Market dispersion refers to the variation in returns of the market’s underlying securities. Opportunities for successful security selection abounds when market dispersion is high. Here we explain the methodology for calculating an asset-weighted standard deviation of share returns, often also referred to as the cross-sectional standard deviation.
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The extent to which a skilful manager can outperform varies with time. It depends, primarily on the dispersion of security returns in a measurement period. If we want to judge investment skill, we need to be aware of the effect of market dispersion.
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Here I summarise the financial market lessons imparted by Ed Thorp in his book “A man for all markets”. My first three sections cover his views on investing, risk and market inefficiencies. My last two sections describe the hedge fund strategies Dr Thorp employed as well as his views on hedge funds in general.
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I summarise Dr Ed Thorp’s practical wisdom and valuable life lessons given in his book “A man for all markets”. The topics covered are those which I find particularly interesting as a Philosophical Investor. Dr Thorp often repeats and expands on the same ideas as they relate to various events of his colourful life.
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Dr Ed Thorp, born in 1932, tells his incredible life story. After starting out as an American mathematics professor, he soon became a very successful quantitative hedge fund manager as well as a blackjack and roulette player. Dr Thorp describes the insights he came to while putting his theories to work. He imparts valuable advice on a broad range of topics, including his approach to investing, managing market risk, investing in hedge funds, and how to protect and generate wealth for the long term.
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It is not possible to refute the existence of skilful investors, as explained in my previous post. So, can we test whether there are investment managers with skill by analysing their investment returns? Investment performance can only be judged on a relative basis. The two candidates to evaluate performance against are either a peer group or a defined benchmark. We consider the merits of both.
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Professional investors are usually either skilled (informed) or incompetent (deluded), but can one actually demonstrate such skill or incompetence empirically?
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Irrational traders know the fundamental value of a security, but rather than basing their trading decisions on this, they base it on their expectations of how other market participants will behave. Here we discuss experimental evidence demonstrating this irrational behaviour. We consider bubbles and IPOs as real life examples.
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Deluded investors are foolish market participants who are uninformed but transact in financial markets with the delusion that they are informed. They would trade actively in an attempt to outperform when a security is mispriced according to their analysis. Deluded participants are, however, wrong in believing that they know the fair value of the security.
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We have classified market participants into five types. In this post we describe the irrational investors or traders in more detail. As explained before, the irrational traders are the market participants who are informed, but still transact although they understand that they are buying securities above fair value or are selling securities below fair value. Even so, they believe that their strategy will lead to outperformance.
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