Playing The Odds And Probability, Power Of Small Edge
The stock market and blackjack are both the game of chance and risk. In blackjack, we strategise to gain an edge over the dealer. In the market, we strategise to gain an edge over other investors to increase profitability.
It all started back in the 1950s. Ed Thorp (one of the most successful money managers in history) was playing the game of blackjack. He noticed patterns that didn’t coincide with the generally accepted structure of probability theory. He put forward with the idea that it was possible to gain an edge in Blackjack. At the time, he didn’t know how, but he got work trying to figure out a way. After years of academic research, he published the book “beat the dealer.”
He refused to accept the conventional belief that the players in casinos cannot have the edge over the dealer, mathematically. He gave himself a little edge over the dealer by calculating the change in probability after the certain card is gone out of the deck. Over time his edge compounds, and he managed to transform the loser’s game of luck to “Game Of Maths.”
Once he mastered his odds in blackjack, he turned to roulette. He hypothesized that we can increase our probability of winning at roulette by calculating how fast the wheel spins, for how long, position and velocity of the ball. Which helped him and his partner, Claude Shannon, forecast where the ball is likely to land. For a long time, roulette was a fool’s game where the player has no edge. The ball has an equal chance of falling into any of the pockets in the wheel. By adding some measurements to the mix, you could gain an edge in the game by calculating where the ball is likely to land.
Like blackjack, Thorp applied the same risk elimination and gaining small edges in different areas in investing. Which led him to avoid all the major market meltdowns in the last three decades. He recalls in an interview that he was offered a chance to invest in a company called Long-Term Capital Management. Still, he later declined the offer saying that the company has too much leverage for him to optimally balance his risk and reward.
One way to improve our financial lives is to avoid playing the game where odds are stacked against us. If you lack the skills to properly analyse the company in a particular sector before investing, resist the temptation of buying that stock. Otherwise, you’re just like the fool at the roulette table, hoping that your luck will smile upon you.
Another way we stack the odds against us is by paying hefty fees to the fund managers for mediocre performance and trading in and out of stock so often that your profit is eaten by the trading fees. If you’re frequently trading and paying a lot in fees, you’re swimming against the current, and if you’re paying the minimum amount and holding your positions for the longer term, you’re swimming with the current. One easiest way to swim with the current is to buy and hold a low-cost index fund. You don’t have to do any research, don’t have to waste your time worrying, how your investments are doing, and your returns are far better than most of the high-flying hedge funds. Unlike gamblers in the casinos, you already have the edge over the game you’re playing.
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