This Hidden Principle is the Key to Making Profitable Investments
The simple framework I use to evaluate every investment (and decision) I make.
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It was a Wednesday afternoon and I had left school early to register for a $30 online tournament on the popular online poker site, PartyPoker.
I had deposited $50 a few weeks earlier using my parent’s credit card and had run it up to a couple hundred. I was nervous; this was the biggest event I had ever played.
More than six hours later, I outlasted more than 500 players and won. I turned my $30 into more than $2,500, a nearly 100x return on my capital in a single day.
I didn’t know it at the time, but I just had my first real-world lesson in an investment principle that would serve me well for decades to come.
I learned about the power of asymmetry.
What Is Asymmetry?
Asymmetry in investing refers to a situation where the potential risks and rewards are not proportional, meaning that the potential for gains and losses is unevenly balanced.
Notably, an investment could either have asymmetry to the upside (meaning a greater potential for gain than loss) or asymmetry to the downside (where the risk is greater than the reward).
Poker Taught Me About Asymmetry
I have reinforced the concept of asymmetry through millions of poker hands I've played over the past two decades. In hindsight, when reflecting on the lessons learned from my past mistakes, some of the most significant ones involve instances where I took excessive risks with my chips, despite the unfavorable risk-reward ratio.
For those who play and understand the game, a common example is when calling a big bet on a draw-heavy board, while holding a marginal hand that has little prospect of improving.
More often than not, you’re either already beaten and drawing slim, or your opponent has a lot of outs to improve to a better hand than yours.
These situations have ‘negative asymmetry’ meaning the most likely outcomes are either you win a little, or lose a lot. Naturally, you want to avoid these spots.
Fortunately, there are many situations in poker where the asymmetry is to the upside. These are some of the situations where I’ve made the most amount of money.
Common examples include calling preflop raises with pocket pairs or suited connectors, where one risks a small amount in hopes of winning a huge pot if they hit their hand.
In seeing firsthand how asymmetry is a crucial factor in determining my success (or even failure) at the poker table, it’s only natural that when it comes to investing, I was intrigued to apply this same principle to making bets off the felt.
Asymmetry in Investing
When making investments, I always filter them through the lens of my reward relative to my risk. In general, I look for investments where the former is many multiples of the latter, and therefore the asymmetry is to the upside.
I’ve written about how I believe Bitcoin is one of the best asymmetric bets in history, for it has the power to disrupt the place where the most amount of wealth is stored: money itself.
When I first began looking into Bitcoin in 2017, I realized it had the power to be a huge disruptor. I knew from playing poker that whenever I made a risky investment, such as playing in a poker tournament, my downside was always fixed. I could only lose what I put in. The upside, however, could be massive.
Seeing that the market cap was less than $100M, and the potential was in the trillions, I realized that opportunity was staring me in the face. Sure, I could lose whatever I put in, but if Bitcoin really does disrupt the global financial system, I’d be sitting on 100x return or more. Given my seemingly incredible reward-to-risk ratio, I pulled the trigger.
The mistake I see many investors make when they look at an asset like Bitcoin, is they are fixed solely on the risk. “What if it fails?” “What if governments ban it?” “What if it gets hacked” To which I tell them, fine, bake that into the equation. Sure, it may fail. You could lose 100% of what you put in.
But what if it succeeds and you make 100x? Put another way, if it only succeeds 1% of the time, you break even in terms of expectation. When it comes to asymmetric investments, a crucial principle to internalize is that one must weigh their reward to their risk, not just look at each in a vacuum.
To win as an asymmetric investor, you need a certain tolerance for risk, and to be focused on the payoff.
Capital Management with Asymmetric Bets
Naturally, a key with all asymmetric bets is to manage your risk. Just as you’d never buy in your entire bankroll in a single poker tournament, you’d never bet your entire bankroll one on an asymmetric bet, no matter how good the odds.
In looking at some of my biggest mistakes, it’s either been when the asymmetry wasn’t there, or I mismanaged my capital by allocating too much to one position, only to have the investment not pan out the way I hoped.
I’ve learned the hard way that it’s important to remain humble and be aware that I can always lose, no matter how good the opportunity seems. That’s why I have a hard rule to never risk what I cannot afford to lose on any given bet.
Put another way, before making any investment, I always ask myself, ‘Would I be able to stomach it if this went to zero?’ I then only allocate the capital I can afford to operate within this framework.
A Simple Framework for Making Investments
I apply this principle of asymmetry to every bet I make. It’s a dance between risk and reward. First, I’m always mindful of the risk. I’m screening for two things:
What is my maximum downside?
How much can I afford to lose if that plays out?
Second, I consider the upside.
What is the maximum upside for this bet?
What is the probability (in percent) that it will get there?
Once you have the above information, you can determine the expected value (EV) of any investment by multiplying the risk and reward by the probability of each.
EV = (Amount Won * Probability of Winning) – (Amount Lost * Probability of Losing)
I find that it’s very difficult to accurately determine the risk and reward, which is why I like my bets to have a large upside skew to compensate for any risk that I’m taking.
This is exacerbated in a high-interest rate environment like the one we are currently living in, where the ‘risk-free’ treasury rate is ~5%, causing complacency in the investor market. The going narrative is, ‘Why take a risk when I can T-Bill and Chill?’
This is why asymmetry is so important. When there’s a huge upside potential for the investment, it makes it more compelling. Aside from the EV equation, on a personal level, I’m much more excited and willing to fire when I know there’s a chance for a meaningful return.
My Take on Asymmetric Investments
Perhaps it’s the poker player in me, but I find I want some element of unknown in the outcome. I find it pretty boring to lock up capital in a retirement account for 30 years, with the expectation I’m going to make 7% in the S&P500. Sure, it’s profitable, and a reasonable allocation for some portion of one’s capital, but it’s certainly not what gets me out of bed in the morning.
I like hunting in the weeds and finding opportunities before the curve explodes up and to the right. I understand I may be wrong some of the time - that’s baked into the equation of asymmetric investments, just like it’s natural to lose in some of the poker tournaments one plays - but the upside potential is what makes the due diligence worth the effort and the risk worth taking.
When the risk is managed appropriately, because one uses prudent bankroll management, the fact the outcome is unknown (such as with Bitcoin as opposed to Treasuries) is actually where a lot of the opportunity lies!
As with all things in investing, a lot of this comes down to personal preference, risk tolerance, and what works for the individual. Having a big-picture investment plan and rock-solid portfolio management are crucial for long-term success.
Asymmetries in Life
Asymmetry isn't just a concept relevant to poker and investing; it applies to life too. Often, successful people attribute their achievements to serendipity, but what they don't always mention is that taking calculated asymmetric risks can significantly increase your chances of getting lucky.
For instance, when seeking an investor for your startup, it's wise to focus on low-risk opportunities like attending conferences, meet-ups, or sharing your work online. I've personally experienced the power of this approach, connecting with remarkable individuals and creating opportunities simply by sharing my journey and ideas online.
Considering that a single relationship or encounter can transform your life, and success hinges on people, it's logical to apply this asymmetric principle to relationships. Seek out low-risk situations to meet exceptional individuals, whether for business partnerships or personal connections and put yourself out there.
Asymmetry doesn’t stop here. It applies to all facets of decision-making. For example, getting a routine blood draw and health screenings are an obvious asymmetric bet. Foolishly, people take a reactive approach toward health instead of a proactive one, costing themselves time, money, and sometimes, in the long run, their lives.
The downside of early detection is a low-cost, low-time commitment one-time activity that’s mildly uncomfortable, but the gain is that you could potentially have a high-cost, life-threatening diagnosis that could cost you everything. Asymmetry is why I get my blood drawn and see a functional medicine doctor twice a year.
I challenge you to think about how you can apply this principle not just to investing, but to daily decision-making as well. I hope I have given you some food for thought to up your game, and you enjoyed this post. If so, please share it with a friend.
Alec