By William Poundstone.
I very much enjoyed this book. The book is the story of the "The Kelly Criterion" a formula that calculates how much of your bank roll you should invest/bet in a situation given particular odds.
The book does have some weak points—it can be very fragmented since its filled with many anecdotes owing to the surprise history of the formula. The book covers Information theory, gambling, the mafia, hedge funds and the efficient market theory.
The Kelly Criterion started out as a way to predict how much information could be transmitted over a given channel given the channels error rates.
This principle was used in the creation of card counting in Black Jack. The bright idea was too look a pack of cards as a channel of information, then counting cards affected the size of bets. That cards could be counted in black jack had been known for years. What the Kelly criterion added was a mechanism that calculated how much your bet should change with each passing card.
The Kelly criterion can also used to calculate how much you should invest in different instruments in a portfolio of investments.
The book also spends a lot of time on the Kelly criterion, hedge funds, and the efficient market hypotheses. Is the market efficient? Maybe not, but it's dam close. In the few cases where we can examine the decisions of an exceptional portfolio a few patterns emerge…
1. Luck. The investor had the luck/foresight to buy a few stocks that grew exceptionally in the long run.
2. Insider information.
3. Sleazy tax & fee dodging mechanisms that blow up, or are shut down as soon as the dodge is brought to light.
4. Extreme leverage that blows up in a crisis.
5. Business makers—invest in a company that is undervalued but has potential. Not only does the Business maker buy the stock, but he also participates in the company by becoming part of the management and leadership.
There are strategies that are very robust and there are strategies that eat them selves up. Many schemes for exploiting market inefficiencies go away the more they are used. Hedge funds regularly struggle with this. They develop a strategy that produces great results at a small scale, but as they try to grow the strategy up, either others figure out out, or the cancel their own efforts out.
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