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Happy Hour: Ed Thorp’s Version of Mr. Market

March 23, 2018 by Jon

Barron’s interviewed Ed Thorp this week. Thorp’s curiosity led him down a path to finding ways to game inefficiencies in markets. He’s a math genius who wrote the book on winning blackjack. He parlayed that into a successful quant fund that earned around 19% a year for 20 years, then rolled that success into a second fund.

The Q&A session was short but had some good answers around the Kelly Criterion, whether market efficiencies still exist (he said yes), the value of time, and more. Okay, two highlights (with the links below).

The first is Thorp’s version of Mr. Market. I find it interesting how different people explain Graham’s parable. This is how a mathematical mind explains it in relation to owning an index fund. The second is on lessons for readers of his book A Man for All Markets.

Q: How are casinos similar to the stock market?

A: Imagine you are investing in an index fund. The casino is Mr. Market, who offers you a collection of bets. If you choose an index fund, say VTSAX [the Vanguard Total Stock Market Index fund], on a typical day it randomly fluctuates by 1%. But there is a long-term drift in your favor of about one twentieth of a [percentage point]. So if you had $1 million in your portfolio in such an index, Mr. Market will come to you each day and say, “Let’s flip a coin. If it’s 50/50, then you’ll win $10,000 or lose $10,000. But I’ll pay you $500 if you play that day.” If you play for one day, you’ll be at $9,500 or at $10,500. If you play for a year, the chances are moderately good that you’ll be ahead because those $500 payments add up and overcome the fluctuation. Maybe a third of the years, you’ll be down and unhappy. But if you play for 10 years or 20 years, then those $500 payments just keep adding up.

Warren Buffett has also devoted his life to compounding. So a similar process happens at blackjack tables. If you’re counting cards, you have a little drift in your favor. But in blackjack you play 100 hands an hour, and in a week you may play 4,000 hands. In a casino, you get to the long run fairly quickly.

Q: What lessons do you want people to come away with from A Man for All Markets?

A: That the best thing you can do for yourself is to educate yourself to think clearly and rationally. It helps to have math or science or logical training. The next is to be widely read and curious. If you are that way, you have so much more to use in terms of tools. [Berkshire Hathaway Vice Chairman] Charlie Munger has a collection of multiple mental models — shorthand ways to think of things. I also have my own, and one of my favorites is to understand externalities [spillover effects from other economic activity].

For example, if I buy fire insurance for my house, my neighbor is a little safer. That’s an externality benefit. If someone drives a polluting gasoline car and uses the atmosphere as a waste dump without paying any consequences, that’s a negative externality. Another one is guns. Gun dealers make a lot of money, their clients go out and kill people, and society pays huge costs. Gun dealers don’t.

Externalities are a good way to start analyzing problems. A lot of problems go away if you make people who distribute negative externalities pay the consequences.

Source:
The Stockpicker’s Burden, and Other Lessons
Why Edward Thorp Owns Only Berkshire Hathaway

Tip: To get around the paid subscription limit, copy and paste the article’s title into Google, then click the first result.

Last Call

  • The Easy Pickings – The Irrelevant Investor
  • Investing is Hard – MicroCapClub
  • Slow and Steady Wins the Race–in the Land of Make-Believe – J. Ptak
  • Rising Treasury Yields Are a Good Problem to Have – B. Carlson
  • The Great Inflation Mystery – Business Week
  • Stock Buybacks are Bad? What About the Alternative: Investment – Alpha Architect
  • What’s Cheap? A Factor Perspective – Factor Investor
  • Why We Listen To Bad Forecasts – M. Housel
  • Getting the Default Settings Right – S. Godin
  • The Most Successful People Are The Ones You’ve Never Heard Of – R. Holiday
  • What the F*** Was Facebook Thinking? – Medium
  • Scraping Bottom – Damn Interesting
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