Highlights from AQR’s interview with Ed Thorp

Below is a fascinating interview with Ed Thorp, who discovered/invented many of quantitative methods used to beat casinos and markets. Full interview can be found here (PDF).

A few of my favorite quotes (and, yes, my confirmation bias is in full effect, since my firm focuses on passive index investing for equities and active investing for fixed-income and private equity/debt/real estate):

On the challenges of finding true alpha in liquid markets:

For liquid asset classes like US bonds and stocks, for instance, this means that everybody who is active, or not indexing, are
collectively a big index fund, on average. That big actively-traded “index fund” is being managed, so it’s also paying costs. So, a couple of percent is being drained out of that pool, compared with the guys who are paying very low amounts for passive indexing. So, these active investors collectively have a couple percent disadvantage. So, all the institutions that are battling for an edge in those liquid asset classes aren’t going to get alpha collectively. They should just index those parts of the portfolio, in my opinion.

On the opportunities in illiquid and opaque markets:

Sullivan: Where do you see additional opportunities for institutional investors?
Thorp: What I see for institutional investors is access to the more illiquid asset classes like private equity. That’s something ordinary investors don’t get a shot at, and it requires active management because there’s a lot of work in evaluating and
hiring managers.

On the importance of approach, strategy, and risk-management, even when the odds are with you.

Brown: A recent paper by Haghani and Dewey (2016) indicated that students in finance often lack the basic quantitative skills to properly think about risk.
Thorp: Yes. The authors conducted a live experiment with college-aged students and young professionals at asset management firms who were knowledgeable about investing. The experiment went like this: each participant gets 30 minutes and $25 to start with. Each has a computer terminal and is informed that they will flip a computerized coin that comes up heads 60% of the time and tails 40% of the time. Then they can bet as much as they want on each coin flip. After 30 minutes, time stops and they get to keep their gains up to a certain dollar limit (otherwise the experimenters might go broke!). If they reach the limit sooner, then betting stops, because they’ve won as much as they can. The others go on betting. So, the question is, what betting policy should you follow? Many of the participants had no idea what to do. Quite a few of them went broke and a rather large portion of them didn’t make any money. Another rather large section made some money but not a lot. The average amount of winnings was around $70 for those not going broke. Aaron wrote a nice piece (2016) which analyzed all this in detail. Winnings should be something like $240 if they follow optimal policy.
Brown: Yes. Very high probability that they’d win about $240 if they used the Kelly method, which as you already know says to bet 20% of their bankroll each flip on heads, calculated as 2(.6)-1=20%. Basically, there seemed to be two types of bettors,
risk-takers who went broke and non-risk takers who bet small amounts like $1 each time, so average winnings of even those not going bankrupt were quite low.
Thorp: Every year in Las Vegas they have something called the Blackjack Ball, where about 50 of the best gamblers in the world gather. If you were to ask any of these professional blackjack players what to do, they would have said, well, I’ll just use the Kelly Criterion because it’s a close approximation to an optimal solution. So, the professional blackjack players would know the answer, but the finance people did not.

Full interview can be found here: https://www.aqr.com/-/media/files/papers/aqr-words-from-the-wise-ed-thorp.pdf

 

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