Investing frameworks II: Dealing with uncertainty

Here’s my way of dealing with uncertainty:

  1. Avoid blow-up risk.
  2. Stick with I-can’t-believe-this-exists situations where the risk/reward is riduclously distorted.

If I am wrong, I don’t want to lose all my money.  With particular instruments, you can even lose more than all your money.  Historically it has happened to people who write options contracts and are short volatility.  It can also happen if you take on mortgage debt or take on debt to finance a business.  If you don’t sell common stock short and if you never sell options, then your portfolio can never go below 0*.  You also won’t make a killing by short selling stock and by writing options contract, so there isn’t a lot of sense in doing it.
*On the other hand, I may not necessarily practice what I preach because I short sell very small amounts of common stock and options.  At the end of the day, we cannot avoid all risk and shouldn’t worry about extremely small risks.

Secondly, stick with situations where the risk/reward is distorted.  There is nothing wrong with holding onto cash.  If you simply saved a lot of money and held cash, you would lead a worry-free life without financial worries.  Nothing wrong with that.  And if you take risk, you might as well have your cake and eat it too.  Find situations where there is little risk and a lot of reward.  Because these situations exist.*  You simply have to wait for them.
*Remember to think for yourself: this is my opinion and I’m not sure I could prove it.  The problem I see with this theory is that it goes hand in hand with loading the boat on your best ideas.  If you’re wrong about a situation being high reward and low risk, then you’d be taking on a lot more risk than you intended.  And this may work badly for most human beings because we tend to be overconfident about our abilities.

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