September 7, 2017

Excellent interview with Ed Thorp on risk management

Edward O. ThorpEdward Thorp is a Ph.D. in mathematics, mathematics professor, author, hedge fund manager, and blackjack player.

Thorp has used his knowledge of probability and statistics in the stock market by discovering and exploiting a number of pricing anomalies in the securities markets, and he has made a significant fortune (20% CAGR over 30 years).


Pysh: [8:57] With respect to probabilities, there are similarities between gambling and investing. How can you use the Kelly criterion in the stock market given a large array of potential outcomes and holding periods?

Thorp: The root idea of the Kelly criterion is that there is a tradeoff between risk and return. The big question is, what is the tradeoff? Let us look at a very simple scenario: tossing a biased coin with probabilities of 60% chance of landing on heads and 40% landing on tails. Clearly, you are betting on heads, but how much should you bet on heads? The Kelly criterion is the solution. In the coin tossing case — suppose the payoff is even — the criterion would suggest betting 20% of your bankroll on heads. This can be scary because of the large variability. If you only bet half as much as the suggestion, you end up growing it only three-quarters but your risk is reduced by half. So I generally recommend people to bet half of Kelly so they are less scared.


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