Article
The Risk–Reward Principle I Didn’t Explain Clearly in My Article on Cyclical Opportunities
When I wrote a post about cyclical opportunities in the stock market, the core idea was relatively simple. In certain segments of equity and commodity markets, cycles repeatedly emerge. At specific moments, these segments reach historically low valuations from the perspective of metrics such as the PB ratio, the price-to-book ratio, meaning the relationship between stock prices and the book value of companies in the sector.
I suggested that precisely these “unpopular” segments may represent a more interesting opportunity than popular growth sectors traded at extremely high PE multiples. Only later did I realise that although I described the market situation, I did not clearly explain the mental model behind that article.
That model is based on a simple question: if I take a certain risk, how much can I gain, and how much can I lose? And is that ratio in my favour? In finance, this is called risk–reward.
This is not about whether something is risky or safe. Every investment is risky. It is about the ratio between potential gain and potential loss. It is about asymmetry.
Simplified Example
Let us deliberately simplify reality.
Imagine an investment with only two possible outcomes:
There is a 60% chance of gaining +80%.
There is a 40% chance of losing −10%.
This can be expressed as:
EV = (probability of gain × size of gain) − (probability of loss × size of loss)
Plugging in the numbers:
EV = (0.6 × 80) − (0.4 × 10)
EV = 48 − 4
EV = +44%
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Disclaimer
This article is intended for informational and educational purposes only. It does not constitute financial advice, a recommendation to buy or sell any securities, or a guarantee of future market performance. The views expressed are solely those of the author, who may also be an investor. Investing in financial markets involves risk, and each reader should make their own decisions independently and, if necessary, consult with a licensed professional.
Summary
Common questions on this article's topic
What is the risk-reward ratio in investing?
What is expected value and how does it apply to investing?
Can a good investment still lose money?
What is asymmetry in investing?
Is risk-reward the same as risk management?
If you have any thoughts, questions, or feedback, feel free to drop me a message at mail@richardgolian.com.
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