Article
The Risk–Reward Principle I Did Not 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.
Expected Value: A 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%
Continue reading for free
Enter your email to keep reading for free. This also subscribes you to my monthly newsletter. No spam, unsubscribe anytime.
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?
How do you calculate the risk-reward ratio?
If you have any thoughts, questions, or feedback, feel free to drop me a message at mail@richardgolian.com.
LinkedIn
Related articles
Embracing this perspective has made my investment journey a real intellectual adventure.
A very good question. More and more, I feel that I am chasing things that do not make me happy at all and that I do not need to be happy at all. So why am I chasing them?
In April, in the first part of this series, I wrote about an AI prediction system I had started building on my own machine. At the time the software was a few hours old and the prediction record was empty. The record since then has shown one thing: the system does not yet understand the market it is being asked to forecast. It can pull macro context, book value, earnings. But it cannot put those together into something that helps it understand the price.
More articles
Are you a content creator playing by the rules of YouTube, Instagram or Google? Are you a small business owner whose business model depends on how often Amazon recommends you, how expensive Facebook ad impressions will be or how expensive Google Ads clicks will be? If all or most of your contact with your audience or customers depends on a big platform showing you to them, you are not in a strong position.
The development of artificial intelligence changes how we look at which paths in life make sense. Which studies and which profession to choose.
It was Thursday, 31 March 2022, when I handed over the last of my responsibilities to my colleagues, closed my laptop and went to the library. I left my job for several months and immersed myself in philosophy. And I am immensely grateful for it. Today I am, like most people, on a merry-go-round, and it is hard for me to stop and think about the fundamental questions of my own life.
It was September 2023. My life, my work, everything was completely different from now. It was simpler. I owned almost nothing. I needed to film an advert, I went up to a floor inside the company where the product I needed for that advert was, and there I noticed her for the first time. She laughs at me when I describe it like this, but at that moment the universe told me, that is her.
How and why I am gradually leaving social media and the big platforms. When I read that Meta is testing a new way to charge for organic posts that link outside its platform, it confirms how right I was to become steadily less dependent on the big platforms and on social media. It does not mean I have left them completely. It means that whether or not I stay in touch with my readers depends on them less and less, and today almost not at all.
One of my family members described a firm that has its data in several different tools, and its employees still join it by hand, in spreadsheets. That is the ordinary state of firms. When somebody tells such people not to do it by hand and to use AI, they will not understand. Most firms do not even have the basic connectors between the tools they use. These firms need help with AI transformation.
The same task, two models. Fable 5 against Opus 4.8. On paper Fable is the better model, with a larger context and stronger specs. And still it lost. Opus handled the task with a single round of checking for 721,000 tokens, while Fable needed nine rounds and burnt through 2.78 million tokens. The difference was not in the model, but in how I set the task. And I know it, because I measured it.
A few weeks ago I installed a small local AI model on my laptop that watches a live camera feed. I turned the webcam on in the dark, and in near total darkness it recognised me and the objects in the room. That such things exist, I have known for a long time. What opened my eyes was the accessibility. I installed it in one prompt, free, and it runs entirely on my machine, sending data nowhere.
I once wrote about building my own privacy-friendly analytics tool. It had bot detection from the first version, yet it was not enough. Direct visits took a strangely high share of my traffic. When someone claims that 20% of their visits are bots and 80% are humans, I used to think the same. Today I would say the opposite ratio is closer to the truth. This is how I got there.
I have Heidegger and my notebook beside me. I am asking where all of this is heading, where artificial intelligence is taking us.
Four days in Catalonia. No computer, no AI, almost no social media. I bought this notebook so that I could write down what I would think about, and what I would come across and learn on the trip.