Readings: Hedge funds & overbetting, Quant models, Gold plunge
- Wall Street Journal: Old Pros Size Up the Game
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.
- Paul Wilmott: This is No Longer Funny
Banks and hedge funds employ mathematicians with no financial-market experience to build models that no one is testing scientifically for use in situations where they were not intended by traders who don’t understand them.
CONVEXITY WILL BE MISSED: One of the more common reasons for losing money is assuming something to be known when it isn’t. Option theory tells us that convexity plus randomness equals value.
RISK MANAGEMENT WILL FAIL: Risk managers have no incentive to limit risk. If the traders don’t take risks and make money, the risk managers won’t make money.
- MarketWatch: The weak hands club
The very purpose of sharp corrections during major bull markets is to transfer ownership from weak to strong hands, thereby preparing for the next leg up. And a contrarian analysis of current sentiment among gold timing newsletters points to gold’s recent plunge as just a correction.
Before the correction begins, bullishness must not have reached excessive levels; and once the decline is underway, there must be an eagerness to jump on the bearish bandwagon. Both of these hallmarks were present during the May 2006 correction, leading contrarians at the time to be bullish. ( Read June 2, 2006, column.) At least one of these hallmarks exists today, furthermore, and the jury is out on the second.
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