Differentiating Investing From Gambling

The line separating investing from gambling is razor-thin, yet critical.

• In gambling, the probability of loss exceeds the probability of gain.
• With investing, the expectation is that the probability of gain exceeds the probability of loss.

The key lies in probability – a tangible metric expressed as a percentage. Serious investors should always weigh the projected return against its associated risk. Regrettably, this is an overlooked step by many.

Consider a coin toss. If I propose a bet where I’d reward you with $10 for accurately predicting the outcome, a logical wager would be $5.

Why?

Because with a 50% chance of success, $5 divided by 50% equates to the expected return of $10. Offering more than $10 for a $5 bet would be in your favor; anything less wouldn’t. Investments, of course, involve more intricate calculations than a mere coin toss, but the foundational logic remains unchanged. It doesn’t matter how you feel about the coin or the person doing the tossing or what kind of story is used to predict the outcome. The probability is the probability.

Risk Is A Number

Risk is not a feeling, it’s not a story. Risk is a number; it’s the probability of loss weighted by the potential degree of that loss. Many investors make the mistake of focusing on returns without considering the risks they’re exposed to in order to achieve those returns.

They’re accustomed to looking at returns as a percentage but risk can also be measured as a percentage. Only measuring returns is like only looking at the deposits in your bank account and ignoring the withdrawals.

Investors also tend to mistakenly believe that their control over a situation reduces risk. (Like driving a car vs. flying in an airplane.) This is somewhat true if you’re a professional driver in a high-performance vehicle. However, in financial situations, the converse is usually true.

Just like pre-2008, investors were lulled into a false sense of confidence by the bull market of the previous decade, this round of DIY investors is not prepared for the next crisis that’s likely to occur in the not-so-distant future. Any meaningful risk assessment must be based upon rigorously executed quantitative analysis of historical data that encompass a minimum of one complete market cycle.

Accurately Measure The Risk of Any Investment

Measuring the risk of an investment accurately is pivotal for informed financial decision-making. Investment risk arises from two primary sources: ‘systematic risk,’ influenced by broad market or economic factors, and ‘unsystematic risk,’ specific to individual investments or industries. Diversification can help mitigate the latter but not the former.

Another significant factor is liquidity risk, which assesses how easily an asset can be sold without price detriment. The risk in any investment can, and should, be measured using a complex set of mathematical calculations referred to as “Risk-Adjusted Performance Measures.” When used properly, they can accurately measure the quality of an investment.

A risk-adjusted return measures an investment’s return after taking into account the degree of risk that was taken to achieve it.

To quantify risk, many investors use statistical tools like standard deviation or Value at Risk (VaR) to gauge investment volatility and potential losses.

Furthermore, to account for the relationship between risk and return, risk-adjusted performance measures like the Sharpe ratio or the Sortino ratio are employed. These metrics help determine whether an investment’s returns justify the risks undertaken.

In essence, understanding and quantifying investment risk involves blending both qualitative and quantitative assessments, with a keen focus on risk-adjusted returns to ensure optimal investment choices.

Invest Like The Smart Money

In essence, this probability-driven approach is how “smart money” like, top hedge fund managers, private equity firms, and investment banks place their capital and make investment decisions. Contrastingly, the majority tend to base their investment decisions on narratives, emotions, or interpersonal relations – all unreliable factors when your capital is at stake.

These leading firms are utilizing the expertise of ‘quants’ (skilled in physics and math) to meticulously measure and calibrate risk-adjusted returns of their investment offerings. They often use this expertise to bet against the general public and push subpar products through their armies of sales staff, aka, financial advisors.

The business of investing is the business of buying risk-adjusted returns at a good price.

Benjamin D. Summers

We’re currently witnessing an unparalleled wealth transition. To align yourself beneficially within this shift, you’ll want to harness the insights and tools used by top hedge funds and investment banks to tip the tables in your favor.

Accurately measuring the risk of any investment requires a deep understanding of various risk types, consideration of both quantitative and qualitative factors, and a recognition of the inherent limitations of any risk assessment tool.

The pursuit of returns is invariably tied to the acceptance of some degree of risk, and a thorough risk assessment is essential to navigate the complex world of investing with confidence.

At Accelerated Capital, we apply third-party risk-adjusted performance measures to our rigorous due diligence process to bring our clients the best investments in clear, objective, and absolute terms.