Counting Cards

February 26th, 2024

When you sit at a blackjack table, you have several options. You can bet the same amount each round, bet a random amount, or try to bet an amount based on how likely you are to win.

Counting cards, where you (try to) keep track of the proportion of high cards to low cards remaining in the deck or shoe, is a way to estimate your chance of winning.

By keeping track of the count, you can determine when the deck is rich in high cards (favorable to the player) or low cards (favorable to the dealer). When the count is high, you increase your bets. When the count is low, you decrease your bets.

This is also an important investing premise. Your edge as an investor is the amount your chance of winning is elevated (relative to having no edge). So a portfolio manager will increase position size when they have an edge.

Position sizing is both art and science. The Kelly criterion is a formula for bet sizing based on expected value (probability and magnitude). When it’s difficult to make accurate expected value estimates, you can adjust position sizes by your conviction for each trade’s expected value.

In this piece, I will unpack risk, uncertainty, and volatility as well as how the risk spectrum affects allocation decisions.

Risk, uncertainty, and volatility

Nate Silver once said, “risk greases the wheels of a free-market economy; uncertainty grinds them to a halt.” Said another way, risk is something you can price and accurately estimate. Uncertainty, on the other hand, is risk that is hard to measure, ie. your estimate of the outcome could be easily off by orders of magnitude.

Volatility and risk are close cousins but are not the same. However, volatility is easier to measure than risk so it is often used as a proxy for it: more volatile = riskier.

Now let’s say you have a high conviction belief about something and there are multiple ways to express that belief.

A high volatility option will provide more upside if the belief is correct but also more downside if not. So the stronger your conviction, the more volatility you might invite into how you express it.

There are ways to change the volatility of something, such as leverage and derivatives, but those are out of scope for this piece.

For now, let’s say once you commit to making a directional bet on a belief, you need to also decide how much volatility you can tolerate.

The Risk Spectrum

Risk appetite can be described as either on or off.

In a ‘risk on’ environment, investors believe conditions are favorable (optimistic economic outlook, accommodative central bank policies, and corporate earnings growth) with heightened odds of an upward trend in asset prices. Risk on is similar to the deck rich with high cards in blackjack.

In a ‘risk off’ environment marked by less favorable conditions, investors switch to capital preservation mode and rotate capital to ‘safer’ (less volatile) assets.

In volatility terms, investors seek higher volatility ways of expressing beliefs in a risk on environment and dial back expected volatility in a risk off environment.

Here is an illustrative example of a risk on and a risk off crypto portfolio:

Risk On | 10% BTC, 10% ETH, 20% SOL, 20% STX, 35% Other Alts, 5% USDC

Risk Off | 20% BTC, 20% ETH, 60% USDC

Both portfolios express the belief that asset prices will rise in the digital economy. But the risk on portfolio will appreciate more during a bull phase of the market cycle and draw down more during a bear phase (higher volatility). So the goal is to be risk on during an upward trend in asset prices and risk off before the trend flips downward.

…

Ok but how to determine whether there’s likely to be an upward or downward trend in asset prices?

In a future post, I’ll explore how indicators, catalysts, and the market cycle influence risk posture. Till next time ✌️

References

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