Old Pros Size Up the Game

WSJ interview with Ed Thorp and Bill Gross.

-

WSJ: What can your blackjack strategy tell us about how to manage risk in today's markets?

-
Mr. Thorp: You have to make sure that you don't over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss -- but never more. If you bet much more you can be ruined, even if you have a favorable situation.

-
WSJ: Your key risk-management strategy is known as the Kelly Criterion. What is it?

-
Mr. Thorp: It's a formula Bell Labs scientist John Kelly devised in the 1950s for maximizing the long-term growth rate of capital. It tells you how to allocate your money among the choices available, and how much to invest as your edge increases and the risk decreases. It also avoids the over-betting that can ruin an investor who otherwise has an edge.

...

WSJ: What's your assessment of the state of hedge funds today?

-
Mr. Thorp: In the last 15 years or so, there has been a large flow of capital into the hedge-fund world, from $100 billion in the early 1990s to $2 trillion now. But the amount of available investing opportunities hasn't increased that much. That has led to the over-betting phenomenon Bill and I were talking about, or gambler's ruin.

-
Hedge funds started using a great deal of leverage to increase returns. But you can get wiped out if you bet too aggressively. A classic example is Long-Term Capital Management [the huge hedge fund that blew up in 1998]. We'll probably be seeing more of that now.

-
Mr. Gross: It's true that the available edge has been diminished, and that led to increased leverage to maintain the same returns. It's the leverage, the over-betting, that leads to the big unwind. Stability leads to instability, and here we are. The supposed stability deceived people.

-
Mr. Thorp: Any good investment, sufficiently leveraged, can lead to ruin.

-

....................

-

On a related note, I've been meaning to do a write-up one weekend on the Kelly Criterion, how I use it and how I believe it should be used in investing. Many opinions have been given on this topic but I believe a simplified, expected value approach that still involves the art behind valuation work is the correct one. Until then (or in case there is no then), here are a few related links:

-

Book: Fortune's Formula

-

Mauboussin: Size Matters

-

William Poundstone site page (author of Fortune's Formula)

-

Previous post and link: Bill Miller: What's luck got to do with it?