This is not investing advice. Seek a financial professional before making important financial decisions. This article is for informational purposes and should not be interpreted as a recommendation to buy/sell/or trade any security.
“Minimizing downside risk while maximizing the upside is a powerful concept.” – Mohnish Pabrai
We often decide between two options based on the expected outcome. Say you go to a new restaurant and are choosing between pasta and brisket. You like brisket so you go with that. But it is hard to make brisket well and so you might end up going hungry. Perhaps you should have gone with the pasta…it’s really hard to screw up pasta.
Positive skew is that there is a bigger chance of a large loss than a large gain. Brisket, in this example, may provide you with a higher expected return (better tasting), but carries a greater risk of (but easier to screw up). The best decision makers are those that learn to think in terms of probabilities. This is true with dinner, investing and perhaps even politics. The best decisions are those that avoid “tail risks” and allow for potentially very positive outcomes.
In investing...positive skew is a rare property. The company, commodity, or currency needs to provide very little downside risk compared to the potential gain.
Options provide artificial positive skew. An option gives the holder (long position) the right, but not the obligation, to purchase a financial asset at a given price. If the price moves against you then the most you can lose is the cost of the option, but gains are limited only by how far the price can move in the money. Option traders know this and so option buyers on the whole are required to pay large premiums to compensate sellers for the negative skew they are taking. But assets can also exhibit natural positive skew, and that is what we look for.
So where does one search for natural positive skew?
In truth the return distribution (i.e. probability of gains and losses) is unknowable. Much in the world of finance is determined by “radical uncertainty” a term coined by Mervyn King. What this means is that not only do we not know what the future will bring, but that we generally cannot put probabilities on future states of the world.
But if we put enough time and effort into understanding an investment we can at least try to get a good sense for the range of potential outcomes.
We don’t do “price targets”. No one knows the “intrinsic value” of any asset. That’s the trap that “current income” investors fall into … they want certainty in how much money they will receive even though certainly in investing is always an illusion.
Our portfolio contains many investments that we believe to have the quality of positive skew. In any given year we try to expose ourselves to the potential for large positive returns by accepting a modest reduction in our worst case scenario. These may appear risky by themselves but as a group they are diversified with considerable upside potential.
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