Ed Thorp says it is all about balancing investment risk and return – Economic Times

Eminent investor Ed Thorp says most investors do not understand the probability calculations required in investing to amass superior returns and achieve investment success. A proper balance should be maintained between risks and return by not betting too much and by not leaving too much money on the table, says the mathematics professor and hedge fund manager. “Understanding and dealing correctly with the trade-off between risk and return is a fundamental, but poorly understood, challenge faced by all investors,” Thorp says in his book,
A Man for all Markets (2017).

He is of the view that the best thing investors can do for themselves is to educate themselves to think clearly and rationally. Investors should be well read and be curious if they want to avoid poor investment decisions.

Thorp is arguably one of the most successful money managers in history. Apart from being a mathematics professor, 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 figure out ways to take advantage of mispricings.

Before he started his career in the financial markets, Thorp did a tremendous amount of reading which helped him greatly throughout his career. His first hedge fund, Princeton Newport Partners, never had a down year during his tenure. The firm compounded money at 19.1% for almost 20 years. Thorp also is the author of the bestseller
Beat the Dealer (1966). The tips in the book have helped many investors make the right investment decisions.

2 mistakes to avoid
Thorp confesses that during his first ever share purchase, he did not understand the company as his decision was based on a newspaper story. He learnt an early lesson that most stock-picking stories, advice and recommendations were completely worthless. Another mistake he reveals is that he refused to sell after a large decline in share price. The stock fell back to the buying price and he lost an opportunity to make a profit from that investment. So he learnt that it is essential to consider the economic fundamentals of the investment as well as the opportunity cost of holding it.

Thorp also tried to use charting or technical analysis of stocks and commodities, but after months of investigating data and predictions, he concluded that they were not of much value. “People see patterns in things and offer explanations when there are none. Similarly, market participants and the financial media forever interpret insignificant price moves, as they are unable to distinguish between statistical noise and unusual events,” he says.

Even though he achieved spectacular success in the market, Thorp says superior stock-picking ability is rare. He recommends indexing for most investors, as the return for the average active investor equals that of the index minus fees.

Investment strategy
The author and mathematician has also developed a successful trading system, which is called “most-up-most-down” (MUD). It involves buying stocks that have fallen the most (the bottom 10%) and selling short those that have risen the most (the top 10%) during the previous two weeks. “Every stock market system with an edge is necessarily limited in the amount of money that it can use and still produce extra returns,” he says.

In his book,
A Man for all Markets, Thorp shares the top investing lessons he learned from his work in probability theory. Let’s look at some of these:

Analyse market history
Thorp says investors can study and analyse the history of the market to determine what may happen if investors decide to take one decisive action over another. Investing is a complex scenario as there are a host of factors that determine the price of a stock, some of which are known and some unknown, the hedge fund manager says, adding that investors should consider as many factors as possible while evaluating a stock to come up with a more accurate prediction.

Develop a strategy
Investors should develop a proper plan and a strategy before making an investment decision. Thorp has developed an approach for evaluating stocks that focused on identifying pricing anomalies in the securities market. By understanding whether a stock was over or undervalued, he says he has been able to take profitable long or short positions.

Test your investment strategy
Thorp says that before implementing an investment strategy, investors need to fully test their methodology and make sure their strategy puts them on the right side of most of the trades. “You don’t always have to be right. But as long as you are right more often, then you are wrong in a proportioned betting scheme you are very likely to be in positive territory over the long-term,” he says.

Keep proper balance between risk and return
Finding that appropriate balance between risk and return is a key component 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 strength, says Thorp, who is also a pioneer in modern applications of probability theory.

“The ups and downs of your bankroll vary greatly, and you can endure several negative sessions before the positive ones kick in and your advantage is realised. It is gut wrenching at times and it becomes harder and harder to make the big bet’s during losing sessions. But you have to trust that the math will kick in and your advantage will come to fruition,” says the professor.

Stay within your circle of competence
A hallmark of investors who are rational is that they stay within their circle of competence. This, Thorp says, helps investors to figure out what their skill set is and apply that to the market.

“If you are really good at accounting, you might be good as a value investor. If you are strong in computers and math, you might do best with a quantitative approach. If you aren’t going to be a professional investor, just index,” he says.

Obtain an investment edge
Thorp, who has in a book proven how to win a blackjack game by counting cards, says investors should try to gain a statically generated advantage or “edge”. Investors can tilt the playing field by getting this edge and generate superior long-term returns, he reasons.

“The first thing people who have control do is tilt the playing field. Maybe the majority of wealth is accumulated because of tilted playing fields. Not because of merit,” he says.

What’s common between investing and gambling
The stock market and gambling have a lot in common, says the hedge fund manager. In investment, like gambling, investors have to learn to fold early when the odds are against them; or if they have a big edge, back it heavily because it is not often that one gets a big edge, he explains.

“The overlap of interest between gambling and the stock market is very high. There are so many similarities and so much one can teach you about the other. Actually, gambling can teach you more about the stock market than the other way around. Gambling provides an analytically simpler world, and you can see principles and test theories. I was lucky in that I came to investments through blackjack tables. And the blackjack tables are an amazingly good training ground for learning how to invest, how to think about investments, how to manage them. And the reason is that they teach you, on the one hand, to use probability and statistics to evaluate things. And on the other hand, they teach you discipline,” he says.

Avoid stock tips and gossips
Thorp asserts that investors avoid giving importance to stock tips and gossips of the market as most stock-picking stories, advice and recommendations are completely worthless. “As far as asset classes go, it is hard to know when you are in a bubble, and if you are in one, when it will pop. Experts receive a lot of media attention because they make strong, definite claims. But definitive claims are usually not accurate predictions,” he says.

Thorp’s investing lessons are perfect for investors who want to find the right balance between 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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