where the potential for gains far outweigh the potential for losses. For example, in the Upside Case, we make 50% IRR and Downside Case we lose maybe 5%. That’s asymmetric risk reward where the upside potential of 50% is far greater than the 5% capital loss we’re risking. It doesn’t have to be the magnitude of gain versus loss. It could also be the likelihood of gain vs. loss. Situations where it’s far more likely that we’re right than we are wrong can also be very compelling investments. Now you don’t want to be on the wrong side of asymmetric risk reward situations where the potential for losses is far greater than potential for gains.
That’s a great way to lose money. We want to stay disciplined and only invest in opportunities where we think that things are likely to go in our favor, and the magnitude of gains is far greater than the magnitude for losses..
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