Ed Thorp’s “Beat the Market” And Risk Management

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Ed Thorp’s “Beat the Market” And Risk Management

A question from a reader on my recent post Me Too!:

I recently ran across Ed Thorp’s “Beat the Market.” I find reasonable his idea that you can take on risks that (almost / essentially) cancel each other out. Find assets that are negatively correlated to buy one long and the other short (he did it with stock warrants in the 60’s but when I started looking into that, well, I’m late to that party, so nevermind).

I’m uncomfortable with shorting anyway, so what about going long in everything and rebalancing when the assets get out of whack? Aren’t a lot of the price movements of various assets (cash, bonds, stocks, real estate, precious metals) the result of money flowing towards or away from that asset? If people are, on net, selling their stocks, to what type of asset are they sending the proceeds? I can’t predict where people will stash their money next, but if I own a little of everything, I’m both hedged against prolonged depression of one asset class and aware of what’s gotten “expensive” and what’s “cheap” now.

Blue Eagle Capital Partners: Long Thesis For This Lending Stock

blue eagleBlue Eagle Capital Partners was up 17.7% net for the third quarter of 2020, bringing its return to 49.1% for the first nine months of the year. During the third quarter, longs contributed 28.15% to the fund's performance, while shorts subtracted 7.36%. The S&P 500 was up 8.93% for the third quarter. Q4 2020 hedge Read More


Along these same “indexing” lines, what do you think of using ALL the sector ETFs (Vanguard has 11) to index each sector and then rebalance among them as they change in value? How would that application of your portfolio rule 7 differ than when applied to individual stocks? Also, do you think it would be subject to the same / similar danger as everyone else “indexing” as you wrote about above?

Risk Free Rates

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My, but there is a lot here.  Let me try to unpack this.

Paragraph 1: All of the easy arbitrages are gone or occupied to the level where the risks are fairly priced.  Specialists ply those trades now, and for the most part, they earn returns roughly equal to short-term risky debt.  They tend to get hurt during financial crises, because at those points in time, fundamental relationships get disturbed because of illiquidity and defaults amid demands for liquidity and safety.

Paragraph 2: First, rebalancing is almost always a good idea, but it presumes the asset classes/subclasses in question is high quality enough that it will mean-revert, and that your time horizon is long enough to benefit from the mean reversion when it happens.  Also, it presumes that you aren’t headed for an utter disaster like pre-WWII Germany with hyperinflation.  Or confiscation of assets in a variety of ways, etc.

Then again, in really horrible times, no strategy works well, so that is not a criticism of rebalancing — just that it is useful most but not all of the time.

Aren’t a lot of the price movements of various assets [snip] the result of money flowing towards or away from that asset?

Back to the basics.  Money does not flow into or out of assets.  When a stock trade happens, shares flow from one account to another, and money flows the opposite direction, with the brokers raking off a tiny amount of cash in the process.  Prices of assets change based on the relative desire of buyers and sellers to buy or sell shares near the existing prior price level.  In a nutshell, that is how secondary markets work.

Then, there is the primary market for assets, which is when they were originally sold to the public.  In this case, corporations offer stocks, bonds, etc. to individuals and institutions in what are called initial public offerings [IPOs].  The securities flow from the companies to the accounts of the buyers, and the money flows from the accounts of the buyers to the companies.  The selling prices of the assets are typically set by syndicates of investment bankers, who rake off a decent-sized chunk of the money going to the companies.  In this case, yes, the amount of money that people are willing to pay for the assets will dictate the initial price, unless the deal is received so poorly that it does not take place.  After that, secondary trading starts.  (Note: this covers 95%+ of all of the ways that assets get to public markets; there are other ways, but I don’t have time for that now.  The same is true for how securities get extinguished, as in the next paragraph.)

The same thing happens in reverse when companies are bought in entire, either fully and partially for cash, and in the process, cease to be publicly traded.  The primary and secondary markets complement each other.  Corporations and syndicates take pricing cues from the levels securities trade at in the secondary markets in order to price new securities, and buy out existing securities.  Value investors often look at primary markets to estimate what the assets of whole companies are worth, and apply those judgments to where they buy and sell in the secondary markets.

Trying to guess where market players will raise their bids for assets in secondary trading is difficult.  There are a few hints:

  • Valuation: are asset cheap or rich relative to where normalized valuation levels would be for this class of assets?
  • Changes in net supply of assets: i.e., the primary markets.  Streaks in M&A tend to persist.
  • Price momentum: in the short-run (3-12 months), things that rise continue to rise, and vice versa for assets with falling prices.
  • Mean-reversion: in the intermediate term (3-5 years), things that currently rise will fall, and vice-versa.  This effect is weaker than the momentum effect.
  • Changes in operating performance: if you have insight into companies or industries such that you see earnings trends ahead of others, you will have insights into the likely future performance of prices.

All of these effects vary in intensity and reliability, both against each other, and over time.  If you own a little of everything, many of these effects become like that of the market, but noisier.

Paragraph 3: If you want to apply rule 7 to a portfolio of sectors, you can do it, but I would probably decrease the trading band from 20% to 10%.  Ditto for a portfolio of country index ETFs, but size your trading band relative to volatility, and limit your assets to developed and the largest emerging market countries.  With a portfolio of 35 stocks, the 20% band has me trade about 4-5 times a month.  With 11 sectors your band should be sized to trade 1-2 times a month.  20 countries, around 3x/month.  If it is a taxable account set the taxation method to be sell highest tax cost lots first.

Remember that portfolio rule 7 is meant to be used over longer periods of time — 3 years minimum.  There are other rules out there that adjust for volatility and momentum effect that have done better in the past, but those two effects are being more heavily traded on now relative to the past, which may invalidate the analogy from history to the future.

Using portfolio rule 7 overweights smaller companies, industries, sectors, or countries vs larger ones.  It will not be as index-like, but it is still a diversified strategy, so it will still be somewhat like an indexed portfolio.

Finally, even if we get to the point where active management outperforms indexing regularly, remember that indexing is still likely to be a decent strategy — the low cost advantage is significant.

That’s all for now, and as always, comments and questions are welcome.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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