Vexxed by the VIX? Here’s a Sane Solution for a Crazy Market
Markets this week have been on a roller-coaster, as headlines send stocks sharply up or down on an intraday basis. The policy whims of the White House are whipsawing investors, especially in regard to trade tariffs. The CBOE Volatility Index (VIX), aka “fear” gauge, has soared.
Political risk is worsening. After a long period of calm, volatility and uncertainty are back. The looming trade war is a major culprit.
Richard Nixon speechwriter Ben Stein, who also happens to be an economist, made a now classic cameo appearance as a high school teacher in the 1986 movie comedy Ferris Bueller’s Day Off. In his bland monotone, Stein tried to teach his comatose class of youngsters a lesson in basic economics:
“In 1930, the Republican-controlled House of Representatives, in an effort to alleviate the effects of the… Anyone? Anyone?… the Great Depression, passed the… Anyone? Anyone? The tariff bill? The Hawley-Smoot Tariff Act? Which, anyone? Raised or lowered?… raised tariffs, in an effort to collect more revenue for the federal government. Did it work? Anyone? Anyone know the effects? It did not work, and the United States sank deeper into the Great Depression. Today we have a similar debate over this.”
President Donald Trump should have attended this class. Of course, the former real estate magnate was busy in the 1980s with other matters, both personal and financial.
Trump officially signed tariff proclamations on Thursday that impose tariffs of 10% on aluminum and 25% on steel. Condemnation was swift and nearly universal. More stock market mayhem is sure to ensue.
How can you cope with this craziness? Let’s turn to the secrets of the super investors.
Warren Buffett, John Malone, Peter Lynch, Carl Icahn, George Soros: They’re all multi-billionaires. They’re called “Masters of the Universe.” What’s their secret to beating Wall Street at its own game?
A key strategy in their trading toolbox is called “asymmetric investing.” You’ve probably never heard of it, but it’s a proven way to get rich. If you want to make serious money over the long haul, you should understand how it works.
You don’t have to be a billionaire. You can and leverage this system for your own gains. It’s an apt approach for the turbulence we face in 2018.
Asymmetric investing is a strategy whereby the outcome of a trade probably has more profit than loss or risk taken. The upside potential may be greater than the downside loss. Or the downside is limited but the upside is unlimited.
Asymmetry. As applied to investing, it means the risks versus the rewards are imbalanced. An asymmetric portfolio entails fewer scenarios where the investment has the potential to lose money. If it does lose money, the amount lost is limited.
This method preserves capital. You also get downside protection. There are more scenarios where the investment has the potential to profit, and when it does the profits are significant.
The weighing scale…
How does this method differ from conventional investing? Like most investors, you probably weigh risks and returns in a way that’s directly correlated.
For example, you already know that a small biotechnology stock has more risk than, say, a large-cap biotech, but the upside potential is great.
The large-cap stock has more upside potential than a stock mutual fund, but the individual equity confers higher risks. A stock mutual fund has more upside potential than bonds, but the risks are higher… and so on.
It’s the old familiar weighing scale. That’s fine for investors who are content with modest gains over the long haul. But it’s no way to become wealthy.
Consider the math of asymmetric investing. Stocks can only go down 100%, but their upside is unlimited.
Sounds simple. The problem is, most investors either don’t use the asymmetric method or they’re unaware of it. They invest their money with tunnel vision. They’re only concerned with avoiding risk and trying to bet on “sure things.”
But the top money managers embrace asymmetric investing. They usually don’t use the term, but it’s how they became billionaires. Sure, sometimes they make a losing bet, but over time an asymmetric approach will trounce the market. You can apply the same technique to your portfolio. You can make big money like the big boys.
Biotechnology illustrates the effectiveness of this technique.
Let’s consider a hypothetical portfolio comprised of three Big Pharma stocks: Pfizer (NYSE: PFE), Merck (NYSE: MRK), and Abbott Laboratories (NYSE: ABT).
Scrutinizing their fundamentals (balance sheets, expected operating results, historical earnings “surprises”), we can determine that each of these stocks entail a 25% chance of losing half of your investment and a 25% chance of doubling it. Your investment range would be a 50% loss to 100% return.
Let’s look at the real-world returns of these three drug firms, over the past five and 10 years, respectively: Pfizer (8.05% and 7.99%); Merck (7.98% and 5.45%); and Abbott Laboratories (13.88% and 7.76%).
Respectable, but…well, pardon me while I stifle a yawn. That’s what you’d expect from these blue chips: less risk, less reward.
Over the past five and 10 years, the S&P 500 has gained 14.27% and 9.99%, respectively. You could have done better by putting your money into an index fund.
Let’s say you’re a more adventurous soul. You embrace the asymmetrical method, by putting your money into a small-cap biotech. This fledgling company is deemed risky, but it boasts a proprietary technology that’s targeted toward a growing medical need.
By vetting this company’s stability and growth potential (cash on hand, projected revenue, potential market share, etc.) and applying an asymmetric approach, you can never lose more than 1X your investment, but your return could be 10X, 100X, 300X… the sky’s the limit.
Questions about how asymmetrical investing works? Drop me a line: firstname.lastname@example.org
John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.