Before he embarked on a career in the financial markets, Dr Thorp did a tremendous amount of reading, including, for example, “Security Analysis” by Graham and Dodd. He recounts that, in general, a lot of what he read was nonsense and he was “surprised and encouraged by how little was known by so many.”
He describes two crucial mistakes he made with his first ever share purchase. Firstly he did not understand the company whose stock he bought, as his decision was based on a newspaper story. He concludes that ”most stock picking stories, advice, and recommendations are completely worthless”. Secondly, by refusing to sell after a large decline in its share price, he anchored himself to his buying price. He believes that anchoring “bedevils” most investors. Instead, they should consider the economic fundamentals of the investment as well as the opportunity cost of holding it.
Next, he examined “charting” or the technical analysis of stocks and commodities, but after months of investigating data and predictions, he concluded that there is no value in it. 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.
Even though he achieved spectacular success in the markets, Dr Thorp believes superior stock picking ability is rare. He recommends indexing for most investors, as the return to the average active investor equals that of the index minus fees. Also, the majority of mutual funds do not beat the index.
Unless you have a big enough edge, he also advocates using a buy-and-hold strategy. At least you are not handing out some of your wealth to high-frequency traders. He agrees with Paul Krugman that high-frequency trading serves no useful purpose and the resources consumed create no social good. (I discussed frequent batch auctions as a possible solution to curtailing high-frequency trading in an earlier post.)
Risk versus investment return
“Understanding and dealing correctly with the trade-off between risk and return is a fundamental, but poorly understood, challenge faced by all gamblers and investors.“ – Ed Thorp
Similar to some other successful investors, such as Charlie Munger2, Dr Thorp believes most people do not understand the probability calculations required in investing, as well as gambling and everyday life. 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. According to him, this is where Long Term Capital Management (LTCM) got it wrong in 1998.
He used the Kelly Criterion to determine his bet sizes as it is theoretically rigorous. However, he only placed bets at emotionally comfortable levels, which enabled him to invest or gamble with “calm and discipline”. Dr Thorp suggests that in practice one should implement half the Kelly Criterion’s bet sizes to avoid wild swings in a portfolio’s value. Also, the Kelly system requires exact probabilities, and when these are unknown, one should use conservative estimates.
After a geared investment in silver went wrong, he realised that he did not fully appreciate the riskiness of trading on margin. Gearing should be set at a level where you can tolerate the worst possible outcome.
He rejects the concept of “value at risk” which measures the capital required for the worst 5% of expected outcomes, as “these extreme events are where ruin is to be found”. The formal methodology of stress testing is also inadequate as it only simulates the effects of the significant adverse events of the past.
Dr Thorp believes that market participants are not prepared for Black Swan events and mentions as examples, LTCM in 1998 and the US insurance company, AIG, during the 2007 financial crisis. He is of the opinion that the 1987 stock market crash was caused by portfolio insurance investment strategies. The market dropped by 23% in one day, which is, as measured by the Dow Jones Industrial Average, the worst in its history.
He used a more comprehensive approach by analysing tail risk and by considering extreme questions such as what is the effect of a 25% market fall on his portfolio in one day.
“We did not ask: ‘Is the market efficient, but rather, in what ways and to what extent is the market inefficient? And how can we exploit this?’ “ – Ed Thorp.
As explained by Dr Thorp, the efficient markets hypothesis can never be logically proven, rather one can only argue to what extent it succeeds in describing reality. He provides many counter-examples including his own track record as well as that of Warren Buffett.
Mispricing of options, warrants, convertible bonds and statistical arbitrage are market inefficiencies Dr Thorp profited from in his hedge funds. Apart from these he also exploited the discounts and premiums to net asset values in closed-end funds.
As a specific example of a market inefficiency, he discusses the 60% fall of Emulex’s share price within 15 minutes on 25 August 2002, in response to a hoax. Even after it was uncovered as fake news, the stock was still 11.4% down eleven days later. Thus, the market does not accurately reflect all available information.
A second example Dr Thorp discusses is the spinoff of PalmPilot from the company 3Com. The market grossly mispriced PalmPilot shares despite this being highlighted in the press at the time. Shareholders in PalmPilot should have sold their stake to buy 3Com which would have given them an even bigger stake in PalmPilot during the subsequent spin off, as well as an additional holding in 3Com.
Dr Thorp also reckons that the efficient market theory is falsified by the many investors who are easily duped, and often so for decades, such as, for example, the investors in Bernard Madoff’s hedge fund. Hence, investors do not rationally incorporate all relevant information into their investment decisions.
Dr Thorp’s version of the efficient market hypothesis is:
Some information is instantly available to a minority who listens at the right time and place.
Each person is financially rational only in a limited way.
Participants typically only have some of the information available to determine a fair price. For each situation, both the time to process and the ability to analyse, vary.
Reaction to news is not instantaneous and is often spread out over hours, days or months.
Hedge fund strategies
Dr Thorp is the father of quantitative market neutral hedge funds. The hedging of mispriced securities with optionality was a major source of profit during his career. This included options, warrants, convertible bonds and convertible preference shares.
Later on, he also employed statistical arbitrage after examining a multitude of indicators such as earnings yields, dividend yields, price-to-book ratios, momentum, short interest, earnings surprises and trading by company insiders. Their system was based on a combination of these indicators and was successful, but dependent on market circumstances.
He also developed a successful trading system, which they called “most-up-most-down” (MUD). This involved buying the stocks that had fallen the most (the bottom 10%) and selling short those that rose the most (the top 10%) during the previous two weeks.
Statistical arbitrage systems need to be continually improved upon as other participants discover the anomalies. Furthermore, in Dr Thorp’s words: “Every stock market system with an edge is necessarily limited in the amount of money that it can use and still produce an extra return.”
Later on, with the help of Gerry Bamberger, they reduced the volatility of their statistical arbitrage returns considerably by implementing not only positions that are market neutral, but also sector neutral. This reminds me of “Rule 20” in David Dremans book ”Contrarian Investment Strategies: The Next Generation”3. Mr Dreman’s rule requires a long only investor to buy, say, the 20% least expensive stocks within each major industry. The investor is then short the more expensive 80% of stocks within each sector, relative to the market index. However, unlike Dr Thorp’s strategy, which is relatively short term, Mr Dreman suggests implementing his strategy for a five year period.
Dr Thorp lowered the volatility or risk of their arbitrage portfolio even further by making it neutral to factors such as inflation and the oil price. However, the tradeoff of from this risk reduction is also a decrease in returns as fewer portfolios satisfy all the conditions.
His fund also profited from the mispricing caused by spin-offs, such as the PalmPilot example discussed above.
Arguments against hedge funds
Despite being a remarkably successful hedge fund manager and also running a hedge fund-of-funds within his partnership, Dr Thorp is very critical of the industry.
In his view, picking good hedge funds is just as difficult as picking winning stocks, because, similar to companies, hedge funds are little businesses.
He highlights the following issues:
Hedge fund industry returns are subject to survivorship bias as performance reporting is voluntary and poor performing funds refrain from submitting data.
Overall, hedge fund investors receive poor returns, as the aggregate performance fees they pay are very high relative to the aggregate value-add delivered. This is so because the combined value add includes the value destruction from poor performing funds.
Hedge fund managers often follow a “heads we win, tails you lose” strategy. Often managers close down an underperforming hedge fund, just to set up a new fund with a clean slate.
Sometimes track records are build up in small closed funds by using IPO’s or cherry picking. Only those with good track records are then made publicly available, even though it is highly unlikely that the initial performance would be repeated.
Dr Thorp also refers to some unethical behaviour within the industry, such as, for example, managers who cherry pick investments for personal accounts ahead of their hedge funds. He also reckons that the improper charging of fees to partnerships is sometimes an issue.
So, Dr Thorp believes that the most important thing to check before investing in a hedge fund is the honesty, ethics, and character of its operators.