Invest when the odds are in your favour

By Larissa Fernand |  03-01-23 | 
 

You might have heard of Bill Gross.

He helped found and lead investment firm PIMCO (an acronym for Pacific Investment Management Company), one of the world’s largest bond-management institutions. Fortune magazine bestowed upon him the title “The Bond King” in 2002, and it pretty much became a moniker for him. Morningstar named him Fixed Income Manager of the Year in 1998, 2000 and 2007, and then of the decade — in 2010.

He transformed the fixed income market, but his supremacy did not last forever.

JAMES GRUBER, assistant editor for Firstlinks.com.au and Morningstar.com.au, shares a fascinating aspect on Bill Gross and Edward Thorp.

His path to finance began by chance. He was in his final year of college when he had a bad car accident which sliced open his scalp. While bedridden, he read a book called Beat the Dealer by Edward Thorp, a math professor at MIT. Written in 1962, the book detailed how you could win at blackjack by using a system for counting cards.

When Gross recovered, he went straight to Las Vegas, where he played 16 hours a day over the next four months. He turned his initial $200 into $10,000.

Once done, his thoughts turned to what to do with his future. He later recalled:

“I said, well, I obviously enjoy mathematical application of a system of some sort, and hard work, and diligence. What’s the adult form of gambling? It’s the stock market. Maybe you can’t outfox it, but let’s see if it can be done. Right then and there I said, ‘I’m getting into the money management business.’”

The rest is history.

Edward Thorp wrote Beat the Dealer when he was 30 and the book not only inspired Gross but generations of professional and amateur gamblers. Several students at MIT successfully used the card counting method, and their exploits became the basis for the 2003 best-selling book, Bringing Down the House  and subsequent film 21, starring Kevin Spacey.

After Thorpe’s book was published, several wealthy individuals bankrolled Thorp so he could use his system at casinos. He was originally welcomed by casinos as they didn’t see him as a threat. As his fame spread, Thorp started wearing disguises, but the mobsters who ran the casinos at that time were onto him and fought back (through violence and other means).

The public corporations which eventually took over the running of casinos from mobsters became smarter at eliminating card counting. They altered table rules to discourage gamblers from counting opportunities.

With the money he’d amassed from gambling, Thorp began investing in the stock market. He figured gamblers and investors shared the same psychological makeup. He developed a system based on arbitraging the price differences of two correlated securities, such as a company’s shares and its warrants.

He outlined his system in Beat the Market where he emphasised that solvency depends on not over betting. He formed a hedge fund in 1969 to put the theory to work. Over the next 19 years, Thorp’s hedge fund returned 20% per annum, or a cumulative 2,734% compared to the S&P 500’s 545%.

In 1991, Thorp was a consultant to hedge funds and a client asked him to review his portfolio. Thorp approved the portfolio with one exception – an investment in a hedge fund run by a guy called Bernie Madoff. Thorp saw that Madoff’s returns were fake. Seventeen years later, Madoff was indicted for a Ponzi scheme worth almost $65 billion. Thorpe said he didn’t blow the whistle on Madoff as he owed a duty of confidentiality to his own client.

This is important: Randomised Luck vs. Systematic Edge

Most people think of gambling as randomized luck. And they’re largely right. At a casino, the casino normally has the advantage.

For instance, you can go to a casino and play blackjack. The dealer will give you, and all other players, two cards face up, while the dealer gets one card face up and another face down. From there, the aim is to get as close to cards totalling 21 as possible, without going over.

But your chances of winning a hand are 42.22%, while the odds of a tie are 8.48%. Conversely, the odds of the casino winning are 49.3%. That’s because the casino dealer has the advantage of going second and can make decisions based on your position. You may get lucky for a few hands, yet if you play long enough, the statistical odds will come back to beat you.

The best investors have a similar trait to the best gamblers: they bet when the odds are overwhelmingly in their favour. Bill Gross knew this. He wasn’t interested in relying on randomized luck though. When he read Thorp’s book, he saw a system of counting cards that could tilt the odds in his favour. He then applied that odds-based mentality to give him an edge in bond markets.

Additional Reading

Larissa Fernand is an Investment Specialist and Senior Editor for Morningstar India. You can follow her on Twitter

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