Should we reconsider the way how we view risks in portfolios?

If you are new to investing, you should probably read ‘Intelligent Investor’ by Benjamin Graham. In his book he notes that you should invest in funds, preferably the ones that are passive or buy blue chip stocks. If you find this strategy boring, he notes you can use a maximum of 10% of your portfolio picking stocks you think will skyrocket and see if you can beat the rest of your portfolio.

Expected value, maybe losing a lot of time is good

Let’s imagine we have two possibilities to invest 10% of our portfolio:

  1. Invest in stocks that have a 50% probability of gaining 10%, a 20% possibility losing 10%, a 30% probability staying the same.
  2. Invest in stocks that have  an 80% probability losing all your money, a 20% probability to gain 3000%

If you invest EUR 1000 in the first stock your expected value is EUR 30 (50%*10*1000€ + 20%*-10%*1000). To get the same expected value from stock number 2 you only need to invest EUR 55 (95%*-100%*55+5%*3000%*55).

If 10% of your whole portfolio is EUR 1000, one might think the latter would be a more interesting choice. But before you go and buy this stock, you should calculate the odds whether it’s more likely you will run out of money before your investment gives you a return. In this case your odds to make money is 52,04 %, because you can only afford losing your money 18 times in a row.

Monte Carlo Simulation

tulokset

When we run the second investment opportunity 1000 times, investing EUR 55 18 times in a row. We can see 38,20% times investing was not profitable, 38,90% of the runs resulted EUR 1715 and 17% of the runs returned EUR 3420.

If you can handle the losses, this seems like a good strategy. Overall return for simulation was EUR 1 850 420 and the amount invested EUR 825 000 making profit of EUR 760 420.

Conclusion

Obviously this case was an extreme example, but it illustrates how making mostly loosing investment can actually be more profitable than making the safe pick. You should realize that when picking a riskier strategy you will have to bear losses a lot of times.

If you pick it, you have to be 100% sure you are doing the right thing and that you can afford to do it mentally and financially. There is absolutely no idea to use risky investment for a while and realize your mentality can’t take the losses, so choose carefully!

Sources

https://www.khanacademy.org/math/probability/independent-dependent-probability/independent_events/v/getting-at-least-one-heads

 

 

 

 

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3 Responses to Should we reconsider the way how we view risks in portfolios?

  1. Ramp says:

    Interesting strategy

  2. jonihh says:

    Interesting graph

  3. latzo says:

    Very interesting topic and good graphs! Very excellent blogpost!!

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