One way to beat the market

By Jerry Wagner
   Seeking alpha

Reading Edward Thorp's 1967 book "Beat the Market" in the summer of 1968 changed my life. I had picked the book up as a summer read while home from college. I was intrigued. Years before, I had read a Life magazine account of how Professor Thorp had created the system to beat the dealer at the game of blackjack, or twenty-one.

The method outlined by Thorp in "Beat the Market" used arbitrage (simultaneously buying one asset while selling short another to realize the difference) with stock warrants (rights often issued with stock to make it more attractive to investors by giving the opportunity to gain more shares at a later time at a fixed price).

It turned out that these warrants were often overpriced, and if one sold them short while buying the underlying stock, you could create a "can't lose" trade that made money whether stocks advanced or declined. Included in the index was a valuation formula that allowed you to calculate what the warrant should actually be selling for at current market conditions.

Since I had just completed my first computer programming course, this was a perfect vehicle to practice my newly acquired skill. Merging computer analytics and the stock market just seemed like a natural fit to me. The rest, so they say, is history. So far, I have spent almost 50 years of my life working on the task.

Of course, the original allure was beating the market. Like in gambling, where the conventional wisdom had been no one could beat the casinos, the accepted academic dogma at that time - and for most of the time since - had been that stock price fluctuations were random, and once you adjusted returns for risk, you could not expect to outperform.

Professor Thorp, for most of his career, was a little-known giant in the stock market. Yet, today he is known as the "father of quantitative investing."

I learned at least three lessons from him. He was the first to "Invest with an Edge." He has always believed that each investment made should be anchored by an identifiable edge.

Secondly, all of Thorp's investments were quantifiably derived and managed. They relied solely upon statistics. This meant that they were always objective. It also meant that they were always rules-based, disciplined, and uninfluenced by emotion or opinion.

Finally, Dr. Thorp made me truly aware of risk. Specifically, he made it clear that one had to focus on the risk of an investment, just like the returns.

In 1981, I founded my registered investment advisory firm, Flexible Plan Investments, Ltd., largely focused on these principles. As a result of what I learned from Dr. Edward Thorp, my company has always sought to deliver dynamic, risk-managed strategies to investors.

What does it mean to "beat the market"? I imagine that most people would say that if you have spent the last five years outperforming some index, like the S&P 500, you have been beating the market. However, if you focus on risk as much as return, that simple comparison might not be enough for you to truly qualify as a "market beater."

As was clear from Dr. Thorp's work, risk is important to the discussion. For most investors, beating the market has usually been accompanied by taking more risk than the market. When you adjust the returns for the amount of risk, one often finds that the perceived advantage disappears.

As a general rule, holding just a few stocks, for example, almost always means more risk is being taken. It usually takes at least 14 different issues to constitute enough diversification to get close to the risk level of, say, the S&P 500 - and that's if the 14 issues represent at least the 11 different major sectors of the S&P. Usually, the more focused the portfolio, the less diversified and the m

In addition, market-watchers generally would not award "market beater" status to an investor that simply beat the market when it was going up. Performance over a complete market cycle is the real test. There is no truer test of the actual risk being taken by a portfolio than its performance during a market downturn.

Many market commentators strangely focus on the S&P 500 as a benchmark for portfolio performance and whether you are beating the market. I say "strangely" because I know very few investors that can truly live with the risk actually exhibited by the S&P. It lost more than 50% during both of the last two bear markets. In my experience, few investors can stick with an investment that falls only 20%! (Of course, the popular NASDAQ 100 cannot even keep up with the S&P when the market falls, as it lost more than 70% in both of those declines.)

This is especially relevant in today's market environment. Stocks, as measured by the S&P 500, have been advancing without a 20% correction since March 9, 2009. That is the second-longest bull rally in the S&P 500's history. In fact, we have not even had a 5% correction in that Index for over a year. That's the seventh-longest such period in that history.

Yet, many investors believe they have beaten the market with their current one-, three-, or five-year performance. The real test of that claim is yet to come.

Everyone is aware of the great gains in the current rally for tech stocks. However, did you know that the S&P 500 Technology Sector Index last hit an all-time high early in 2000? Last week, 17 years later, the Index finally topped the high-water mark it set in 2000.

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