Tuesday, January 25 2022
Prominent investor Ed Thorp says most investors do not understand the probability calculations required to invest in order to amass superior returns and be successful in their investments. A good balance must be maintained between risk and return by not betting too much and not leaving too much money on the table, says the math professor and hedge fund manager. “Understanding and properly managing the trade-off between risk and return is a fundamental, but poorly understood, challenge facing all investors,” Thorp says in his book,
A man for all markets (2017).

He believes that the best thing investors can do for themselves is to educate themselves to think clearly and rationally. Investors need to read well and be curious if they are to avoid bad investment decisions.

Thorp is arguably one of the most successful fund managers in history. In addition to being a math teacher, he is also a blackjack player. Known as the father of quantitative investing, he is famous for his ability to identify inefficient areas of the market and find ways to take advantage of pricing errors.

Before starting his career in the financial markets, Thorp did a lot of reading which helped him a lot throughout his career. His first hedge fund, Princeton Newport Partners, has never seen a year of decline during his tenure. The company has been making 19.1% silver for almost 20 years. Thorp is also the author of the bestseller
Beat the dealer (1966). The advice in the book has helped many investors make the right investment decisions.

2 mistakes to avoid
Thorp admits that when he made his very first share purchase, he didn’t understand the company because his decision was based on a newspaper article. He learned a first lesson that most stock picking stories, tips and recommendations were completely worthless. Another mistake he reveals is that he refused to sell after the share price fell sharply. The stock fell back to the purchase price and he lost an opportunity to profit from that investment. He therefore learned that it is essential to consider the economic fundamentals of an investment as well as the opportunity cost of owning it.

Thorp also tried using charts or technical analysis of stocks and commodities, but after months of investigating the data and forecast, he concluded that they were not of much value. “People see patterns in things and offer explanations when there are none. Likewise, market participants and the financial media always interpret insignificant price movements because they are unable to distinguish between statistical noise and unusual events, ”he says.

Despite having had spectacular success in the market, Thorp says that superior stock selection ability is rare. He recommends indexing for most investors because the return for the average active investor is equal to that of the index less fees.

Investment strategy
The author and mathematician also developed an efficient trading system, called “the highest, lowest” (MUD). It’s about buying the stocks that have fallen the most (the bottom 10%) and short selling the stocks that have risen the most (the top 10%) in the previous two weeks. “Every stock exchange system with an advantage is necessarily limited in the amount of money it can use while producing additional returns,” he says.

In his book,
A man for all markets, Thorp shares the key investment lessons he learned from his work in probability theory. Let’s look at a few of them:

Analyze the history of the market
Thorp says investors can study and analyze market history to determine what can happen if investors decide to take one decisive action over another. Investing is a complex scenario because there are a multitude of factors that determine the price of a stock, some of which are known and others unknown, says the hedge fund manager, adding that investors need to consider so many factors as possible when evaluating an action to make a more accurate prediction.

Develop a strategy
Investors should develop an appropriate plan and strategy before making an investment decision. Thorp has developed an equity valuation approach focused on identifying price anomalies in the securities market. By understanding whether a stock was overvalued or undervalued, he claims to have been able to take profitable long or short positions.

Test your investment strategy
Thorp says that before implementing an investment strategy, investors should fully test their methodology and ensure that their strategy places them on the right side of most transactions. “You don’t have to be always right. But as long as you’re right more often, then you’re wrong in a proportionate betting pattern, you’re very likely to be in positive territory in the long run,” he says. he.

Keep a good balance between risk and return
Finding that appropriate balance between risk and return is a key element for successful investment returns, he reiterates.

Be mentally strong
Mental toughness is probably the hardest lesson for an investor. Financial volatility can be violent, traumatic, and in most cases tests the character of one’s own mental toughness, explains Thorp, who is also a pioneer in modern applications of probability theory.

“The ups and downs of your bankroll vary widely, and you can endure several negative sessions before the positive ones kick in and your advantage is realized. It can be heartbreaking at times and it gets harder and harder to make the big bet during the losing sessions. But you have to be sure that the math will come into play and that your advantage will materialize, ”explains the professor.

Stay in your circle of competence
A characteristic of rational investors is that they stay within their circle of competence. This, Thorp says, helps investors determine their skills and apply them to the market.

“If you’re really good at accounting, you could be good as a value investor. If you are good at computer science and math, you may do better with a quantitative approach. If you don’t want to be a professional investor, just index it, ”he says.

Get an investment advantage
Thorp, who has proven in a book how to win a game of blackjack by counting cards, says investors should try to get a statically generated edge or “edge”. Investors can tip the scales by gaining this advantage and generating superior returns over the long term, he explains.

“The first thing people in control do is tilt the playing field. Perhaps most of the wealth is accumulated because of tilted playing fields. Not because of merit, ”he says.

What is common between investing and gambling
The stock market and gambling have a lot in common, explains the hedge fund manager. In investing, like gambling, investors must learn to go to bed early when the odds are stacked against them; or if they have a big advantage, strongly support it because it’s not often that you get a big advantage, he explains.

“The overlap of interests between gambling and the stock market is very high. There are so many similarities and there is so much that you can learn about each other. In fact, gambling can teach you more about the stock market than the other way around. The game offers an analytically simpler world, and you can see principles and test theories. I was fortunate to have arrived at the investments via the blackjack tables. And blackjack tables are an incredibly good training ground for learning to invest, to think about investments, to manage them. And the reason is that they teach you, on the one hand, how to use probability and statistics to evaluate things. And on the other hand, they teach you discipline, ”he says.

Avoid stock tips and gossip
Thorp says investors avoid giving importance to stock advice and market gossip because most stock picking stories, advice and recommendations are completely worthless. “When it comes to asset classes, it’s hard to know when you’re in a bubble, and if you’re in a bubble, when it will burst. Experts get a lot of media attention because they do strong and precise claims, but definitive claims are usually not precise predictions, ”he says.

Thorp’s investing lessons are perfect for investors who want to find the right balance of risk and return to generate extraordinary returns.

(Disclaimer: this article is based on Ed Thorp’s book “A Man for all Markets”)

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