Investment gurus Edward Thorp and Bill Gross discussed the theories and strategies behind their winning ways with Scott Patterson in the Wall Street Journal this weekend.
Thorp's book 'Beat the Dealer' published in 1962 described how his formula of counting cards and measured bets would maximize winnings at blackjack. He then took the same strategy into the world of investments with his book 'Beat the Market'. Gross was heavily influenced by Thorp's reasoning, and became in time managing director of PIMCO, and himself a widely followed investment strategist.
Cards and gambling played an important role for both Thorp and Gross, in their early days. Both tried out their strategies in the gaming rooms of Las Vegas, and realized that the same skills could be used for investing. Patterson asked what their blackjack strategy can tell us about managing risk in today's market:
Mr. Thorp: You have to make sure that you don't over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss -- but never more. If you bet much more you can be ruined, even if you have a favorable situation.
WSJ: Your key risk-management strategy is known as the Kelly Criterion. What is it?
Mr. Thorp: It's a formula Bell Labs scientist John Kelly devised in the 1950s for maximizing the long-term growth rate of capital. It tells you how to allocate your money among the choices available, and how much to invest as your edge increases and the risk decreases. It also avoids the over-betting that can ruin an investor who otherwise has an edge.
Mr. Gross: Ed's basic thrust concerns the idea of gambler's ruin, where you lose everything by over-betting. In the context of blackjack, you can never bet more than 2% of your stake without the possibility of eventually losing your entire pot.
Here at Pimco, it doesn't matter how much you have, whether it's $200 or $1 trillion. You'll see it throughout our portfolio. We don't have more than 2% in any one credit. Professional blackjack is being played in this trading room from the standpoint of risk management, and that's a big part of our success.
Indeed card-playing doesn't seem so far removed from Gross' thinking even today. In his latest PIMCO monthly outlook, Gross compares what is going on in the credit markets today to another card game, Old Maid, where deceptions are deployed to ensure that you don't end up with the dreaded Old Maid card.
Both Thorp and Gross note that troubles in the hedge funds can be partly attributed to their heavy leverage, "the over-betting" leading eventually to the big unwind. As Thorp tells Patterson, "any good investment, sufficiently leveraged, can lead to ruin."
And yet given the enormous recent changes in the markets, both mavens agree that opportunities are there for the taking, albeit with caution:
Mr. Gross: Six or 12 months ago, we were despairing in terms of finding good opportunities. But now the opportunities are enormous, and we're looking for places to jump in... Is there blood on the streets? Yes. But there are strong-quality assets out there.
Mr. Thorp: Fear creates opportunities. So as Bill was saying, this is probably a great time.