“Upside risk” I am going to divide into two categories:
Skewed returns—“Bets with a payoff which is either very large and positive; or small and negative”
Outsized returns—“Bets with a higher mean return”
It seems to me that you’re mostly thinking in terms 1. There are plenty of ways to do this systematically;
buying options [Buying SPACs slightly above NAV is roughly equivalent to buying options]
buying insurance
buying early-stage growth stocks
buying lottery tickets
betting on dogs
They all have a range of distributions but largely they are money-losing (on average). The reasons for this are fairly straightforward. Everyone likes lots of upside, with limited downside, so those bets get bid up and their expected returns fall. Personally I think these are a bad thing to do systematically*. You need to be deriving some value from the “excitement” for these strategies to be compensating you for the average loss you’re taking. * Where you’re hedging some personal risk and paying over the odds to do it (health/home insurance) then you should do it systematically.
More interesting to me is how can retail investors achieve 2. without losing their shirts. (You mentioned a few of these (selling options, EM equity)). Off the top of my head there are a few different ways to boost your returns systematically (roughly in order of how “good” I think they are for retail):
Leverage
Equity factors (momentum, value, etc)
Vol risk premium
FX/Rates carry, CDS premia, …
“Alpha”
People have already mentioned vol risk premium. (Mostly expounding it’s virtues). To give a bear case on this. This strategy can definitely become crowded. Even before the March ’20 sell-off, vol sellers had had a terrible run from 2018-2020. Personally I believe that VRP exists, but it’s not a premium I’d want to collect as a retail account. The market is pretty sophisticated and most of the ways to express that trade are full of nasty gotchas.
There have also been a few discussions of alpha. (Or at least the idea that LW-ers can beat the market in some risk-adjusted sense). For someone uninterested in finance, I think this is extremely unlikely—and probably going to end badly.
I think leverage is broadly underrated by retail. Margin accounts are getting cheaper and cheaper, and running a leveraged (say) 60⁄40 portfolio is becoming increasingly viable. This will increase risk and returns. You will pay some cost for the leverage, but this is by far the cleanest way to boost your returns in my option.
Equity factors—momentum, value etc. There’s hundreds of these factors now all with a range of “acceptance” within the finance community. Access to them is becoming much easier (factor ETFs are a thing).
Carry etc - … There’s a bunch of different strategies which fall into this bucket. I’m not going to say a huge amount about them because I think this is something which is really worth doing your own research on. They are accessible to smart retail investors, but you will need to think carefully about what your strategy is,
Leverage is very important for maximizing returns, but too much is counterproductive. Sometimes even 1x is too much, or even 10x is not enough. The right amount is the Kelly fraction and it depends on the payoff distribution of your strategy, which you can only estimate. This is mostly what I was getting at in How to Lose a Fair Game
They all have a range of distributions but largely they are money-losing (on average). The reasons for this are fairly straightforward. Everyone likes lots of upside, with limited downside, so those bets get bid up and their expected returns fall. Personally I think these are a bad thing to do systematically*.
TL;DR Leverage
“Upside risk” I am going to divide into two categories:
Skewed returns—“Bets with a payoff which is either very large and positive; or small and negative”
Outsized returns—“Bets with a higher mean return”
It seems to me that you’re mostly thinking in terms 1. There are plenty of ways to do this systematically;
buying options [Buying SPACs slightly above NAV is roughly equivalent to buying options]
buying insurance
buying early-stage growth stocks
buying lottery tickets
betting on dogs
They all have a range of distributions but largely they are money-losing (on average). The reasons for this are fairly straightforward. Everyone likes lots of upside, with limited downside, so those bets get bid up and their expected returns fall. Personally I think these are a bad thing to do systematically*. You need to be deriving some value from the “excitement” for these strategies to be compensating you for the average loss you’re taking.
* Where you’re hedging some personal risk and paying over the odds to do it (health/home insurance) then you should do it systematically.
More interesting to me is how can retail investors achieve 2. without losing their shirts. (You mentioned a few of these (selling options, EM equity)). Off the top of my head there are a few different ways to boost your returns systematically (roughly in order of how “good” I think they are for retail):
Leverage
Equity factors (momentum, value, etc)
Vol risk premium
FX/Rates carry, CDS premia, …
“Alpha”
People have already mentioned vol risk premium. (Mostly expounding it’s virtues). To give a bear case on this. This strategy can definitely become crowded. Even before the March ’20 sell-off, vol sellers had had a terrible run from 2018-2020. Personally I believe that VRP exists, but it’s not a premium I’d want to collect as a retail account. The market is pretty sophisticated and most of the ways to express that trade are full of nasty gotchas.
There have also been a few discussions of alpha. (Or at least the idea that LW-ers can beat the market in some risk-adjusted sense). For someone uninterested in finance, I think this is extremely unlikely—and probably going to end badly.
I think leverage is broadly underrated by retail. Margin accounts are getting cheaper and cheaper, and running a leveraged (say) 60⁄40 portfolio is becoming increasingly viable. This will increase risk and returns. You will pay some cost for the leverage, but this is by far the cleanest way to boost your returns in my option.
Equity factors—momentum, value etc. There’s hundreds of these factors now all with a range of “acceptance” within the finance community. Access to them is becoming much easier (factor ETFs are a thing).
Carry etc - … There’s a bunch of different strategies which fall into this bucket. I’m not going to say a huge amount about them because I think this is something which is really worth doing your own research on. They are accessible to smart retail investors, but you will need to think carefully about what your strategy is,
I came in here to say leverage. There are options outside of margin lending that are interesting to explore, such as:
Investment Loan (Although the rate is similar to that of a margin loan)
Home Equity Line of Credit (Cheaper than the above)
Borrowing to re-investing and pledging your assets as collateral has been used for decades by wealthy investors to increase their return.
Box spreads. That’s still margin though.
Leveraged ETFs.
Leverage is very important for maximizing returns, but too much is counterproductive. Sometimes even 1x is too much, or even 10x is not enough. The right amount is the Kelly fraction and it depends on the payoff distribution of your strategy, which you can only estimate. This is mostly what I was getting at in How to Lose a Fair Game
This is basically what I was trying to say in The Wrong Side of Risk.
Hi, thank you for the comments! Do you have any preferred resources for learning about leverage investing/using a margin account?