The Limited Downside and Unlimited Upside of Stocks

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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Theoretically speaking, stocks have limited downside (which is limited to your capital) and unlimited upside (based on the company's future growth). 

So by investing in stocks, you are willing to lose your entire capital for the potential for it to grow with no upside limit. This makes it a compelling bet probability wise.

Let's say theoretically it's possible to achieve unlimited returns for a stock. 

This means that regardless of the probability of unlimited returns, you are going to get unlimited returns. Why? 

Because for any given probability of unlimited returns, your expected value is going to be unlimited. How? 

Assuming a 0.0000001% of unlimited returns, the expected return would thus be unlimited, because unlimited returns multiplied by any probability (no matter how miniscule) will give us unlimited returns. 

As long as our probability of unlimited returns isn't zero, the expected return is going to be unlimited.

This may oversimplify the actual nature and performance of equities but it drives home the point that equities offer much more upside compared to a risk-free investment like cash. 

By owning a stock, you are betting that the company is able to deliver returns and growth, which theoretically speaking, is unlimited.

We know that "unlimited returns" exists only in theory but not in reality.

But it proves a point: investing in assets which offer you the potential for unlimited returns is going to far outperform assets which limit your upside even though it is guaranteed.

Take for example cash paying you 4% p.a. risk-free. 

This essentially caps your returns at 4% p.a. while having the remote possibility of losing your entire capital (e.g. government or bank defaults). 

Though improbable, it is not impossible. So while cash may offer guaranteed returns, there is no absolute guarantee that your capital will be preserved—there's always a small chance that your capital might go bust should something terrible unforeseen materialise.

Conversely, for equities, you are not ignoring the fact that equities could go to zero. 

In fact, when you invest in equities, you generally are mentally prepared for the remote possibility of losing your entire capital. It's simply planning for the worst-case scenario.

So it pays to be aware that equities give rise to the possibility of losing all your capital.

However, with that being said, equities also give you the potential for infinite upside returns, theoretically speaking. 

In other words, you are not limiting yourself to X% of returns each year like in the case of risk-free assets. 

Instead, you are willing to receive varying amounts of returns each year (ranging from negative to positive) for a higher average return overall than a risk-free asset like cash.

So, for example, if we invest in stock A, and it gives us a 20% chance of going to zero BUT at the same time it gives us an 80% chance of earning 10% a year. 

While the probability of losing your capital completely isn't low, your expected return is 8% p.a. This is compared to cash which guarantees 4% per annum. 

So even though the chance of losing your entire capital is improbable and thus much lower than equities, the fact that your upside is capped makes equities a much more compelling long term investment. 

As long as we can get the probabilities to be in our favour, investing in equities is always going to be a winning game compared to cash.

But then, why do people still hold cash?

The fact is, the above explanation and example oversimplifies the actual performance and returns of equities. It force fits equities into a fixed set of guaranteed probabilities. 

But the issue with equities is that nothing is guaranteed. You may estimate that an equity gives a 20% of your investment going to zero and a 80% of your investment growing at 10% p.a. but the truth is that your expected return isn't going to be your actual return.

As its name suggest, it's only an expected return and therefore by no means an estimate of your actual return. 

At best, it's a benchmark of what you're going to get. The volatile nature of equities is that oftentimes what you're going to get might be quite far off from what you expect to get. 

The probability distribution of an equity's return is nothing more than a probability distribution, which tells us an equity's expected future return based solely on its historical performance.

But the truth is that if historical performance were an accurate representation of future returns, then everyone would easily get rich because the future would be predictable. 

But as everyone knows, in the world of investing, what causes majority of investors and traders to lose money isn't risk but unpredictability.

Risk can be managed but unpredictability can't — it can only be hedged against. In finance, risk is often equated to volatility. With volatility comes risk. 

But in reality, risk is much more complex and volatility only compromises one aspect of risk. The other huge aspect of risk which few people talk about is unpredictability. 

The unpredictable nature of stocks is what makes them inherently risky and which is what causes people to lose money despite the long-term positive returns of equities.

A stock can be volatile but predictable. Similarly, a stock can be stable but unpredictable. In short, volatility does not equal unpredictability.

You may own an extremely volatile stock but it can be predictably volatile. Conversely, you can own all very stable stock but it can be unpredictably stable. It seems counter-intuitive but such stocks and assets exist.

For example, the Magnificent Seven stocks are volatile but many would agree that their future prospects are more predictable compared to many smaller companies or start-ups. Their cashflows, revenue growth and profitability are all much more stable and predictable than many others.

While some stable but unpredictable stocks could include some Singapore stocks. Their stock prices are relatively stable compared to US stocks but their future prospects are uncertain. These stocks are commonly found in sunset industries as opposed to the Magnificent Seven stocks in sunrise industries.

As investors, we aim to invest in companies which are predictable even though they may be volatile. It's stock price may be volatile but it's future prospects may be predictable.

These are the stocks we want to invest in — not the other way round, such as stocks that are stable but have very uncertain future prospects. 

So how do we turn the unpredictability of the market in our favour? Well, we can't. 

The best thing we can do is to first be aware of it. Only when we are aware of the unpredictability of the market, then can we acknowledge it. And only when we acknowledge it, can we accept it. 

Acceptance is a key part of our hedge against unpredictability. We accept that we cannot avoid unpredictability and as such, we utilise tools to help us hedge against it. 

And while hedging limits our downside losses, it also limits our upside gains. That's what makes it a fair game. And hedging is one of the primary reasons why people still keep and hoard cash despite giving lower returns than equities. 

Cash acts as a hedge or cushion against the unpredictability of the market. We cannot predict the market, so we need some measure of hedge to protect ourselves against the unpredictable. 

Cash is therefore one of the simplest and most basic forms of hedging available to practically all investors.

Unlike more sophisticated hedging tools used by hedge funds measures like derivatives, cash is the easiest and most hassle-free way of managing risk and hedging against unpredictability. So much so that even the legendary investor Warran Buffett uses it more than anyone else, — hoarding over US$250b of cash in Berkshire Hathaway as a hedge against the unpredictability of the market.

If even the greatest investor of our day hoards and uses cash as a hedge against the unpredictability of the market, how much more we as smaller individual retail investors should hedge against unpredictability with cash.

So, in the world of hedging and finance, cash is still king — it provides the best hedge against uncertainty and unpredictability.

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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