Sunday, January 22, 2017

Thorp, A Man for All Markets

Edward O. Thorp is a legend in both the gaming and the quant worlds. The author of Beat the Dealer and Beat the Market, he went from math professor and blackjack whiz to renowned hedge fund manager. In A Man for All Markets (Random House, 2017), he reflects on his life and the power of thinking differently—and deeply.

Thorp learned how to puzzle things out for himself as a largely self-taught child. He also devised methods for learning how to learn. For instance, when at the age of 12 he set out to master Morse Code, required to get his ham radio operator license, he invested almost three weeks’ income from delivering newspapers in a “tape machine” to practice transcribing code. The machine’s speed was adjustable. Young Thorp’s plan “was to understand every tape at a slow rate, then speed the tapes up slightly and master them again.” He measured his progress against that of World War II army trainees. He writes: “I drew a graph of the hours I spent versus my speed and found that using my method I learned four times as fast per hour spent as did the army trainees.” That Thorp was uncommonly bright might also have contributed just a tad to this carefully recorded outcome.

Fast forward to Thorp’s time at the blackjack table. He recalls playing at one casino where the rules were excellent: “players could insure, split any pair, and double down on any set of cards. Even so, the cards ran badly, I lost steadily, and after four hours I was behind $1,700 and discouraged. Of course, I knew that just as the house can lose in the short run even though it has the advantage in a game, so a card counter can fall behind and this can last for hours or, sometimes, even days. Persisting, I waited for the deck to become favorable just one more time.” Soon enough the deck produced a 5 percent advantage, so Thorp made the maximum bet of $300, all his remaining chips. Dealt a pair of 8s, he pulled out his wallet to bet another $300 on the split hands. And, getting a favorable second card on one of the 8s, he dropped another $300 on the hand. The dealer busted, so Thorp gained $900. The deck continued to be favorable, “calling for big bets,” and the next deck was good as well. In a few minutes he was ahead $255 and quit for the evening.

As Thorp reflects, “for the second time, the Ten-Count System had shown moderately heavy losses mixed with ‘lucky’ streaks of the most dazzling brilliance. I learned later that this was a characteristic of a random series of favorable bets. And I would see it again and again in real life in both the gambling and the investment worlds.”

Indeed, at Princeton Newport Partners, which restarted its statistical arbitrage operation in 1992, Thorp expected “the statistical behavior of a large number of favorable bets to deliver [their] profit.” By 2000 they were placing a million bets a year, at an average trade size of $54,000, or “one bet every six seconds when the market is open.”

A Man for All Markets is an inspiring memoir. Not surprisingly, Thorp, in his final chapter, writes: “Education has made all the difference for me. Mathematics taught me to reason logically and to understand numbers, tables, charts, and calculations as second nature. Physics, chemistry, astronomy, and biology revealed wonders of the world, and showed me how to build models and theories to describe and to predict. This paid off for me in both gambling and investing.” And, to come full circle, he notes: “Much of what I’ve learned came from schools and teachers. Even more valuable, I learned at an early age to teach myself. This paid off later because there weren’t any courses in how to beat blackjack, build a computer for roulette, or launch a market-neutral hedge fund.”

Wednesday, January 4, 2017

Clark, The Tao of Charlie Munger

David Clark, who has written eight books on Warren Buffett, has moved on to Charlie Munger. The Tao of Charlie Munger (Scribner) is, in the words of the subtitle, A Compilation of Quotes from Berkshire Hathaway’s Vice Chairman on Life, Business, and the Pursuit of Wealth. Clark provides commentary.

Clark divided the 138 quotations he selected for this book into four categories: Charlie’s thoughts on successful investing; Charlie on business, banking, and the economy; Charlie’s philosophy applied to business and investing; and Charlie’s advice on life, education, and the pursuit of happiness.

Here are a couple of my favorites:

“It’s been my experience in life, if you just keep thinking and reading, you don’t have to work.”

“Any year that passes in which you don’t destroy one of your best loved ideas is a wasted year.”

There’s already a substantial body of literature about the ideas of Charlie Munger. And, of course, we have Poor Charlie’s Almanack. Do we need yet another book? Probably not. But even when I’m reading a quotation for the umpteenth time—for instance, that his children think he’s “a book with a couple of legs sticking out”—I still smile. And, by the way, he really is a reader. “It’s said that Charlie reads up to six hundred pages a day—which includes three newspapers a day and a weekly diet of several books.”

If you want to up your own personal daily page count, you might consider adding this book to your list.

Thursday, December 29, 2016

Banner, Speculation

Few people today call themselves speculators. The word is too loaded. Instead, they are traders, hedge fund managers, and the like. But, whatever they call themselves, they are speculators. They’re the ones people blame for everything from business cycles to political corruption to income inequality to financial crises. And the ones amateurs try to emulate when the economy and markets are booming—day trade, flip this house, risk money to make money fast.

Stuart Banner, in Speculation: A History of the Fine Line between Gambling and Investing (Oxford University Press, 2017), traces how American ambivalence toward speculation, especially as reflected in regulatory and legal decisions, tips one way and then the other. Is the speculator engaged in unsavory conduct or is he performing a service? Is he anti-American or the quintessential American?

Speculation has had its harsh critics since early in the history of this country. And much of the criticism gets repeated generation after generation. For instance, in 1835 a New Hampshire newspaper warned: “In our rising manufacturing villages this speculating mania rages to a great extent, and is laying a foundation for that poverty, dependence and wretchedness which characterizes the population of similar places in Europe. The few are becoming immensely rich, the middling interest poor, and the poor abject.” That has a familiar ring to it, doesn’t it?

Support for speculation is usually more muted. Alexander Hamilton argued that (in Banner’s rephrasing) “the buying and selling of paper did not remove capital from the productive economy … but added capital to the economy.” Elbridge Gerry defended speculators at the Constitutional Convention, saying that “They keep up the value of the paper. Without them there would be no market.” Another justification for speculators, common in the first half of the nineteenth century, is that they stabilize prices, buying when prices are low and selling when prices are high.

Legal attitudes to insider trading, to which Banner devotes a chapter, have followed a different trajectory. In a 1933 ruling, the Massachusetts Supreme Court found that Rodolphe Agassiz, president of Cliff Mining, had not broken the law when he made well over a million dollars in today’s money by trading on favorable inside information. The law, the opinion read, “cannot undertake to put all parties to every contract on an equality as to knowledge, experience, skill and shrewdness.” Seventy years later Sam Waksal sought to take advantage of his advance knowledge of bad news—that the FDA would not permit ImClone’s cancer treatment Erbitux to be sold. But the court no longer thought that exploiting one’s superior access to knowledge was at worst inevitable, at best good: Waksal was sentenced to seven years in prison.

Banner’s history is carefully researched and well documented. It shows just how difficult, and probably impossible, it is to find “the” proper place for speculation in the financial markets. Just when regulators think they have reined in speculators and made the financial world “safe,” allowing good risk and forbidding bad risk (gambling), financial engineers and traders will redefine those boundaries and send regulators scrambling again.

Tuesday, December 27, 2016

Crosby, The Laws of Wealth

Thinking about your New Year’s resolutions? You know, the ones you never keep? When it comes to investing, The Laws of Wealth: Psychology and the Secret to Investing Success (Harriman House, 2016) by Daniel Crosby might be a good antidote to yet another year of backsliding. His basic message is that one should engage in rule-based behavioral investing to help defeat behavioral risk.

In the first part of the book Crosby sets out ten sometimes counterintuitive rules of behavioral self-management, the behavioral risk side of his equation for success. They are: (1) you control what matters most, (2) you cannot do this alone, (3) trouble is opportunity, (4) if you’re excited, it’s a bad idea, (5) you are not special, (6) your life is the best benchmark, (7) forecasting is for weathermen, (8) excess is never permanent, (9) diversification means always having to say you’re sorry, and (10) risk is not a squiggly line.

He devotes the second part to behavioral asset management. Investing, he argues, is an area in which intuition and common sense fail us because, among other reasons, it is “performed infrequently, provides delayed feedback and includes an overwhelmingly complex array of variables.” In fact, stock picking can be fairly well described using five variables that, according to Daniel Kahneman, lead to suboptimal decision making: a complex problem, incomplete and changing information, changing and competing goals, high stress and high stakes involved, and must interact with others to make decisions.

If we are to be successful investors, Crosby argues, we must automate the process by which we make decisions. We must follow a model and not taint it with on-the-fly judgment calls. We must “set systematic parameters for buying, selling, holding and re-investing funds and follow them slavishly.” We must take advantage of human fallibility and pursue rule-based behavioral investing.

Crosby suggests one such investing model , which combines value and momentum along with risk assessment (using such metrics as Montier C-scores and Altman Z-scores to vet all purchases).

The Laws of Wealth does not offer a path to consistent outperformance (which, Crosby argues, is one reason his model will have lasting power). Over time, however, systematic behavioral investing should produce an impressive track record. Which, of course, should translate into wealth.

Thursday, December 22, 2016

Bytheway & Metzler, Central Banks and Gold

Central Banks and Gold: How Tokyo, London, and New York Shaped the Modern World (Cornell University Press, 2016) by Simon James Bytheway and Mark Metzler is an academic study that covers the period between the late 1890s and the 1930s. Although it’s no page turner, by relying on extensive archival research and bringing Japan into the picture it highlights some hitherto unknown aspects of the international central banking system.

Here are a few bullet points.

In the 1890s Great Britain was the world’s largest creditor country, replaced by the United States in 1914. In the 1980s Japan replaced the U.S. as the world’s largest creditor country and remains so today.

The Bank of England and the Bank of Japan “secretly developed a close form of cooperation in the early years of the [nineteenth] century. … [F]or much of the period from 1896 to 1914, the BoJ was the Bank of England’s largest single depositor. The Bank of England’s ability to maintain its global financial position during the decade and a half before 1914 was supported by its ability to manage these Japanese funds and quietly to draw on them in moments of need.”

In early 1915, well before the United States entered World War I, American private banks, backed by the Federal Reserve Bank of New York, “began to finance the enormous military purchasing programs run by the British and French governments in the United States.”

“Every truly major international financial crisis of the era—1907, 1920, 1929—appeared first in Tokyo, having an onset some three to six months earlier than in New York and London.” Tokyo markets were “a sensitive leading indicator.”