Asymmetric Risk Reward For The Win!
By: J SCOTT
As an investor, seeking out opportunities with a favorable risk-reward ratio is crucial to maximizing returns while minimizing risk. I often talk about the concept of risk adjusted returns, meaning the likely return we are to receive relative to the risk of the investment. In general, if two investments are likely to generate about the same returns, we would want the one that has the least amount of risk.
Pretty obvious, right?
In fact, that’s the entire basis of looking at risk adjusted returns – we are attempting to get the biggest bang for our investment buck with as little risk as possible.
And this is where the concept of asymmetric risk reward comes in…
Asymmetric Risk Reward
Asymmetric risk reward is a situation where an investment offers a bigger upside reward potential than downside risk potential (or vice versa).
For example, imagine I offered to play a game with you where we flipped a coin – if you guess the flip correctly, you win $10; if you guess the flip incorrectly, you lose $9. Obviously, this is a game you’d play all day; over many flips, you would almost certainly win more money than you’d lose.
Now, as you can imagine, we don’t often find investments that are this obviously providing a positive asymmetric risk reward. There’s rarely a situation where investments are giving us free money.
But, there are plenty of situations where, as a smart investor, we can tip the balance of risk/reward in our own favor and put ourselves in situations where we are likely to generate a larger return than the risks would otherwise indicate.
Let’s look at a couple examples of how I like to create asymmetric risk reward opportunities…
Expertise To Create Asymmetric Opportunities
The first set of examples create an asymmetric risk reward through knowledge and expertise.
I have two professional areas where I am more knowledgeable than most people – technology and real estate. I started my career as an engineer and MBA, having worked for companies such as Microsoft, eBay and DirecTV. And I’ve spent the past 15 years as a real estate investor, learning the ins and outs of residential real estate.
If I were to invest in the stock market, or in artwork, or in gold, my knowledge of the investment would be about the same as any other random person making the investment. My risk/reward profile for those investments would be exactly the same as everyone else, and my potential upside returns would be exactly commensurate with the risk I was taking.
But, when I invest in real estate, I have very specific expertise that I can apply to that investment. I can perform much better due diligence than the average investor. I might even be able to perform better due diligence than the operator I’m investing with. So, investing in real estate gives me the opportunity to create an asymmetric risk reward opportunity.
Likewise, I am an angel investor in some small startup tech firms, specifically focusing on real estate technology. Because I have some very specialized expertise in both technology and real estate, I can examine these businesses better than most people, and I’m likely to make better investing decisions – tipping the risk/reward scale in my favor – than most others.
Proxies To Create Asymmetric Opportunities
The next common way to create asymmetric risk reward opportunities is to do so through proxies – which is just a fancy way of saying that you can rely on other people who have expertise to help you lower risk.
The most common example here is to find the best people to oversee the management of your money. Whether you’re looking for a financial adviser, a tax advisor, an accountant or a syndication operator, finding those who are much better than average is a great way to tip the risk/reward in your favor.
For example, I often invest in syndications as an LP. I know that most syndications offer about the same returns these days, so if I were to pick an operator to invest with at random, I’ve created a situation where the risk I’m taking is probably pretty in line with the potential upside returns from the investment. But, by choosing the best syndicators I know, I get the same returns as all the deals I could invest in, but with a significantly reduced risk (based on the expertise of the operator).
It's exactly the same thing when you hand over your money to a money manager, financial advisor or fund manager.
Historical Analysis To Create Asymmetric Opportunities
The third way that I like to create asymmetric risk reward opportunities is through the study of economic history. In 2018, I published a book called Recession Proof Real Estate Investing, where I examined economic cycles and how they have related to real estate investing strategies.
What I found in my research is that there are certain trends that are common throughout different parts of the economic cycle that lead some real estate strategies (and asset classes) to outperform at certain times, and others to under-perform at certain times. By focusing my investments on those asset classes that tend to perform well during specific stages of the economic cycle, I’ve been able to create opportunities where my investments are more likely to succeed than if I had put my money elsewhere.
For example, I stopped flipping houses back in 2018 when I suspected that we were hitting the top of the economic cycle (I was obviously off by a couple years given Covid, but the idea was correct). And at that time, I moved into multifamily, as I recognized that large-scale residential property tended to perform well during recessionary periods and during periods of inflation.
By doing nothing other than moving money from single family residential to large multifamily, I was able to take advantage of the historical trend of multifamily property performing well during periods of economic downturn and inflation. This didn’t require any specialized expertise or any well-honed investing ability – it simply required me to be aware of historic trends and how they affect the industry.
This obviously won’t eliminate all risk to my portfolio (multifamily could still take a hit), but it does provide me with an asymmetrical risk reward situation, where my likely upside is greater than my likely downside, and my chances of investment success are better than if I chose an asset class to invest in at random.
Long story short, if you want to be a successful investor long-term, you need to find those opportunities where you have some advantage over the hoards of other investors looking for strong returns with less risk. And the best way to find them is through the application of your own expertise, finding others with expertise and learning your economic history.
Do these things, and you’ll be able to tip the scales towards the reward and away from the risk.