Book Review: A man for all markets

In “A man for all markets”,  Edward Thorp tells his incredible life story. The book is filled with practical wisdom on investments and life in general. Here I will concentrate briefly on those parts that might be of interest to the Stockopedia community.

Interestingly, this is also the only book Charlie Munger recommended at the 2017 meeting of the Daily Journal Corporation.

Dr Thorp, born in 1932, was an American mathematics professor, who became an extremely successful quantitative hedge fund manager. He started investing in financial markets using his winnings from a money-making foray into gambling which he describes in his book “Beat the Dealer”. Dr Thorp is the first person to derive and then apply theoretically sound option pricing models to financial markets.

His Principal Newport Partners hedge fund outperformed the S&P500, on a gross basis, by about 9% per annum from 1969 to 1988, without one negative year. His XYZ statistical arbitrage fund outperformed the S&P500 by 10.4% per annum for the ten year period 1992 to 2002, on an un-levered basis.

Dr Thorp was not interested in the fundamental worth of businesses, but rather in using his mathematical skill in finding relative mispricing among securities. He did, however, make a very profitable investment in Berkshire Hathaway, after he played bridge with Warren Buffett. He recounts that meeting Mr Buffett also helped him to move along the path to his own hedge fund.
Dr Thorp probably started the first ever quantitative market neutral hedge fund. The hedging of mispriced securities with optionality was a major source of profit. This included stock options, warrants, convertible bonds and convertible preference shares.

Probably of more interest to Stockopedia subscribers is his use of statistical arbitrage. His trading systems were based on a combination of indicators, similar to those used in many of the Stockopedia screens. He mentions the use of earnings yields, dividend yields, price-to-book ratios, momentum, short interest, earnings surprises and trading by company insiders. The profitability of his systems was, however, dependent on market conditions.

He also developed a successful trading system, which he called “most-up-most-down”. 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.

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 rare events.

Dr Thorp believes a proper balance should be maintained between risks and return, or in his words: “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.“ He is also of the opinion 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.

For managing the position sizes in his portfolio, Dr Thorp pioneered the use of the Kelly Criterion 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 bet sizes to avoid wild swings in a portfolio’s value. Also, the Kelly Criterion requires exact probabilities, and when these are unknown, one should use conservative estimates.

For any Stockopedia investor who is trying to beat the market the following quote from the book is encouraging: “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?"  He provides many counter-examples to the efficient market theory, including his own track record as well as that of Warren Buffett.

More discouraging though is Dr Thorp’s belief that superior stock picking ability is rare, even though he achieved spectacular success in the markets. He recommends indexing for most investors, as the return to the average active investor equals that of the index minus costs.

I give a more comprehensive version of his investment lessons here. If you are interested in another take on Dr Thorp’s investment advice, refer to Tren Griffin’s 25iq post “A Dozen Lessons on Investing from Ed Thorp”.

For readers with a more general interest, Dr Thorp also imparts valuable life lessons, and he asks questions such as: ”Is the winner really the one who dies with the most toys?” I give a summary of his wisdom here.

The Investors Podcast interviewed Dr Thorp in March 2017. The podcast is available here.

Phi