Streetwise for Friday, April 20, 2018

Let me state at the onset that I dislike analogies comparing Wall Street to Las Vegas. Investing and gambling are not the same. Yet, I can see where you might conclude that Wall Street is one large casino where millions of Americans place their bets with the hope of striking it rich.

To compound the problem, if you look in the dictionary you will find that gambling is defined as “taking a risk to gain wealth.” And that is essentially the essence of investing.

However, what sets investors apart from Las Vegas are the odds. The increased odds of winning on Wall Street result from solid mathematical forecasting strategies. Implement proven, mathematically oriented investment strategies and you will likely increase your wealth.

Looking back into history, 1962 saw mathematics professor Dr. Edward O. Thorp publish his revolutionary work “Beat the Dealer,” in which he demonstrated that the game of Blackjack could be defeated using mathematically proven card-counting strategies. Thorp wrote that the utilization of his tried and true unemotional strategy would, in the long run, make you money. (Note: Casinos have since changed the rules to defeat card counting.)

Thorp has a new book out, “A Man for All Markets: From Las Vegas to Wall Street, How I Beat the Dealer and the Market.” 

Keep in mind that Thorp was a key player in bringing forth the era of quantitative finance. Along the way, the so-called godfather of the quants played bridge with Warren Buffett, crossed swords with a young Rudy Giuliani and detected Bernie Madoff’s Ponzi scheme.

It would not be unreasonable to say that this new book is replete with practical wisdom and guidance designed to assist you in tackling uncertain financial waters. Thorp challenges readers to think logically about a seemingly irrational world.

Thorp’s first book ends with two pages dedicated to the stock market that every investor should keep in mind.  Remember, these words were penned over 54 years ago.

“The greatest gambling game played on earth is the one played daily through the brokerage houses across the country…. The advantages of this gambling game are two. First, it presumably serves a social purpose by helping to finance companies…. Second, the average value of stocks has tended strongly upward over the last century, so the game has an advantage, on average, for the player.”

Academic studies have shown that over the short-term, stocks display the same mathematical randomness as characterized by the games of chance in the casinos. However, over a period of years stocks achieve a nominal average return of about 11 percent per year or about a 7 percent real return, meaning after inflation. While compelling, remember that an average is not synonymous with guarantee.

OK, assume you are now convinced that time is on your side but what about the market. There is still the argument that the market appears to be overdue for a rest. How do you solve that dilemma?

It does not matter if the market falls or rises each year, but rather the price of your investments when you cash in your chips. Keep in mind that if the equity market gains 11 percent per year on average and you invest on a regular basis, it is to your advantage if the market drops and stays low for a portion of your investment life-span.

Let’s look at an idealized example. Assume you invest $5000 initially and then $2000 per year for 10 years, totaling $25,000. With an average annual return of 11 percent, your portfolio will be worth about $51,000.

Now suppose the market loses 10 percent each year for the first 3 years. Given an average return for the decade of 11 percent, your portfolio will be worth about $15,000 more than the first scenario, or about $66,000, given the same $25,000 investment!

You are investing $2,000 per year, so you acquired a disproportionately larger number of shares at lower prices early on. If the market returns 11 percent on average for the decade but loses 10 percent in each of the first three years, you will have an average gain of over 21 percent during the subsequent seven years.

Lauren Rudd is a financial writer and columnist. You can write to him at Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to