Risk of Gain
Not all of Permanent Equity’s employees have finance or investing backgrounds, so we do what we can from time to time to help everyone gain a shared understanding of how this sick, sad world works. A little while back, it was a Lunch & Learn about personal finance and investing. More recently, it was a note explaining how our investors might react to news of a loss in our portfolio.
In that note, I said this: “Our partners are sophisticated investors who know that equity investing involves the risk of loss. The reason they, or anyone, take this risk is because equity investing also involves the risk of gain.”
“Risk of gain,” I heard back, was a curious term. What did I mean by that?
Volatility, variance, beta…whatever jargon you want to use (and among professional investors there is a lot), one way to think about gains is they are the same as losses, just reversed. In other words, both are what happens when an asset you purchase changes in value or price…just don’t get a professional investor started on the difference between the meaning of “price” and “value.”
But if you think this way about gains and losses, then a key to investing successfully is to only traffic in transactions where the risk of gain is greater than the risk of loss i.e., if your thesis is correct, you stand to make more than you stand to lose if you’re wrong.
Provided you don’t use leverage, since the most you can lose is all of your money, this is why making a portfolio of equity investments and holding them for a long period of time mathematically makes sense. Some will go to zero, but that’s a bounded loss, while others will increase exponentially in value, creating boundless upside. So if you own a group of them and you’re only, or more than, or even less than coin-flip talented, your risk of gain is more than your risk of loss.
The same reasoning helps explain why if you own a home, you should absolutely have homeowner’s insurance. You only have one home, it’s only going to appreciate in value (on average) a few percentage points per year, but one catastrophic event such as a fire could zero it out in a blink, leaving you without shelter and owing a bank a lot of money. That's an unbounded downside in my view, so pay to insure against it.
The point is when a party and a counterparty are transacting, both are assuming a risk of gain and a risk of loss. If that’s you and your risk of gain is greater than your risk of loss, that’s a good investment. If they are equal, then hopefully the transaction makes sense for some other reason. And if your risk of gain is less than your risk of loss, then hopefully the transaction makes sense for some other reason, but also buy insurance.
– By Tim Hanson