Created by Rishabh Srivastava, Founder of Loki.ai
This summary was largely done for my own note-taking, sharing it just in case it adds more value to other people.
I have no affiliation whatsoever with anyone in this note. This is a summary largely taken for my own reference, and may contain errors :)
Context
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Why is it important: Contains useful principles for model-based thinking and investment hedging
Keywords
investing, hedging
Summary
General Principles
- Learn how to think using models. A model is a simplified version of reality. You can discover the rules by experimenting. And if you get them right, you can use the rules to discover what would happen in new situations by using models
- Being self-taught leads you to think differently. If you test theories you come up with by trying new experiments and discover "truth", you get an edge over others
- Identify a clear edge that puts the odds in your favour in the long run. The edge has to be obvious and uncomplicated. Capture the edge, and convert it into investments.
- Having an edge and surviving are two different things. In order to succeed you must first survive. You need to avoid ruin at all cost. You have to get the magnitude of betting right
- Optimise for opportunities that give you the freedom to pursue your intellectual interests. Wherever they may lead you
- Bet only at a level at which you’re emotionally comfortable, and don’t advance till you’re ready
Hedging
- VaR is a bad metric, as it doesn't include tail-risk
- Use simple correlation coefficients and ratios
- Concept of statistical arbitrage. The market is inefficient in some ways. You can exploit inefficiencies in how the market is correlated
- Used a mixture of short options and stocks for hedging
Highlights
Preface
Learnt how to think using models. A model is a simplified version of reality. Simple devices like gears, levers, and pulleys are all the basic rules
You can discover the rules by experimenting. And if you get them right, you can use the rules to discover what would happen in new situations
Was largely self taught, which led him to think differently. Instead of subscribing to widely accepted views (like you can’t beat the casino, tried it himself)
Since he tested theories he came up with by trying new experiments, started to use the results of pure thought in the real world and test them out if they worked well
Foreword
Method: identify a clear edge, that puts the odds in your favour in the long run. The edge has to be obvious and uncomplicated. For example: calculating the momentum of a roulette wheel
Capture the edge, and convert it into money. You have to hey the magnitude of betting right. It can’t be too much or too little
Thorp favoured learning by doing. Crystalize complicated research into simple rules that any generic smart person can follow
Having an edge and surviving are two different things. In order to succeed you must first survive. You need to avoid ruin at all cost
There’s a dialectic between you and your P&L. You start betting small as a percentage of your capital. Your dosage (how much you’re willing to risk) also controls the discovery of your edge. It’s trial and error. You revise your risk appetite and the assessment of your odds one step at a time
Avoiding ruin != maximising expected outcome
Chapter 4
To get rich, only play gambling games or make investments where you have an edge
Chapter 5
Optimise for opportunities that give you the freedom to pursue your intellectual interests. Wherever they may lead you
Chapter 6
The fastest and easiest way to test out an idea is to put skin in the game
Bet only at a level at which you’re emotionally comfortable, and don’t advance till you’re ready
Moderately heavy losses throughout punctuated by highly positive returns and characteristics of many mathematically sound hedging investment strategies
Chapter 11
Investing — arrived a lot that other people didn’t know from first principles. First investment was a loss, which contributed to his education. Bought 100 shares of a stock at $40, and watched it decline to $20 in the next 2 years
He decided to hang on until the stock returned to its original purchase price so as not to take a loss. This is exactly what bad gamblers do when they’re losing. Took 4 years before he got out with his original $4k. Years later, tech investors had the same issues after the dot com crash
Mistake: 1) too much risk for the expected return, 2) staying in the investment for too long and not getting out — anchored to the price he had got in at, not to the opp cost and the market price, and 3) do not assume that momentum (a streak of price increases or falls) will continue until you have a strong reason for believing so
Started a second education in economics and the markets in 1965. Decided to do hedges that were as protected as possible for the return that they promised as he had no experience in analysing companies
Chapter 12
Investment strategies are not necessarily transitive. If A is better than B, and B is better than C, this does not necessarily mean that A is better than C.
Chapter 13
Buffett understood the power of compound interest and intended to apply it for a long time
Mostly used “dynamic hedging”. An approach that was based on using computers. Wanted to get the minimum possible risk for his return
Did management by walking around, personally talking to employees and giving them high level directives since management time was in short supply and he couldn’t micromanage
Employed young grads who were smart and had no experience instead of experienced people with ingrained bad habits
Used a mixture of options and stocks for hedging
Chapter 14
Used dynamic hedging and rejected VaR, as VaR doesn’t account for tail risk
Mismatch in interests rates in short term lending and long term borrowing are generally a warning sign
Later chapters
Knew when to call it quits and when enough was enough for him
Concept of statistical arbitrage. The market is inefficient in some ways. You can exploit inefficiencies in how the market is correlated
At attempt to reduce risk also reduces returns, most of the time
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