A Coin Flip

The result of the 2016 US Presidential Election was a win for Donald Trump. This result was indicated as less likely by some forecasting models – which saw Clinton as a c. 70 percent favorite to win the election. In such a situation, with essentially only a binary outcome, a heads-biased coin will still sometimes come up tails. Given the unpredictability inherent in forecasting the future, even with sophisticated modeling, how can we build an investment strategy around binary events?

  • Win/Loss Ratio = magnitude of the profit from winners divided by the loss from the losers (greater than 1.5 as a reference value)
  • Asymmetric outcomes – similarly, understanding the potential downside vs. upside of a position and looking for option-like payoffs
  • Margin of safety – from a value investing perspective, this will come looking at assets or cash flows that are undervalued by the market; there is also a probabilistic approach, where margin is achieved through high expected value.
  • Mispricings – following on from the last bullet, look for high probability events (based on your conviction, developed through fundamental analysis) priced assuming a low probability.
  • Loss aversion – Consider Jesse Livermore’s advice to “always sell what shows you a loss and keep what shows you a profit” or similarly the Wall Street adage to “cut your losses short and let your winners run.”

Sources and additional links for reference:

https://www.ft.com/content/72a116f2-b3d3-11e1-a3db-00144feabdc0

http://fivethirtyeight.com/features/final-election-update-theres-a-wide-range-of-outcomes-and-most-of-them-come-up-clinton/

http://onlinelibrary.wiley.com/store/10.1002/9781119203469.ch7/asset/ch7.pdf?v=1&t=ivbsjfx5&s=9055e7622a4f0d98dcdde61d324b81d451aa25e4

https://en.wikipedia.org/wiki/Reminiscences_of_a_Stock_Operator

http://www.investopedia.com/articles/stocks/08/capital-losses.asp

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