A long time ago I listened and watched as a Mentor (M) of mine explained, to a large gathering of people, the relationship between risk and reward. Most folks in that day, and this day also, concluded that the greatest reward came with the greatest risk. M believed that only fools embraced that philosophy. Apparently the world has been awash in foolishness for a long time.
I said that I both listened and watched since M believed that people are either auditory or visual learners. If you only present charts and graphs you will lose half the audience. Conversely, he believed, if you simply talk and ramble, with nothing to look at, you will lose the other half of your audience. Thus a combination of both was imperative to deliver the message.
M would place a large red poster at one end of the room. At the other end would be a large green poster. Both posters representing risk and reward respectively. (I will both speak-auditory- and create a word picture-visual- so that no reader is “left behind.” [given the uproar about plagiarism I’d like to credit George W. Bush for being the person most responsible for putting those two words together])
M believed that if you stood in the middle of the room, dead center between the red and green posters, you had a 50 percent chance of gain and a 50 percent chance of loss. Not a very good bet, trade or speculation.
The closer you got to the red poster the less opportunity for loss and the greater the opportunity for gain on a new position. At a 40 percent distance from red and a 60 percent distance from green the trade started to look better. Anything from a 25 percent distance to red and a 75 percent distance to green made M sit up and take notice. As green got further away, in the rear view mirror, the trade became almost a certainty. Conversely, the closer you got to the green poster a short position became the trade of choice.
M would always say publicly that if it “were that simple everyone would be vacationing on the Riviera.” M would then call me aside and say “It is that simple. Let’s keep it our little secret.”
Most , and I mean almost all retail customers of Wall Street, have been brainwashed into believing just the opposite of M’s conclusion. They risk a lot for little reward whereas M risked little for a great reward.
Bernard Baruch, Titan of Wall Street, would never go long a position until it had advanced 20 percent from the red poster on the way to the green. He also would always exit his position when he was within 20 percent of the green poster. He always mused that he never caught the top nor the bottom just the 60 percent meat in the middle. He simply inversed the strategy when going short.
The great crash of 1929 was child’s play and a great opportunity for Baruch and others who had their colored posters positioned correctly.
Whether you step up to the window at the track, sit down at the table in Vegas or wire a wad to Wall Street the paramount consideration should be risk and reward. Where the red and green posters are placed and the current distance from each will dictate your action as to long, short or going fishing and the size of your commitment.
So how do we know where the posters are placed?
Next time we will dig deeper and learn M’s secret about the magic of risk and reward- by the colors.