In casino gambling it is the ultimate idle fantasy that one will find a game where the house miscalculate the payouts and offers up a positive expectation game to the customer. I found one once, a side bet in blackjack that was set up with a ~3% advantage to the player. Unfortunately the two limiting factors, a) number of resolved hands per hour—around 60 at a full table and b) a maximum bet limit of $25 dollars on the side bet meant that your expected win rate was $25 x 60 x 3% = $45 dollars per hour. Not exactly a get rich quick scheme but an amusing way to pass a couple hours.
I think of that evening when I see people talk about someone or something being on the wrong side of the market and attempt to calculate the odds the house is giving up and the optimal bet sizing to accelerate the accumulation of loot while minimizing the risk of gamblers ruin (the Kelly Criterion, see after the jump).
And then I wake up from my reverie.
From Neue Zürcher Zeitung's The Market.ch, November 7:
Jim Grant, editor of Grant's Interest Rate Observer, warns of the rampant speculation in the stock market. He worries that the central banks are underestimating the threat of persistently high inflation and explains why gold has a bright future.
The financial markets are «high». In the U.S., the S&P 500 is up for seven straight days, closing on another record at the end of last week. Particularly in demand are red-hot stocks like Tesla and Nvidia with fantastically rich valuations. Together, the two companies have gained around $600 billion in market value in the past three weeks alone.
For Jim Grant, this is an environment that calls for increased caution. According to the editor of the iconic investment bulletin «Grant’s Interest Rate Observer», investors have to beware of an explosive cocktail combining exceptionally easy monetary policy, a pronounced appetite for speculation, and the high degree of leverage. He also thinks that central banks are underestimating the risk of persistent inflation.
«The Fed reminds me of a speculator who is on the wrong side of the market», says Mr. Grant. The fact that the Federal Reserve is now beginning to taper its bond purchases makes little difference in his view. «It's like pouring a little less gasoline on the fire,» he thinks.
In this in-depth interview with The Market/NZZ, which has been edited and condensed for clarity, the outspoken market observer and contrarian investor compares today's environment with the second half of the 1960s and explains why he expects persistently high inflation rates. He explains what this means for the dollar as well as for gold, and where the best investment opportunities are with respect to the challenge of global warming.
Mr. Grant, what does the financial world look like from your perspective in late fall 2021?
It feels like the only days the stock market doesn’t make new highs is Saturday and Sunday when it’s not open. So certainly, there is never a dull moment. Things are very different, they are singular: We have the lowest interest rates in about 4000 years, or perhaps 3990 years because they have recently gone up a bit. But these are still some of the lowest interest rates on record. At the same time, we have some of the highest equity valuations with perhaps the exception of 1999 and 2000. And, we have one of the most speculative Zeitgeists on record. It is a time of disinhibition, of rampant, riotous speculation and of all the accompanying thrills and chills.
Few people know the history of financial markets as well as you do. What parallels would you draw to the current environment from the past?
There are certainly some things that resemble it. For instance, the late 1960s anticipated some of this. It was a time of rising CPI inflation and a great boom in new issues and over the counter stocks. During that era, a writer who went by the pen name «Adam Smith» wrote popular books about Wall Street, including «The Money Game». He said what you have to do is to go out and hire some very young people to run your portfolios for you because only they understand what’s happening. I think of this in connection with the novelties of today: You want to go out and hire people in the age of perhaps 21 or 22 and give them each a million dollars as they go out and speculate without any pretense of security analysis. They just go out and buy all of the NFTs and cryptos that are going up.
Are there also specific differences from previous speculative bubbles?
I think today’s Zeitgeist is unique in the intensity of the speculation and in the amount of dollars, or Swiss Francs, British Pounds or Euros involved. And, it is perhaps unprecedented in the leverage applied to these speculations. But it is not unique in the sense that humanity, the human race in one great aggregate in its past and present, has lived through these episodes before. We have lived through them in the tulip mania of course, and the great speculation of the early 18th Century with the Mississippi Company and the likes, and the railroad bubble after that. Speculative episodes aren’t anything but unprecedented. So let me re-emphasize: What is unique today is the intensity, the amount of money, the amount of leverage and the monetary backdrop. All of these things are unique.
Where do you observe the biggest excesses when it comes to leverage?....
....MUCH MORE
If interested some of our previous posts on the math
"Is semi-variance a more useful measure of downside risk than standard deviation?"
"The Equation that Will Change Finance"
What Proportion of Your Bankroll Should You Bet? "A New Interpretation of Information Rate"
Gambler's Ruin and Bet Sizing
Repost: Dreamtime Finance (and the Kelly Criterion)
I've been meaning to write about Kelly for a couple years and keep forgetting. Today I forget no more."How did Ed Thorp Win in Blackjack and the Stock Market?"
In probability theory the Kelly Criterion is a bet sizing technique used when the player has a quantifiable edge.
(When there is no edge the optimal bet size is $0.00)
The criterion will deliver the fastest growth rate balanced by reduced risk of ruin.
You can grow your pile faster but you increase the risk of ending up broke should you, for example bet 100% of your net worth in a situation where you have anything less than a 100% chance of winning.
The criterion says bet roughly your advantage as a percentage of your current bankroll divided by the variance of the game/market/sports book etc..
Variance is the standard deviation of the game squared. In blackjack the s.d. is 1.15 so the square is 1.3225.
As blackjack is played in the U.S. the most a card counter can hope for is a 1/2% to 1% average advantage with much of that average accruing from the fact that you can get up from a negative table.
Divide by 1.3225 and you've got your bet size.
It's a tough way to grind out a living but hopefully this exercise will stop you from pulling a Leeson, betting all of Barings money and destroying the 233 year old bank.
Markets, Risk and Gambler's Ruin
Journal of Investment Consulting: Interview With Edward O. Thorp
Finally, another rule of life:
Cassandra's (Not so) Golden Rules About Investing (And Not Investing)
#21. NEVER double-down (except when you have material non-public information and deep pockets) or if you're Ed Thorp, or if you're playing at The Martingale Room.
Don't double down, double up.
