Hi Guys,
Recently I have been thinking about the reward-risk tradeoff ratio, especially as it might apply to sporting events. Wagering on a sport outcome certainly might be equated to a speculative financial investment, but with some added advantages.
One advantage is coupled to the formal distinction made between risk and uncertainty. A bet on a sporting event has well-defined quoted odds so that the payoffs are well established; both the winnings and the losses are quantifiable with precision. Also the timeframe is known. These attributes are more poorly defined, both for potential profits and for a projected timetable for any financial investment.
A second advantage is that sporting event odds are likely less rational than those of the marketplace. Although the absolute efficiency of the marketplace can surely be challenged, it is probably less emotionally-driven than sporting wagers. For instance, The NY Yankees enjoy a far more loyal fan base than the much smaller and antsy cohort that root for IBM.
My thoughts on this subject were prompted by a recent Forum posting that referenced a new ETF product that will bear Nassim Nicholas Taleb’s nameplate.
I do not in any way consider myself a sports authority. I know a little, probably less than most Forum members on sports in general, and I suppose that makes me a dangerous man.
I am particularly amazed how sporting odds seem to gravitate to extremes. Under those conditions I suppose that emotions dominate the decision making process. Surely, among professional athletes and teams, no participants in a contest should be a 100 to 1 underdog. If that were true, the match should never have been scheduled in the first place.
The odds instantaneously reflect public sentiment and opinion as the Las Vegas bookmakers adjust the odds in a pari-mutuel system such that they usually gather a profit regardless of the outcome. This suggests that the largest profits for a gambler (an investment speculator) are derived by adapting a contrarian’s philosophy.
In fact, the only racetrack gambler that I knew used exactly this style to secure profits over the long haul. He only wagered when the odds shifted to higher payoffs for his “investment” as the race approached. Otherwise he would control risk by not wagering.
Harry Browne recognized this contrarian’s attribute for successful investing many decades ago. He often cited the need to assess the Reward-to-Risk tradeoff ratio. He emphasized the need to estimate the potential profit and to control the downside risk. He recognized that a contrarian’s opinion would enhance the size of a positive speculation. Browne favored stop-loss and trailing stop-loss adjustments to curtail losses.
To quote Harry Browne (chapter 21, “Why the Best-Laid Investment Plans Usually Go Wrong”): “Being in the minority doesn’t make you right, but it usually means that you have more to gain if you are right.”
Browne recommended a minimum Reward-to-Risk ratio of 5, but favored a ratio of 10 or above. Of course you must estimate the values that go into the construction of that ratio. It is interesting to note that the behavioral researchers typically find that the payout ratio must be above 2 for most gamblers/speculators/investors/vested individuals to accept an even wager.
In the sporting world, boxing seems the most prone to move in the direction of unrealistic odds. I recall championship matches when the odds spiked well north of 10. Is there an investment opportunity in those identifiable cases? Maybe so. I wonder if there are some investment ponies here?
The boxing world, and many other sporting events often seem to provoke extreme opinions, extreme emotions, extreme betting support, and perhaps, extreme speculative investment opportunities. One simple rule might be to accept any offered odds in excess of 10. Professionals are hardly ever that mismatched. I suspect this has been researched extensively, but not by me. Another future task to add to my list.
Let’s return to Nassim Nicholas Taleb, of “Black Swan” fame, once again. I wonder if his newly minted investment product will reincarnate the speculative approach that he practiced in his earlier hedge fund and his books.
Basically, Taleb has recommended a portfolio that is composed of a permanent risk-free component like Treasuries, plus a highly volatile speculative group. He roughly adhered to the 80/20 rule. About 80 % commitment to safe, risk-free positions, and about a 20 % commitment to speculative investments.
Since the risk is inherently high, outcomes highly uncertain, and timing impossible for the speculative components, he advocated diversified, multi-component holdings in that unit. In his older investment entries, he acknowledged the likelihood of many losing positions, numerous losing weeks and months before a windfall strike. His own coworkers described the difficulty and worries of such a strategy as “bleeding to death a few drops at a time”.
The doubts that arise from this investment style must magnify fears, and I suspect finally ended the life of his original hedge fund. Is Universa a new entity entirely or an outgrowth of his original outfit? Taleb doesn’t run the fund. Apparently he will serve as an advisor with unclear duties and responsibilities at this juncture.
So, what’s Taleb’s new product feature? I visited the website announcement posted by Investor on June 27. That short piece indicated that Taleb would use “puts” as part of his overall strategy. However, the article was too brief to make any meaningful judgments. My Google search did yield a few stimulating articles from the financial websites. Here is one such article from the Seeking Alpha website:
http://seekingalpha.com/article/275773-universal-investments-mulls-black-swan-etfThere were many others supporting the Seeking Alpha position and some that did not. The referenced article expressed reservations about the methodology. The author discussed alternate investments that would achieve similar goals. Others were more positive. As usual, you get to chose your own poison.
Mark Spitznagel is the expert who will head the Universa investment team. It operates from Santa Monica offices in LA. Spitznagel was the primary trader who worked for Taleb at Emperica. I guess he intends to duplicate Taleb’s investment philosophy once again. If history repeats itself, that philosophy expects to enter speculative investments that will prove to be losers as much as 95 % of the time. Of course they expect that the wishful 5 % winners will reward them with profits that allow for loss recovery and for a respectable annual net return. I wish them luck; they will need it in Spades.
The Bogleheads site had an excellent observation posted that completely represented the perspective of most Boglehead devotees: “Investors would get a much better deal if the ETF was 100% invested in out of the money puts and they held T-bills separately without paying 1.5% on them.” There are always many ways to skin a cat, some a lot less costly than others.
If it is finally approved by the SEC (if ever), and if the founding firm elects to market the fund, I will pass on it.
Best Regards.
Comments
After the last crash a lot of untested and exotic "alternative" investing instruments are introduced. They are often using derivatives. I think most of these are in response to re-capture the fleeting investor monies and will fail to meet the expectations next time and will be quietly liquidated and all records will be expunged. But until then Wall Street is making good money on extremely high fees.
For my investing I am mostly sticking with a largely conventional portfolio.