Asymmetric investing is the backbone of many investing strategies. The whole idea behind asymmetric investing is to set your possible return to be bigger than your possible risk and then earn the risk premium. This strategy requires a great understanding of yourself, the market, and the current megatrends. This approach is well known within the market for Venture Capital but can be a very beneficial for investors.
Different Investing Strategies.
Most people are familiar with investing in one way or another. Today, there are many different ways to approach an investment. Some are passive investors who in accordance with The Effective Market Hypothesis believe the market price of a share reflects the alpha  and all the available information. In other words, you can’t beat the market. Others try to actively beat the market with different investment strategies. You might have heard about the strategy of value investing.
Value investing is best known because of the success of Warren Buffet who has become famous for benefitting from this approach. This strategy is all about investing in companies that seem to be on sale and priced below their true value. These companies are typically large companies generating great cash flows and has done so for many years. Value investors intend to generate stable returns during a longer time period with relatively low risk.
Other types of investors could be people who primarily invests in dividend paying companies, growth companies or investing to influence certain environments.
It is important as an investor to have a defined strategy, but you should be able to change it along with changing market conditions to avoid contributing to the negative statistics, that say; Retail investors tends to keep losers and sell winners or investors are irrational loss averse. A reason why these statistics turns out negative is because people don’t follow a defined strategy or they aren’t adjusting it to new market terms. Professional investors often benefit from remaining flexible as the market changes and thereby favors different types of investments.
 The return an investment generates relative to a benchmark index.
What is Asymmetric Investing?
Asymmetric investing is as the name suggests the opposite of symmetric investing. If you make a symmetric investment you invest in a security that has the potential to rise, let’s say, 10% or decline 10%. There is an equilibrium between the risk and reward.
The difference between symmetric and asymmetric investing is shown in the illustration below with the blue line representing the current valuation of an investment with the possible return on the righthand side and the risk on the left- side.
Asymmetric investment opportunities have a tilted correlation between risk/reward. The asymmetry can be either positive or negative. If negative, the downside is expected to be bigger than the upside. For positive asymmetric investments, the upside is potentially way bigger than the downside. An example of positive asymmetric could be investments in financial assets like shares. Shares can decline 1x the investment while they hypothetically can rise 10x the initial investment or even more. Shares are by definition asymmetric investments.
Negative asymmetric investments could relate to shorting. A company can only drop 100% in value which means the short positions are limited to climb 100%, but if the underlying asset skyrockets with 500% then you would lose 5x your short investment.
Theory Behind Asymmetric Investing
A main reason why asymmetric investment is possible is because investors (human beings) are loss averse. Daniel Kahneman and Amos Tversky have scientifically proven that people are more sensitive to the probability of losing than the probability of winning. This means that investors in general prefer ‘the safer choice’ with a minimum of risk.
The illustration below shows the asymmetric correlation between the psychological value of gains and losses. The S-shaped curve shows us that the psychological value has a steeper decline on the downside than the return on the upside. Losses provides more pain than gains give joy.
According to this thinking people would choose to do investment A (in the sheet presented below) even though investment B has a risk premium of $5. Logically this makes no sense because the reward related to investment B is obviously higher compared to the risk, but people are acting on their feelings which is why we should suppress the psychological value of gains and losses and try to be objective as investors.
The risk premium is calculated by comparing the potential risk with the potential reward:
A = (120-100)+(80-100) = $0
B = (135-100)+(70-100) = $5
When having a positive risk premium, the investment appears attractive. If we assume the outcome of these investments is binary and the end value is equal to either ‘potential risk’ or ‘potential reward’, then there is a 50% chance that investments fail or succeed. If you have two identical investments similar to investment A you statistically would end up with $0, because there is a 50% chance one would turn out negative and a 50% chance one would turn out positive.
If the same thing happened with two investments similar to investment B, you would end up with $5. You would according to the statistics lose $30 and win $35, which means your risk premium is $5.
Characteristics of an Asymmetric Investment.
Companies which could be an asymmetric investment opportunity are often characterized by the following:• Relatively low market value
• High growth
• Operates within new megatrends
• High risk / even higher reward
When we say the market value of these companies are relatively low it doesn’t mean it cannot be a multi-billion-dollar company. When you witness these extreme cases with companies that have high double, triple or even quadruple-digit returns within a period of time it is most often companies with a >$1b market value. It could be a biotech company who publish new positive data on their studies or a new tech company signing a big contract with an important costumer. This new data or contract could be the main pillar for long term growth opportunities. Something has to be the kick starter for long term growth like Apple’s development of the first iPhone or Mark Zuckerberg’s development of a social media platform for Harvard students, which has been the foundation for the success of Apple and Facebook respectively.
Companies operating on growing markets (for example within technology) could be underrated because it is difficult for investors to relate to. It is easier to be hindsight and see which macrotrends has been central for the past 10 years than to predict what trends will be dominant in the 10 years to come. This is contributing to a common misunderstanding of the potential of investing in new and disrupting technologies.
There are always ongoing megatrends in a dynamic world. They do change from time to time but are usually there for many years or decades. What is characteristic for megatrends is that they influence numerous activities, processes, and perceptions. Older megatrends deal among others with social, environmental, or technological changes, like:• We live longer
• We get wealthier
• The Earth gets warmer
• Growing pace of technological innovation
Newer megatrends within technological changes could for instance be:• Growing demand for data
• Growing demand for AI and IoT
• Improving healthcare technology
Megatrends can likewise have an impact on each other as well. Growth within technological innovation impacts an improving healthcare technology, which might be central for the fact that we live longer.
What is shared by small companies operating within strong megatrends is that the potential return is way higher than the risk. If all these cases end up with a negative outcome, their loss is limited to a max of 100% of the investment, but on the other hand, there is no limits for how high the return can possibly be. Amazon is an example of a company that has disrupted the way we shop today. The stock price has risen an astonishing +150,000% since their IPO in 1997! This is an example of why it could be worth building a portfolio with this investing philosophy in mind. Only a few investments must succeed to generate enough return to compensate for the failures.
Example of an Asymmetric Portfolio.
Here is an example of a portfolio consisting of 10 companies that was considered undervalued due to asymmetric investing. When thinking of an investment to be undervalued it is important to be aware of the probabilities that different outcomes happen. There could be a 5% chance that a stock rises 10x, a 20% chance it rises 5x or even falls to zero and so on. An attractive asymmetric investment has to take the probability of different outcomes into account. After having kept the same stocks in the portfolio for 10 years they have developed very differently. Only four of the 10 companies have succeeded and grown in value. 6 of them have either applied for bankruptcy or declined in value. The portfolio is presented below:
You can calculate the return of the portfolio with the following formula:
Rp = w1R1 + w2R2 + ⋯ + wnRn
Rp = Return of the portfolio
Rn = Return of a stock
wn = Weight of a stock in the portfolio
We can then calculate the return of our 10-stock portfolio.
Rp = (0.1 – 0.61 ) + (0.1 * 3.42 ) + (0.1 * -13) … (0.1 * 1010) = 258%
In this scenario the value of our portfolio would have grown 258% during a 10 year time period. This equals an Internal Rate of Return(IRR) of 25.8 % annually. With the MSCI World Index as a measurement of the market it has had an average gross return of 8.32% annually from 1870-2020. This underlines that with this approach only a few succeeding companies is nescessary in a portfolio to beat the market in the long run. Actually, you could have a 10-stock portfolio with just one company succeeding with +1000% to be sure of a positive return. Then it doesn’t matter if the 9 other positions fall -100%.
What Skills is Important When Using This Approach?
To be able to benefit from this investing style where you chase attractive probability weighted asymmetric investment opportunities you will need some certain abilities. First of all, you need to be patient. You should value your “time in the market” higher than your “timing in the market”. Patience is a key factor in many investing strategies but especially in this one because you never know when the next big disclosure happens. Then it would be a shame not to be invested.
To remain patient, it is important to minimize the consequences of behavioral biases that could affect investors’ decision-making process. This means you shouldn’t care of whether the stock prices go up or down when the case remains unchanged. Some investors tend to buy or sell due to daily fluctuations but when operating in a highly volatile market you should just ignore this.
Basically, it is very essential that you as an investor is very future-oriented. The importance of the ability to be aware of current megatrends can’t be highlighted enough since you are investing over a long time period. The better you are at analyzing ongoing megatrends and understanding new technologies and their potential the better a foundation you have to make a wise future-oriented decision.
CDON AB an example of an attractive probability weighted asymmetric investment?
A real example of attractive probability weighted asymmetric investment could be CDON AB, which has an e-commerce market platform in the Nordics. CDON has a leading position in a very underpenetrated and growing market that had a CAGR of 13% from 2015-2019. This means that if CDON is able to just keep their market share until the local market penetration in the Nordics of just a few percent equals the penetration of global marketplaces that have a market share of 50% their revenue would rise 20x. The question is if the probability of this potential revenue growth is priced in the current share price?
No one knows the probabilities of different outcomes, but a P/S of just 3.6 seems low compared to the fact that CDON is a high growth stock with a huge upside potential. Amazon launched a Swedish department in October 2020 so there might be risk that they would dominate CDON and steal market shares, but the Q4-earnings report from CDON doesn’t indicate any loss of momentum. A fast-growing market will attract competitors and normally there is space enough for more players, which might signal that the probability of CDON decreasing in value in the years to come is not that high.
This is not a complete analysis of the case of CDON AB, so there will be other factors that will have an impact on both the probability and the outcomes, but this will give an indication of one way to think when considering attractive probability weighted asymmetric investments.
It has to be declared that the above-mentioned example of a portfolio is not based on any real stocks which means the numbers related to this are fictional. The purpose of this writing is to inform the reader about the theory behind an asymmetric approach to investing.
Valuation of a Company
There is no ‘right’ way to valuate a company, which implies that different investors will make different valuations. Due to this there is no right, indisputable valuation method and then it can be even more difficult to predict potential outcomes.
Hyper Scale-Ups Stay Private for Longer.
Today, there is a trend for companies to stay private for a longer time before they go public. The average age of companies before they go public has evolved from 6 to 12 years during the past 40 years. When companies stay private it’s normally Venture Capital Funds who can invest and it’s more complicated for retail investors.
Despite of operating in highly volatile markets (like asymmetric investors normally do) doesn’t mean that you should ignore the current share prices completely. If the share price has soared significantly since the acquisition and no relevant news has been published, then you should still be aware of the opportunity costs and maybe sell with the profits and buy something else that now has a higher reward compared to the risk. When the share price rises without any related news then the risk increases, and the reward decreases, and you might find better asymmetric options in the market.
Prospect theory: An analysis of decision under risk:
Ulrich Schmidt & Horst Zank (2005), “What is Loss Aversion?” https://link.springer.com/article/10.1007/s11166-005-6564-6
MSCI World Index:
The Psychology of Investing Biases:
Companies stay private for longer:
Berk, Demarzo, and Harford (2019), “Fundamentals of Corporate Finance”
Bodie, Kane, and Marcus (2018), “Investments”
CDON AB: Q4 2020 earnings report