The Secret To Wealth Generation: Asymmetric Returns

There are many secrets to generating wealth but in one form or another it is all about the asymmetric return. Asymmetric returns or asymmetrical distribution can be illustrated with a "positive skew" or what most people refer to as a "skewed right" distribution.  It can be done with a normal distribution or skewed left as well as long as the median is far enough above zero but that is less likely.





Over time trades have a slight skew right because wealth is generated over the long run. Stocks go through many cycles but the ones that outperform only need a slight skew over a long period of time to generate a positive return independent of your strategy. However, there are plenty of situations that you can create an asymmetric return on risk or what can also be considered "asymmetric risk".
Take for example the secrets of Warren Buffett. He did so many things well.
First he had a strategy that was going to provide him with an edge which produced asymmetric returns through outperformance in bear markets. (see bottom right)

He did this through having a portion of his account in what he called "workouts" which was "risk arbitrage" and "special situations" that would profit independent of market direction.

Second through his value investments and "net-nets" he was able to buy stocks well below intrinsic value or "purchasing a dollar for 50 cents" This on average both reduced risk and increased return and boosted performance in both conditions, but typically in the intermediate term still correlated with the market. (But due to his "workouts" he would be capitalized to add more undervalued stocks if the market declined rather than being forced to sell something undervalued to buy something more undervalued like most value investors.

Third he traded with other people's money and with a disproportional amount of someone else's money on the line he started a hedge fund where he shared in 25% of the returns beyond the first 6%.
Forth he merged the partnerships he had to buy Birkshire, a textile company that was priced well BELOW the inventory liquidation cost. (Buying $1 for 50 cents)
5th he liquidated the inventory and turned the company into an asset management company and
6th hetook the company public, selling 80% of the company at a premium to the public raising a ton of money while still owning 20% of the upside in the company's future return on his remaining stake.
7th he took the public shareholder's money and put it to work buying insurance companies that would continue to collect income and pay off his initial investment and
8th he invested the float of the available balance from the operating income. In other words insurance companies collect money monthly from the insurance and are sitting on that money before they pay out claims. Buffett took this money and put it to work
9th He bought good companies at a fair price like coca cola which would grow in value and continue to earn money over time and eventually the investment would continue to compound and the untaxed earnings would also compound if he didn't sell. The key would be to find a company unlikely to go bankrupt and that will also earn in excess of 100%. This provides a greater than 1:1 relationship between risk and reward.

Note that he not only had an asymmetric return in everything that he did, but he also found ways to get more out of each decision he made and create leverage without leveraging the risk.
Ben Graham would use Net Nets, he also liked insurance companies for the same reason Buffett did and Graham would also adjust his allocation to handicap market so that he had more towards investments when he had bullish expectation and more towards treasuries when he had a bearish expectations and he used an allocation strategy which over time produces asymmetric returns.

As a trader I use out of the money options which are all about the assumption that returns will be skewed towards one direction, and if you are right you can make many times the risk. The clear thing is that if you have an outlier to the downside, (say an overnight gap down) you only lose your initial risk. If you have an outlier to the upside (say an overnight gap up) you can gain ridiculous sums of money well in excess of your risk. Even without the outliers, the trading system is done where the underlying stock has a limited downside as it will be near support and the upside will be well in excess of that downside in around 80% of all cases. Another thing I do for the asymmetric return is identify stocks that have been hit with negative emotions and with tarnished sentiment that isn't beyond repair. People that get frustrated with the trade giving up for emotional reasons take a lot of the downside risk OUT of the stock independent of how stops are managed and the upside risk for shortsellers outweighs the downside risk providing the asymmetric risk/reward to the benefit of the trading system.

Volume profile also offer the psychological conditions for where the action required to drive the stock up or down is asymmetric. In other words, an equal amount of buying pressure will produce much larger price movement than the same amount of selling pressure. This is because there isn't the psychological price history to provide a backstop from stocks continuing their momentum to the upside, but there are plenty of past action below to potentially behave as support.

Finding stocks that are oversold by multiple time frames can also offer an opportunity where the downside risk has been largely sucked out particularly on high volume indicative of capitulation. However, often times the severe oversold indication will have risk to option buyers including high volatility and high premium cost that make capitalizing off of it using leverage a bit more difficult. However, looking at instruments like gold and oil and copper can provide a situation where even though the underlying commodity is oversold with high volatility, the individual stock may have low volatility, and in a much more manageable location.