by William Poundstone
400 pages, Hill and Wang, September 14, 2005
List: $27.00; $17.82 at Amazon.com
With the power of advanced computers mathematicians over the last several decades have developed models to accurately predict the outcome of games of chance. Using these models some of these experts � like MIT Professor Dr. Edward Thorpe � have proven that an individual can increase their chances of success in blackjack and other games of chance.
Elements of a Successful Investment System
According to Dr. Thorpe and other like-minded researchers, an individual should not bet in a game of chance or invest in the market unless they have a statistical advantage. One of the most challenging issues for Dr. Thorpe was finding situations where the individual has an edge. Thorpe noted that many sectors of the stock market are inefficient, and for this reason individuals are more likely to find an edge in the equity markets than in gambling venues.
When an investor finds a situation where they have a statistical edge they should place �proportional bets� based on their analysis of the applicable risks and rewards. When a large positive outcome has a high probability of occurring, the investor should bet (invest) heavily. When the odds are not as heavily tilted in an investors favor they should scale back the size of the bet.
If an individual does not have an advantage or edge in the market they should not invest according to Thorpe. Instead they should place their money in a passive exchange traded fund that tracks the major market indexes, or keep their assets in cash.
Statistics indicate that most professional money managers of public mutual funds underperform the major market averages � their �edge� does not compensate for the cost of their active management activities according to Thorpe. In many cases investors would obtain better returns with index funds.
The "Kelly Formula" and Charles Munger
Using this proportional betting system, sometimes referred to as the �Kelly Formula�, academics have shown that an investor should experience exponential portfolio growth � well in excess of the market averages. The downside is the portfolio volatility created by a system utilizing the Kelly Formula will be above average in most cases.
Some well known investment managers have reached similar conclusions with regard to investment systems without the mathematical undertone. Charles Munger, Warren Buffett's partner, attributes the most important factor in their joint investment success was the patience to wait for a good investment idea, then to bet heavily on that idea when the odds were stacked in their favor.
The amount of time required to conduct the due diligence to evaluate the hundreds of investment opportunities, and the expected odds of success, is something most investors don't appreciate. Munger and Buffett both found the process of due diligence stimulating. When they found attractive situations where the odds were in their favor they �bet heavily� according to Mr. Munger.
Developing the Investor's 'Edge'
In a recent article in Kiplinger�s Personal Finance author James Glassman identified one niche where an investor might develop an edge:
Small - So Profitable
by James K. Glassman
A quarter-century ago, a young University of Chicago economist named Rolf Banz made a surprising discovery: the smaller a stock's market value, the more profitable the investment.
This is how it works. If you divide the stock universe into ten slices--deciles--by company size, they line up perfectly. The stocks in the first decile (that is, the ones with the largest stock-market valuations) have the lowest average returns.
The ones in the second decile have the second-lowest returns and so on, down to the tenth decile, home of the smallest stocks and the highest returns.
Double the return
The figures are eye-popping. Ibbotson Associates found that between 1926 and 2004, the average return (price increases plus dividends) for the first decile was 11%; for the fifth decile, 15%; and for the tenth, 22%. In other words, in a typical year, the smallest stocks return about twice as much as the largest. . . .
In What Works on Wall Street, author James O'Shaughnessy tested the results of different investing strategies between 1951 and 2003. He found that the smallest of the micro caps--those with capitalizations less than $25 million--returned an annualized 28%.
Slightly larger stocks, with caps between $25 million and $100 million, returned 16%. Meanwhile, the S&P 500 returned only 12%. . . . (emphasis supplied)
In theory, this small company niche could give an investor an �edge� � and allow them to use the Kelly Formula to outperform the market, making proportional bets on highly probable events that have an attractive risk/reward relationships.
In fact both Mr. Munger and Buffett exploited this small company niche early in their investment management career � many of the firms they included in their portfolios would be classified as microcap stocks. The excess returns that they generated for investors in their portfolios reflect the success of their methodology � and the successful application of the Kelly Formula and the related statistical theory.
An interesting new book on the Kelly Formula and its application to gaming and investment decision making has been written by William Poundstone. Entitled �Fortune�s Formula,� it is an interesting and entertaining read.
The book chronicles Dr. Thorpe�s study of blackjack, roulette, and ultimately the stock market, and his transformation from a mathematics professor into a hedge fund manager. It also provides colorful insight on how the use of information in the gaming and gambling industries has evolved over the decades.
Thorpe�s strategy worked in theory as well as practice. His fund outperformed the S&P 500 index by an average of 6.3% per year over a 19 year period and had very consistent positive returns � much like Warren Buffett's early partnerships.
© 2005 Joseph Dancy
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