Ed Thorp & Over-betting

In today’s Wall Street Journal, there's a great interview with Edward Thorp and Bill Gross.

Both investors are asked about current market conditions and their thoughts on investing in general.

Ed Thorp is a hedge fund manager who ran Princton-Newport Partners and has returns of 20% over a 28-year period (ending 1998). In addition to his investing skills, Thorp is best known for his work at the Blackjack tables. In 1962, he authored the book Beat the Dealer, which explained the methods he used to win at Blackjack.

For more information on Ed Thorp, check out the book Fortune's Formula. It's a great read that details the evolution of information theory, the Kelly Criterion, gambling strategies, hedge funds, and the mob's involvement in all of the above. Math, gambling, the mafia, and investing. Who could ask for anything more? Also, if you're interested in Thorp's Blackjack strategies (card counting), the book Bringing Down the House is another great read. But I'll stick to the subject of investing for this post.

Over-betting

Below is a section from the WSJ article where Gross and Thorp discuss hedge funds:

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.

This prevalence of over-betting has caused the downfall of many hedge funds and most recently the collapse of Bear Stearns. As Thorp states above, excessive leverage has a lot to do with it. Of course, you don't need leverage to over-bet.

Let's say you knew the exact probabilities and possible outcomes of a certain investment. Then you use the Kelly criterion to determine the optimum amount of your portfolio that should be placed in the investment. In this case, it's 40%. If you keep making this same bet over and over again, a 40% allocation will give you the maximum possible return (which comes with large volatility). If you only put 30% into it, you'll get a little less return with reduced volatility. If you over-bet, putting 50% into the investment, you'll get less return with more volatility. A pretty bad combination.

So basically, you never want to over-bet. If you always knew the exact probabilities like the above example, assuming you don't mind a little volatility, you wouldn't under-bet either. But outside the world of gambling, you never know the exact probabilities.

That's the problem. When you estimate the chances of a negative outcome, it's just a guess. No one knows the actual numbers. Hopefully, you over-estimate the chances of something going wrong. In that case, you'd end up betting less than you should. A little less possible returns, but no harm done—it's better than the other option. Under-estimating the odds (or the extent of the damage) of a negative outcome causes over-betting using the Kelly Formula.

That's why it's always best to purposely under-bet. It leaves a "margin of safety" if you underestimate the downside.

Leverage makes you bet more than you probably want to. When making risky bets, investment operations like Bear Sterns that are leveraged more than 30-to-1 are accidents waiting to happen. In their case, an allocation of only 2% of assets amounts to over 60% of the portfolio in one security. Combined with liquidity problems, it's easy to see a scenario where things go wrong very quickly.

I doubt Bear Stearns and these hedge fund managers knew they were over-betting as they placed their bets. They wouldn't do it on purpose. If anything, they were too confident in their estimates of probabilities and possible outcomes.

As Bill Gross said, "The supposed stability deceived people." In other words, they assumed everything would continue as it had in the past. Looking through the rear-view mirror while you drive works great until you run into a brick wall.