You may not be familiar with the phrase “asymmetrical risk/reward management” but you learned the concept at an
early age when Mom or Dad warned you not to get run over by a jeepney when crossing the street.
Stock-market investors learn quickly that they must figure out some sort of reward- risk-management system. The first part of the formula is deciding what the chances are of profit and loss. Since you do not buy a stock unless you think it is going to go higher, at the very least the odds are 51 percent to 100 percent the price is going to go up. Therefore, the risk is somewhere between 0 percent and 49 percent.
Now comes the profit/loss numbers. This is usually decided one of three ways. First might be relying on Technical Analysis, which says that the price should go to the next
resistance. Using fundamental analysis, we can pick some sort of fair value based on whatever corporate value you might want to use. Then there is the “My Facebook friend said the price is going to…”
But all that—from the odds of going higher or lower to the potential profit or loss—assumes a symmetrical risk/reward. But you learned at an early age that crossing the street and either getting to the other side or getting smashed by a bus is never ever the same twice. Winning or losing is forever asymmetrical. In the stock market, the odds of going higher or lower are never the same, just like the amount of potential profit or loss.
We attempt to deny the lack of balance with investing tips like “Let your profits run” and “Keep your losses small.” That is like Mom limiting her advice to “Don’t get run over and if you do, make sure your underpants are clean.”
Asymmetrical risk/reward management is based on the “possibility”—it might happen—of making a profit against the “probability”—it will likely happen—of losing. You know exactly that the 6/49 odds is 1 in 13,983,816. You are probably going to lose. But you possibly might win.
Further, to make the risk/reward equation more in balance, the lotto payout must be 13,983,816 times the cost of your ticket. The last 6/49 payout was P35,204,519 which means your P20 was a bad bet.
How then can a stock-market investor manage risk and reward in a world of asymmetrical possibilities and probabilities and unequal profits and losses? The answer is he cannot.
You cannot put the possibility of a stock going up or the probability of a loss no matter how great your analysis is beyond a “really, really good guess.” It is all arbitrary and the best you can do is reduce those numbers from totally bogus to sort of accurate. “Sort of” does not make you money consistently and under all unforeseen circumstances.
With experience you can cross the street by figuring out how to manage the asymmetrical risk/reward. Until you gain enough experience, you stay extremely cautious on not generating any losses, and do not worry how large your profits are as in “I want to cross the street right now!” You learn by practice how to keep losses small even if you do not make any money.
But the best way to cross the street is at the crosswalk with a traffic signal, where there is almost no probability of loss and great possibility of profit. In the stock market, that is called “buying with the trend and selling on the turning point.”
E-mail me at [email protected] Visit my web site at www.mangunonmarkets.com. Follow me on Twitter @mangunonmarkets. PSE stock-market information and technical analysis tools provided by the COL Financial Group Inc.
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