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.”
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