Monday, March 24, 2008

Markets, Risk and Gambler's Ruin

From the Wall Street Journal:

Old Pros Size Up the Game
Thorp and Pimco's Gross Open Up on Dangers
Of Over-Betting, How to Play the Bond Market

About 50 years ago, a young math instructor at the Massachusetts Institute of Technology, Edward Thorp, created a strategy for wagering on blackjack that maximized winnings and effectively eliminated the chance of getting wiped out.

The strategy involved getting an edge over the dealer by counting cards, and never making especially big bets. He described the method in a 1962 book, "Beat the Dealer," then took on Wall Street in "Beat the Market."

Mr. Thorp ran two hedge funds, Princeton-Newport Partners and Ridgeline Partners, which went nearly 30 years without a down year, and averaged 19%-20% annual returns, he says.

One of his followers became Bill Gross, managing director of Allianz SE's giant bond-fund company, Pacific Investment Management Co., or Pimco. He read the books in college and still uses the risk-management techniques.

The Bear Stearns debacle shows that managing risk is more important than ever. Messrs. Gross and Thorp talked about risk management and markets -- and cards, of course -- in an interview at Pimco's Newport Beach, Calif., base:

Wall Street Journal: How did you get interested in blackjack?

Edward Thorp: I went to Las Vegas in 1958. I'd learned a strategy that would let you play just about even, so I decided to play with $10. My $10 lasted a lot longer than anyone else's at the table. I thought there had to be a mathematical way to beat the game, and that would be interesting mathematics. I figured it out and a few years later I wrote "Beat the Dealer."

WSJ: What about you, Bill?

Bill Gross: I picked up Ed's book in early 1966. I got in an automobile accident and had to go into the hospital and had time to practice the card-counting technique he discovered. And it worked! I had $200, so I headed out to Las Vegas. I turned my $200 into $10,000. I didn't care about the money. I wanted to prove that you could beat the system. Then I thought about what I could do that takes the same skills. I realized it was investing.

Mr. Thorp: He started out with $200 and now he manages nearly $1 trillion.

Mr. Gross: "Beat the Market" was even more fortuitous -- it was the reason I got hired at Pimco, or what was Pacific Mutual Life then. I had done a master's thesis on convertible bonds and "Beat the Market." The people who hired me said, 'We have a lot of smart candidates, but this guy is interested in the bond market.' So I got my job because of Ed.

WSJ: What can your blackjack strategy tell us about how to manage risk in today's markets?>>>MORE

HT: Abnormal Returns

Gambler's ruin is a concept in statistics that is critical for the blackjack player to know and essential for most other situations where you are putting money at risk, it is also useful in population studies, it can be used to predict extinctions.

From Wikipedia:

The basic meaning of gambler's ruin is a gambler's loss of the last of his bank of gambling money and consequent inability to continue gambling. In probability theory, the term sometimes refers to the fact that a gambler will almost certainly go broke in the long run against an opponent with much more money, even if the opponent's advantage on each turn is small or zero....
Google Scholar returns 944 hits for "Gamblers ruin", I thought there would be thousands.