“I don’t understand… You’re taking a position that you know will likely lose money?”
As a rookie in the financial markets, I was lucky to have the chance to sit down with some amazing professional investors.
I was an inquisitive young man, eager to learn everything I could about the markets. So I took every meeting I could and asked a lot of questions.
This particular conversation was with a family office manager who had a history of great returns for his clients.
We hit it off at a lunch meeting, and he started telling me about one of his current trades that he was particularly excited about.
“Zach, you’re not looking at the whole picture,” he told me.
“Yes, I would say there’s only about a 20% chance that this trade works out. But if it does, we’re going to make a killing!”
This conversation with Darren had a huge impact on how I looked at investing.
And the more I think about it, the more I realize how this lunch had a huge impact on my career.
So in light of the speculative action we’re seeing in the market right now, I want to share some of the wisdom I learned from Darren that day almost 20 years ago.
I think it could have a similar impact on your approach to the markets and help you earn much more retirement wealth!
Understanding Probability and Payoff
The trade my new friend Darren was telling me about was a speculative option play that his office was invested in.
Darren explained that a pharmaceutical company had a drug that could wind up being a blockbuster hit. It all depended on whether the FDA approved the drug as a treatment for a disease.
The probability that the FDA would make this announcement was fairly low (Darren only gave it a 20% chance of success). But the potential payoff was huge!
Because Darren was using a speculative options approach to the trade, he estimated that the position would give his clients a 1,200% gain if the FDA approved the drug.
“If you run the numbers, it’s a tremendous risk/reward opportunity,” Darren told me.
“There’s an 80% chance of losing our entire investment in this play. And we’ve got a 20% chance of turning every $100 invested into $1,300.”
I started to see the logic as Darren explained the potential payoff. Since the potential gain was so big, it made sense to accept a higher amount of risk.
“You see Zach, if we did 100 different trades like this and invested $100 into each one, we’d lose all our money on 80 of the trades. That would add up to a loss of $8,000.”
“But if the other 20% of the trades each turned $100 into $1,300, we would earn a $24,000 profit on those trades. Add the winners and the losers together and you’ll come out with a net gain of $16,000.”
It all made sense!
And as Darren went on to explain how to put together an entire portfolio of trades like this, I began to rethink how I managed my trading career.
Balancing Your Risk and Reward
What Darren showed me that day was simply how risk and reward intersect with each other. He also helped change my opinion about how much risk was appropriate for any one trade.
In certain cases, it can be appropriate to take a lot of risk on one position if the potential payoff makes it worthwhile.
That might come as a surprise to you here at Rich Retirement Letter since I’m constantly talking about the importance of managing your retirement carefully and not taking too much risk.
But if you take a balanced approach and invest some of your capital in stable opportunities and some in potential home runs, you can grow your wealth more quickly without putting your entire nest egg at risk.
“It all comes down to size and diversification,” Darren explained.
He told me how this risky pharmaceutical position only made up a very small percentage of his clients’ overall investment.
If the play didn’t work out (and there was an 80% chance that it wouldn’t), it wouldn’t cause a meaningful problem.
Darren only had about half of one percent of his clients’ money invested in this one play.
On the other hand, if the deal did work out, this small investment would lead to a 6% gain for his clients in a very short amount of time.
The majority of his other investments were still in conservative plays generating reliable returns week after week.
“At any given point in time, we’ve got about a dozen small aggressive positions like this in play,” Darren explained.
“And they’re all different. Some will make money if a company strikes oil or gold. Some will pop higher if a regulatory change hits. Others could profit from a buyout transaction or patent approval.”
As Darren walked me through his portfolio of “slow and steady” investments peppered with a handful of aggressive “ten-bagger” opportunities, I got a much clearer picture of what a balanced approach to investing means…
Choosing the Right Size and Assortment
As we navigate through an investment environment that seems full of both opportunity and risk, I want to help you think through your strategic approach to retirement.
Every healthy retirement plan should start with a foundation of great companies that generate reliable profits and pay regular dividends.
By putting this in place, you’ll be able to sleep well at night knowing that your retirement plan is safe, growing and generating cash for your day-to-day needs.
On top of this foundation, it’s a great idea to add some more speculative positions.
Maybe you could include shares of aggressive stocks that are surging due to investor excitement. Or maybe you want some option contracts that can magnify your gains if the underlying stock moves in your favor.
These speculative plays can help turbo-charge your retirement gains when they work well.
The key is to keep your more aggressive positions small enough so that when they don’t work, your losses are manageable.
In fact, these losses should be offset by the reliable gains you’re generating from your foundation of stable positions.
Then when the aggressive positions do work, they can add meaningful gains to your account and help you compound profits more quickly.
Keep in mind that we always want to have an assortment of plays that have different catalysts to send them higher.
You never want to have too many oil plays, too many semiconductor stocks or too many electric vehicle positions.
If you spread your bets around different types of investments, you’ll be less likely to wind up in a situation where your positions are all trading against you at once.
That’s smart diversification, which is another great way of managing risk.
If you follow this blueprint with your retirement investing, you’ll wind up with a much higher probability of success!