Ecoinometrics - How to compose a portfolio of bets?

Thinking about individual investments as bets has lots of advantages. Now let's see how to combine them in a portfolio.

We have seen that thinking of investments as bets has benefits. You need to make clear assumptions. You need to quantify how much you believe in each possible outcome. You get all you need to compute expected performance metrics.

That’s already a lot.  But there is more.

Today we look at why this is also useful to build a portfolio.

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How to compose a portfolio of bets?

Over the past few weeks we have looked at the basics of how to analyze a given investment idea through the betting lens. The principle behind this analysis is pretty simple. 

You make explicit assumptions on the possible outcomes of the trade. You put a probability on each of those outcomes based on your confidence level. Out of that you can reduce the trade to a few numbers:

• The annualized return of the trade. Or how fast you expect this investment to grow.

• The duration of the trade. Or how long do you think it will take for your bull case to play out.

• The ratio of expected return to maximum loss. That is a quantification of the asymmetry of this trade.

If we stopped there we’d already be ahead of most people who put random trades based on what Jim Crammer said yesterday. Just looking at those three numbers by themselves we can get a sense for whether or not this is a bet we’d like to make.

But typically your portfolio won’t consist of a single investment. Which means that we can use those bet metrics to compare investment ideas against each other.