How to Assess Risk in Investing: Expected Return and Distribution Analysis

Assessing the risk of pursuing an opportunity is a critical step in the investment and trading process. In this article, we will explore the key factors to consider, focusing on expected return and the return distribution, to determine whether a risk is worth pursuing.

Expected Return: The Foundation of Risk Assessment

When evaluating whether a risk is worth taking, the expected return is a fundamental metric. The expected return can be calculated using the following formula:

Expected Return (Probability of Winning x Average Gain) - (Probability of Losing x Average Loss)

In essence, the expected return represents the long-term profit potential of an investment or trading strategy. If the expected return is negative, the risk is not worth taking. Conversely, if the expected return is positive and satisfying, we move on to the next step in our evaluation process.

Return Distribution: Understanding the Risk Dynamics

Even if an investment or trading strategy has a positive expected return, it is crucial to assess the distribution of returns to ensure that the risk is manageable and that the strategy aligns with your overall investment goals.

Understanding the return distribution involves several critical considerations:

1. Correlation with Other Strategies/Assets

The return stream of a new strategy should be examined for its correlation with your existing strategies and assets. Highly correlated returns do not add value because they may expose you to the same risks in a different guise. A return stream that is less correlated can provide valuable diversification benefits, potentially mitigating overall risk.

2. Frequency and Magnitude of Gains and Losses

The distribution of returns can also indicate the frequency and magnitude of gains and losses. It is important to be wary of extreme gains or losses, as they can be unpredictable and may not occur as frequently as expected. The impact of occasional losses, particularly those that occur consecutively, should be managed to prevent significant negative impacts on your portfolio.

3. The Irony of Extreme Gains in Backtests

Backtests can sometimes present scenarios where extreme gains or losses (hitting or losing the account) are more frequent. While these results may look favorable, relying on extreme gains to save an account can be risky. In reality, extreme gains may not occur as often, and even when they do, they may not happen in the desired sequence or timing.

Conclusion

After performing these evaluations, traders can make an informed decision on whether a particular risk is worth taking. By considering the expected return and the return distribution, traders can better align their strategies with their risk tolerance and investment goals.

Remember, the ultimate goal is to identify opportunities with a positive expected return and a manageable risk profile, ensuring the long-term sustainability of your investment portfolio.

Thank you for reading, and feel free to share your thoughts or ask questions in the comments section below.