When I was 19, my best friend and I loved to go to the casino and play blackjack. A few times a month, we would take a $20 out of the ATM, head over to the casino, sit down at a $5 table, and see how we would do.
Sometimes we came out ahead. One time I won $200. Most times we both lost our $20’s.
Blackjack is a game where the dealer and house have an advantage over a player. In blackjack, the house edge is roughly 0.5%, meaning that over time, you will lose 50 cents per $100 that you bet (if you bring $100, and bet $5 a hand, after 20 hands on average, you will have lost 50 cents).
Blackjack is a game which you don’t have an advantage. It’s a gamble, and not a great strategy for building extreme wealth.
Extreme wealth and financial freedom at a young age is one of my goals. To reap this big reward in a short amount of time, I need to take on a fair amount of risk with my money, but also keep in mind I should be careful where I’m placing my money and bets.
In this post, I will be discussing the concept of expectation from statistics, talk about risk, reward, and investing, and finally, touch on how you can use asymmetric bets to build extreme wealth in your twenties and thirties utilizing asymmetric bets.
Note: the following discussion can also be applied to someone’s career, educational path, and seeking higher compensation – with that being said, I’ve chosen for this article to focus on asymmetric bets as they apply to investing.
What is Risk?
Risk is a funny concept.
There are so many people who talk about risk like it’s something concrete or tangible.
Heck, I work in a entire department devoted to analyzing risk. As a credit risk quantitative analyst, I know a thing or two about risk.
What is risk?
As defined by Wikipedia, risk is the potential of gaining or losing something of value.
It’s an abstract concept – the potential of something changing the current state.
Risk has a negative connotation, but in my opinion, there is good risk, and, of course, bad risk.
To build extreme wealth, taking good risks is key and can have a healthy pay-off.
Before getting into what are some of these good risks, I need to talk about the concept of expectation and the expected value of a situation. I’m going to do my best to explain this statistical concept in everyday language, so don’t be afraid if you aren’t a math person. 🙂
What is the Expected Value?
To talk about risk appropriately, I need to talk about the expected value and the expectation of a situation.
Speaking statistically, the expectation of a situation is the average value over all potential outcomes.
For an example, let’s look at a coin flip.
If we define a heads coming up as 1, and a tails coming up as 0, then the expected value is 1 * 50% (a 50% chance of coming up heads) + 0 * 50% = 1 * 50% + 0 * 50% = 50%.
The expected value of a coin flip is 50% of the time, you should expect heads and 50% of the time you should expect tails.
To go more general, let’s define X as a scenario with outcomes 5, 10, 15, 20, and 100, and all of these outcomes having an equal chance (a 20% or 1/5 chance of happening) of being realized.
The expectation of X is the average value over all outcomes, or putting this into an equation:
E(X) = (5+10+15+20+100)/5 = 30
What happens to the expectation if the chances of these outcomes change?
What if, respectively, the probability of these outcomes become 10%, 20%, 10%, 20%, and 40%?
Then the expected value calculation changes:
E(X) = 5*10% + 10*20% + 15*10% + 20*20% + 100*40% = 48
Not all outcomes in real life are equal.. and this is something that many people do not understand.
Applying Expectations and Expected Values in Personal Finance and Investing
With our knowledge of the concept of expectation, we will now use it to think about asymmetric bets and the expected value of returns of different investment classes.
Before investing, I believe it’s critical to first track your income and expenses, and establish an emergency fund. After doing these two things, then it’s appropriate to start thinking about getting fancy with your investments.
Remember, the expected value of an event can be thought of as the average outcome.
The Expected Value of Returns of the Stock Market
On average, the return of the stock market has been roughly 7% a year over the last 100+ years.
Using the language we’ve built up, we could say the expected value of returns for the stock market is 7% a year.
That is not to say there will not be years where there could be a 20% return, or there could be a -20% return. This is saying that on average, we can expect a return of 7%.
With this 7% does carry some risk, many investors consider the stock market to be a fairly safe investment.
The Expected Value of Returns of Real Estate
Every property and real estate deal is slightly different, and there is also leverage to consider, so there’s no definitive number for the average return for real estate. With that said, for investors, returns on real estate are a little more than the stock market.
While the numbers vary, real estate will typically return around 10 to 12% a year.
Thinking about the risks associated with this return, a single house can have a whole bevy or issues: pipes frozen, appliances needing to be replaced, etc. which will eat into the return.
Even though there is risk for there to be reduced returns, with leverage and strong cash flow, real estate can be a great investment.
The Expected Value of Returns for Your Bank Account
This article is not about inflation, how the economy works, and how banks make money, but for all intents and purposes, the return of your bank balance is 0%.
Your money is guaranteed by the government, and while yes, you do get interest paid each month, relative to inflation, you are losing.
The Expected Value of Returns on Debt
The return on debt is precisely the interest rate you are paying on your debt.
Your 5% mortgage has an expected value of a -5% return for your wealth.
Debt has a negative impact on your wealth over time.
The Expected Value of Returns on a Business
This is a tough one. I’m a huge believer that you can use businesses to grow your wealth – and this is something I’m trying to do.
Some people are more successful than others. My current efforts have resulted in a negative hit to my net worth, but I’ve learned a ton.
The possible outcomes here could be $1,000,000, -$15,000, $10,000, or anything in between.
The expected value of your return in business is also dependent on growth, time, and industry.
With this many variables, I’m not sure the expected value here.
The Expected Value of Returns on Cryptocurrencies
Another tough one, and one I’m currently trying to answer.
Let’s look at Litecoin: in 2017, Litecoin returned roughly 5000%.
Could it go to 0? Absolutely. Could it go up another 5000% in 2018, 2019, and 2020? There’s a chance.
What is the expected value for returns for cryptocurrencies? It’s something I’m trying to figure out right now.
With this question in mind, this brings me to the part of the article I’ve been incredibly excited to write about: asymmetric bets, and building extreme wealth in your twenties and thirties.
How I’m Using Asymmetric Bets to Build Extreme Wealth
While earning money, saving money, and investing money is a tired and true strategy for building wealth over time, there’s a catch: it takes a lot of time.
While yes, investing $10,000 a year in the stock market over 30 years will inevitably result in you becoming a millionaire, who wants to work for 30 years and then be wealthy?
$1,000,000 isn’t what it used to be, and really, once 30 years passes, will you have the health and energy to enjoy your wealth?
Personally, while I’m putting some of my money to work in the stock market, I’m also taking an active approach to building wealth.
House Hacking to a Big Asymmetric Pay-off
When I was 20 years old, I started learning about how to build wealth. One of my favorite websites and blogs back in 2012 was Financial Samurai. His article, The Average Net Worth for the Above Average Person had me hooked and thinking, “I’m above average, and wealth is my goal. Where do I need to be when I’m 25, 28, 30, 35? What can I do to build wealth?”
3 years later, I made my first financial splash.
I bought a house the day before my 23rd birthday.
When I bought my house, I had a negative net worth. I put less than 3% down, and I wasn’t very handy.
I had less than $2,000 when I moved in.
This was an incredible “risk”. But let’s look at the other side of things.
I had 3 roommates moving in with me who would be paying me rent which covering roughly 90% of my mortgage. I had a great job – which at the time was paying me $63,000, and if all else failed, I could call up my grandpa and get his opinion on fixing something up.
Thinking in terms of expected value, and the context of this article, what were the possible incomes and what were the odds of those outcomes?
- There was probably a chance, maybe 5%, that I would get completely wiped out. 100% loss on my down payment of $10,000, a ruining of my credit, and no job.
- There was probably a decent chance as well that some of the appliances would need to be replaced. Maybe this would have cost me $25,000 to update.
- Another possibly is nothing would go wrong, I would rent out my house for 3 years, and I wouldn’t need to spend too much on repairs and maintenance.
What was the expected value of my investment looking out a few years? Initially, I was forecasting my net worth would grow about $10,000 from owning this house and house hacking.
Over the last 3 years, I’ve grown my net worth over $100,000 through this house hacking.
I used asymmetric risk to my advantage, and as a result, I don’t have a student loan anymore. I don’t have an auto loan. The best part, at 25, almost 26 years old, I have a net worth approaching $200,000, and the ability to now look at other opportunities to continue to grow my wealth.
Applying the Barbell Strategy of Nassim Taleb for Extreme Wealth
One of my favorite books of all time is The Black Swan, by Nassim Taleb.
In the 90’s, Nassim Taleb was a trader on Wall Street and applied the Barbell Strategy to make money for his firm.
What is the Barbell Strategy for creating wealth? Essentially, the strategy is to, with 90% of your capital, take little to no risk, and with the other 10% of your capital, invest in a diversified set of very risky asset investments.
This way, your investment portfolio will not be crushed when something goes very wrong; by only risking 10%, the maximum you can lose is 10%.
Let’s do an expected value calculation using the barbell strategy.
Let’s say we put 90% of our capital into something with a 100% chance of returning exactly 0%. With the other 10% of our capital, we have a 50% chance of returning 1000%, and a 50% chance of returning -100%.
What’s our expected value of our return under these conditions?
E(X) = 90%*(100%*0%) + 10%*(50%*1000% + 50%*-100%) = 45%
The expected value calculation yields an expected return of 45%. This is just an example, but something which happens in real life all the time.
Why Investing in the Stock Market Might Not Be as Safe as You Think
Over the last few years, I’ve read a number of articles on millionaires.
Since the stock market crash in 2008 and subsequent recovery, there are now many millionaires who mainly have their assets in equities.
Having $1,000,000 in a 401(k) and IRA is great in all, but what happens with a 40% downturn? You just lost $400,000.
I’m maxing out my 401(k) and Roth IRA’s this year, but am not blind to the fact that we have been in “recovery” for 10 years.
Again, while the expected value for returns in the stock market is 7%, the potential drawdown is a little shocking to me, as well as seeing markets such as the Nikkei 225, where in 1989 there was an 65% drop and things still haven’t recovered.
Having a “diversified” portfolio in equities is great in theory, but with medium risk, there is potential for losses.
What I’d feel better seeing instead is multiple investment classes in your portfolio: real estate, cash, and consider some alternative assets such as a business or precious metals as a hedge and minimize your net worth decrease – but this is getting a little bit off topic.
My Strategy of Diversifying into Alternative Assets
Over the last year, I’ve been looking into alternative assets to continue to apply the barbell strategy in my financial life.
Everyone wants to find the next Amazon, the next Apple, or the next Bitcoin to throw 100% of their money into and become wildly rich.
That’s stupid to do, and is not what I’m recommending – or what I’m talking about in this post.
Putting a little bit of your wealth into risky assets is the way to go if you want to build wealth offensively, and become rich in your twenties and thirties.
There are three asset classes I’m looking at in particular. These are some things I’m experimenting with. Please assess your own financial situation – I’m not a financial advisor, and would urge you to please do your due diligence before investing in anything.
Here are some assets classes I’ve thrown a little bit of money:
- The overall cryptocurrency market is under $1 trillion dollars. The stock market in comparison is around $75 trillon dollars.
- Do you think the cryptocurrency market could reach $2 trillion dollars? Personally, I do, and that would be a 400% return from prices today.
- I don’t think it will go to 0 as many pundits and people say – institutional money has yet to enter, and now extremely rich people like George Soros are looking to get in, making it seem like it could be a decent bet going forward.
- Precious Metals
- Since 2011, silver and gold have been crushed. For example, silver, from a peak of nearly $50, is now sitting around $17.
- Could silver get back to $50? What about $35?
- This seems to be a decent asymmetric bet in the next few years, and something I’m experimenting with.
- My Own Businesses
- I have a solid day job which is bringing in great income, but to really build wealth, I need to earn more.
- I’m experimenting with this blog and a subscription kit business – if these start making a few hundred to a thousand dollars a month, I’ll be creating wealth fast for myself, as well as unlock funds to put into real estate, the stock market, or the alternative investments I discussed above.
If the barbell strategy is something you think would be valuable to you, figure out what you are comfortable with, do your due diligence, and look to use place some asymmetric bets to build extreme wealth.
Build Extreme Wealth in Your Twenties and Thirties through Smart Asymmetric Bets
After getting your emergency fund in place, the next steps with your additional savings should be investing in wise assets and building a robust investment portfolio should be on your mind.
Your goals may not include extreme wealth or financial freedom at a young age.
If they do, I’m glad you’ve stopped by and learned about how placing asymmetric bets and using expected values to your advantage can result in financial success.
Always look to expand your perspective on the world, keep an open mind, and live with an abundance mindset.
Readers: are you utilizing asymmetric bets to build extreme wealth? Are you playing it slow and steady instead? What are your thoughts on alternative assets?
Become a MASTERMIND
Sign up for our mailing list and receive instant access to all the Mastermind Within freebies (tools, spreadsheets, and an eBook), and exclusive content.
Your future self will thank you.