I’ve been thinking about small things that can have a disproportionately large impact.
For example, buying options against potential Black Swans. The cost of an option for an unlikely event occurring is generally small but if it happens, the upside can be huge.
Conversely, you can have the opposite happen. Credit Suisse made $17.5m in fees from Archegos last year but the downside, which eventuated this year, is a loss of $5.5 billion. The fees may have seemed juicy enough to overlook the downside risks.
The interesting thing about asymmetric risk is that they’re not really intuitive.
It’s something that you need to sit down and really think through the potential outcomes. In some cases, it can really feel like going against your instincts. There’s also of course the case of seriously misjudging probabilities.
In considering asymmetric bets, I’m looking to minimize instances of large downside risks and maximize upside potential relative to the benefit and cost, respectively.
Downside Risk — Cycling and Scooters
Ed Thorp (a mathematics genius that taught probability theory and ran successful hedge fund) once looked at the downside risk of cycling and decided that the benefit simply wasn’t worth the risk to him.
And he was someone that really loved cycling and understood the health benefits of cycling daily to and from work.
The same principle can be applied to Bolt and Lime scooters (on which I myself had an accident and broke my wrist) but I’d say the risks are probably higher than cycling.
When I first started selling on Amazon FBA, there wasn’t much competition and each product experiment (in the form of new product listings on Amazon) would only cost a few hundred to a few thousand dollars. That would be the total cost of my downside.
The upside was pretty much unlimited. Sure, many of the products have flopped. But some of the other products would end up making 6 figures per year. I’d price low, build up sales momentum, get reviews and eventually dominate in niches.
The cost should always be considered.
For a typical venture capital firm, investing say $100k for 10% equity in a start up with the hopes that it goes to the moon can be a good strategy.
For someone whose entire net worth is $100k, the same will probably not hold true.
On the other hand, if that same person is an expert in the industry the start up is in and has the opportunity to be an advisor with equity involved, then this can again be a case of low cost/big potential upside.
Let’s say you think that AI may eventually replace 98% of all jobs including yours sometime in the medium future. You decide to invest 10% of your money into a collection of tech companies that you think will most likely be leaders in this new world.
The downside is that you lose a portion of your money in case their share price declines or the companies go bust.
The upside is that some of the companies you invested in goes up exponentially as your thesis plays out. Or they go up anyway, perhaps to a lower degree, because they’re solid companies that continues to make money.