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The Power Of Asymmetry: The Importance Of Minimizing Losses And Maximizing Gains

|Includes: BB, Caplease, Inc. (LSE), X


Asymmetric investing is the process of identifying and executing trades with a positively skewed asymmetric distribution of possible returns. Asymmetric trades have a small and defined down-side, when forecasts or analysis is proven wrong, and a relativel larger upside when forecasts or analysis is proven right.

Asymmetry vs. Binary

Markets are unpredictable, irrational and inefficient. These traits do not prevent investors from placing a great deal of confidence in their ability to beat the market. Retail investor hubris remains prevalent despite the warnings of industry professionals and asset managers.

The retail investor's misplaced confidence in predictive ability is evident in their tendency to accept binary outcomes. In other words, retail investors hold positions with exposure to a significant upside as well as a significant downside. They either ignore the potential of significant losses or drastically underestimate the probability of their occurrence. Even a systematic, extensive analysis may yield an edge in forecasting accuracy of only one to two percent. To mitigate risk, invest with the purpose of preserving capital and minimizing losses when analysis is proven wrong by the market.

Asymmetry in Security Selection

On an individual security basis, an asymmetric trade provides a larger margin for error and decreases the required accuracy rate for profitability. For example; analysis of security A determines that if an expected outcome occurs the security will rise in value by 50%. Analysis also determines that if the expected outcome does not occur the security will decline by 10%. The asymmetry of the trade lies in its distribution of returns. An investor earns 50% if accurate and loses 10% if inaccurate. An investor's analysis has to be accurate and validated 3 out of 10 trades to be profitable. To work this out further, let's assume a $100 investment in 10 asymmetric trades; 7 wrong forecasts with a 10% loss for a total loss of $70 and 3 correct forecasts with a 50% gain and a total gain of $150. The investor yielded a net return of $80, or 8%, despite a 30% accurate rate. Of course, this is an extreme case but it demonstrates the inverse relationship between asymmetry and accuracy. The higher the degree of asymmetry, the lower the forecast accuracy required for profitability.

Next, let us contrast two real world examples to help distinguish between a binary and asymmetric investment. Most readers are likely familiar with Blackberry, BB; a prolific Canadian cellphone manufacturer whose stock, and profitability, declined significantly. Blackberry's steep selloff, when it traded under RIMM at well over $60, eventually stabilized. RIMM then displayed volatile price movements within a range of $10 to $15. Purchasing BB in Q2 of 2013, prior to Q2 reported earnings, is a classic example of binary investing. If Blackberry beat estimates, with guidance set at breakeven by the firm's CEO, analysis yields an expected stock price of $20 or higher. If, on the other hand, Blackberry reported a loss, a drastic sell-off was likely. The distribution of outcomes is binary and investors can earn either a significant gain or significant loss. Binary investors who purchased BB prior to Q2 2013 found themselves on the wrong end of the binary distribution when BB reported a Q2 loss and shares declined over 25% in a single trading day.

An example of an asymmetric trade, on the other hand, is investing in TMX group, X, prior to Q2 2012. TMX group owns and operates Canadian stock exchanges such as the Toronto Stock exchange, TSX, and the Montreal Exchange, MX. The company, at the time, had strong fundamentals and a valuation in line with its peer group. In Q1 2012, the company announced a proposed merger with the London Stock Exchange Group (NYSE:LSE) which would create a new firm with a market cap larger than the NASDAQ. The merger faced challenges in winning over shareholders and had to compete with a rival offer from the Maple Group. TMX shares traded in the range of $40 to $45 in Q2 2012 despite an expected takeover price of $50 a share. I am uncertain why TMX's stock price failed to appreciate to the rumored takeover offer price. Maybe investors believed the merger would not receive regulatory approval, or that LSE's or Maple's offer would fail to gain the required two thirds shareholder approval. Whatever the reason, retail investors could purchase shares of X for ~$45 in Q2 2012. The asymmetry in this trade lies in the range of possible outcomes. If the takeover offer succeeded at a tender offer of $50 a share, shareholders stood to gain over 10%. If, on the other hand, the offer failed, a sharp sell-off was unlikely due to the company's strong fundamentals, the stock's fair valuation and the priced in uncertainty of a succesful takeover. Asymmetrical trades yield proportionally larger gains when right and small losses when wrong. Ultimately, TMX shareholders accepted a tender offer from Maple Group of $50 a share after regulatory approval was granted in July of 2012.

Power of Asymmetry

In conclusion, retail investors stand to gain by converting from a binary investment process to an asymmetric investment process. Asymmetric investing benefits retail investors by reducing the effects of capital erosion and lowering the required accurate rate for profitability.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.