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Date of review: March 2020
Book author: Edward O. Thorp
Вook published: 2017

A Man for All Markets: Beating the Odds, from Las Vegas to Wall Street by Edward O. Thorp (2017)

Ed Thorp is a great example of a highy intelligent person with exceptional skills in math who applied his knowledge in a world of finance and achieved great success.

Thorp argues that markets are not always efficient and there are ways to exploit it.

One lesson I got from his book is about Humility. Despite having extraordinary intellectual capabilities, Thorp concludes that investing in an index is safer and he does not try to beat the market through individual stocks anymore. Although his latest investment strategy probably better reflects his personal choice of valuing time and freedom more than monetary gains at this stage of his life (and net worth).

Thorp first developed a system to win in casinos using math and described his method in a separate book, then he launched two hedge fund –Princeton Newport Partners first and Ridgeline Partners after - which generated over 20% annualised return over a thirty years without a single down quarter.

Unlike many value investors, Thorp focused on arbitrage opportunities – looking at different securities of the same company and trying to identify mispricing of any of them. The strategy has worked better with smaller amount of capital ($273mn of capital at peak in 1988 with gross investments at $1bn).

One of the key reasons I found the book important is that Thorp, world's top mathematician with proven track record in investing, argues that markets are not always efficient and there are ways to exploit it. It is not so surprising to hear such an idea, but was it unusual is that it comes from the world's top mathematician – not an active investor (who has to sell his services) or a market commentator.

Thorp discusses some fairly well-known concepts but brings his own examples which are still quite useful. They include:

Compounding

7.3% average annual market return doubles your investment in 10 years.

Long-term holding with little dividends and high reinvestments by companies.

This helps to reduce your tax liabilities and improves your net performance as you are not taxed each time there is a dividend distribution or you sell one stock to buy another one.

Thorp advice on beating the market includes:

1
Get information early (if you are not sure how valuable your information is then it probably is not). Few people occasionally listen to some information at the right time and the right place.
2
Be a disciplined rational investor. Follow the logic and analysis rather than sales pitches, whims, or emotion. Don't gamble unless you are highly confident you have the edge. In real markets the rationality of the participants is limited.
3
Find a superior method of analysis.
4
When securities are known to be mispriced and people take advantage of this, their trading tends to eliminate the mispricing. The earliest traders gain the most.

Thorp also refers to Kelly formula (Edge / Payoff) which helps to determine the size of a bet or investment. Thorp has used it in both his gambling and investing. He notes that this formula allows to 1) avoid total loss; 2) bet more as edge gets bigger; and 3) bet more as risk is lower. Results may still be volatile which makes such method less attractive for short-term investors.
There is also an important concept of trade-off between money, time and health (e.g.  you may be better of leaving closer to work and spending less time driving even if you face higher monthly bill which is a cost most people focus on because it is explicit).

Chapter 26 ('Can you beat the market? Should you try?') was one of the most interesting for me. A few examples of market inefficiency to be exploited by investors presented in the chapter include price discounts to NAV of closed-end funds, SPACs trading well below cash, cases of holding companies trading below the value of underlying assets.

Finally, it is pleasing to find Thorp discuss his investment in Berkshire and valuation approach he uses. Interestingly enough, both have known each other since late 1960s (the book provides an interesting story of how they met).

Key notes:

  • It doesn't pay [in negotiations] to push the other party to their absolute limit. A small extra gain is generally not worth the substantial risk the deal will break up.

  • The defect of VaR alone is that it doesn't fully account for the worst 5 percent of expected cases. But these extreme events are where ruin to be found…We took a more comprehensive view. We analysed and incorporated tail risk, and considered extreme question such as, 'What if the market fell 25% in one day?'.

  • I had overwhelming evidence of inefficiency from blackjack from the history of Warren Buffett and friends, and from our daily success in Princeton Newport Partners. We didn't ask, Is the market efficient? but rather , In what ways and what extent in the market inefficient? and How can we exploit this?

  • What appears random for one state of knowledge may not be if we are given more information.

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