The Changing Moods of the Stock Market
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28 July 2024
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Hi, I am Richard. On this blog, I share thoughts, personal stories — and what I am working on. I hope this article brings you some value.
The Risk–Reward Principle I Didn’t Explain Clearly in My Article on Cyclical Opportunities
Risk vs reward investing principle
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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
60% chance of gaining 80%. 40% chance of losing 10%. Expected value: +44%. Individual decisions may lose. But a series of positive-expectancy decisions produces favourable long-term outcomes. This is the mental model behind every investment I make.
Common questions on this article's topic
What is the risk-reward ratio in investing?
Risk-reward is a framework for evaluating whether the potential gain from an investment justifies the potential loss. It asks: if I am wrong, how much do I lose? If I am right, how much do I gain? And is that ratio in my favour? In the article, this is presented not as a formula but as the fundamental mental model behind every investment decision — the foundation on which position sizing, capital allocation, and discipline are built.
What is expected value and how does it apply to investing?
Expected value (EV) is calculated by multiplying each possible outcome by its probability and summing the results. In the article, a simplified example illustrates this: a 60% chance of gaining 80% and a 40% chance of losing 10% produces an expected value of +44%. This does not mean any single investment returns 44% — it means that a series of decisions with similar asymmetry will converge toward that average over time.
Can a good investment still lose money?
Yes. In the article, this is stated explicitly: an individual decision can result in a loss, and several losses can occur in a row. What matters is not any single outcome but whether the series of decisions has a positive expected value. This connects directly to the Weak Law of Large Numbers — as the number of trials increases, the average converges to the expected value.
What is asymmetry in investing?
Asymmetry means the potential upside significantly exceeds the potential downside, or vice versa. In the article, the cyclical opportunity example illustrates positive asymmetry: when an entire sector trades near book value, further decline becomes less likely while recovery potential is substantial. The question is always whether the ratio between what you can gain and what you can lose tilts in your favour.
Is risk-reward the same as risk management?
Risk-reward is the foundation; risk management is the broader discipline built on top of it. In the article, the point is made that a positive expected value alone is not enough — if too much capital is allocated to a single idea, even a small negative scenario can cause disproportionate damage. Position sizing, diversification, and time horizon are additional layers that determine whether a theoretically sound risk-reward ratio translates into actual long-term success.
If you have any thoughts, questions, or feedback, feel free to drop me a message at mail@richardgolian.com.