Old Maid

Read a good article over the weekend in the Wall Street Journal that interviewed Edward Thorp and Bill Gross some excerpts from the interview:

WSJ: What can your blackjack strategy tell us about how to manage risk in today's markets?

Mr. Thorp: You have to make sure that you don't over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss -- but never more. If you bet much more you can be ruined, even if you have a favorable situation.

WSJ: Bill, you've compared what's going on in the credit markets today to another card game: Old Maid.

Mr. Gross: In Old Maid there's a card nobody wants: the old maid. In today's marketplace, there are quite a few old maids. The ones America knows about are subprime mortgages. And they've spread to, for goodness sakes, the municipal market and sacrosanct areas that presumably are default-free. In Old Maid, you try to pretend to your opponent that you don't have the maid, and you try to entice the other side to pick it up. That is happening extensively in today's market.

WSJ: What's your assessment of the state of hedge funds today?

Mr. Thorp: In the last 15 years or so, there has been a large flow of capital into the hedge-fund world, from $100 billion in the early 1990s to $2 trillion now. But the amount of available investing opportunities hasn't increased that much. That has led to the over-betting phenomenon Bill and I were talking about, or gambler's ruin. Hedge funds started using a great deal of leverage to increase returns. But you can get wiped out if you bet too aggressively. A classic example is Long-Term Capital Management [the huge hedge fund that blew up in 1998]. We'll probably be seeing more of that now.

Mr. Gross: It's true that the available edge has been diminished, and that led to increased leverage to maintain the same returns. It's the leverage, the over-betting, that leads to the big unwind. Stability leads to instability, and here we are. The supposed stability deceived people.

Mr. Thorp: Any good investment, sufficiently leveraged, can lead to ruin

WSJ: But you must feel a little nervous. (Question was in refrence to buying oppurtunites in the bond market)

Mr. Gross: We're treading cautiously, staying with a high level of quality. We're not going into high-yield or the subprime market. Is there blood on the streets? Yes. But there are strong-quality assets out there.

Mr. Thorp: Fear creates opportunities. So as Bill was saying, this is probably a great time.

Source:
"Old Pros Size Up the Game Thorp and Pimco's Gross Open Up on Dangers Of Over-Betting, How to Play the Bond Market", Scott Patterson, WSJ {$$$}