Great Depression Online Archive Issue:

Martingaling the Market

Great Depression Online
Long Beach, CA
October 06, 2009

Inside This Issue You Will Discover…

*** The Martingale Betting Strategy
*** Acting Like Clowns
*** Martingaling the Market
*** And More

“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes

The Martingale Betting Strategy

Baron de Rothschild is said to have once remarked to M. Blanc, founder of the Monte Carlo casino, “Take off your limit and I will play you as long as you like.”

Legend has it, M. Blanc did not accept the challenge.  Here’s why…

The Martingale betting strategy for a game like roulette is really quite simple.  You begin by placing an initial bet, say $1 on either red or black.  If you win you again place $1 on red or black…which ever your intuition tells you will win. 

But if you lose, your next bet is $2.  If you lose again, you then bet $4.  And if you lose a third time in a row, you bet $8.  In other words, when you lose you double your previous bet.  When you win, you then bet your initial wager.

~~~~~~Free Handbook~~~~~~

Today more and more investors are warming to the fact that psychology moves markets and therefore fundamental analysis, which fails to properly measure mass investor psychology, must be flawed.  Who can blame them?  After all, fundamental analysis – based on past company earnings, rating agency projections and the like – proved to be of little value during the bust.

There is a better way 

~~~~~~~~~~~~~~~~~~~~~~~~~

If you have enough money to keep doubling down after each loss, and if there were no limit, it would be impossible to lose. 

Of course M. Blanc wasn’t a fool…casino owners always tip the odds of the game in their favor.  Plus, for those of us without the resources of Rothschild, the limit really doesn’t matter anyway…the roulette wheel eventually stays irrational longer than we can stay solvent.

Acting Like Clowns

Back in the mid-to-late-1990s a couple of Nobel Prize winners, Myron Scholes and Robert Merton, had a run of extraordinarily good luck.  But to these men it wasn’t providence at all, it was expected…their computer models said so.

These geniuses, along with several Wall Street titans, including John Meriwether, had formed the hedge fund Long Term Capital Management in late 1993.  By early 1998 everyone knew they were smarter and better than all others.  Their track record proved it…over 40 percent per year (after fees) since the fund began.

They were masters of the universe and they loved it.  In fact, they were making so much money and having such a good time they were acting like clowns.  Roger Lowenstein in his book, When Genius Failed, reported that, “Merton had dyed his hair red, left his wife and moved into a snazzy pad in Boston.”

While their trades were based on complex mathematical models, the underlying approach was based on a very simple idea: Bond prices always regress to the mean.  Thus, you could take the spreads between a 30 year treasury bond and a 10 year treasury bond, or a Japanese bond, and calculate the likelihood the spreads would widen or narrow.

With this information, a lot of leverage, and several financial transactions – buying the cheaper bond and shorting the more expensive bond – a profit could be made as the difference in the value of the bonds narrowed.

With their Nobel Prize winning models telling them just what to do, what could possibly go wrong?

Martingaling the Market

Philosopher Sir Karl Popper explained long ago that there are only two types of theories: Theories that are known to be wrong; and, theories that have not yet been known to be wrong, but are exposed to be proved wrong.

Sometime in the late summer of 1998 the models of Scholes and Merton went from being that of the later type, to being that of the former.  This was precisely the moment Long Term Capital Management failed spectacularly.  For their models failed to predict the Russian financial crisis. 

When the Russian government defaulted on their government bonds in August of 1998, panicked investors began selling Japanese and European bonds to buy U.S. treasury bonds.  Suddenly, according to their fancy computer models, the impossible happened…bond spreads began jumping off the charts.

But as bond spreads moved against them, their belief in their models moved against them to zealot extremes.  In desperation, they began Martingaling the market…doubling down on their positions, betting the market would eventually regress to the mean.

Eventually they were right.  The bond spreads did regress to the mean.  But not before they lost $4.6 billion in less than four months.  Shortly after the fund folded.

Long Term Capital Management’s epic bust is full of lessons for investors.  “Its astonishing profits,” said Lowenstein, “looked less impressive in the light of the losses that followed.”

The same may soon be said of the DOW’s 48 percent rise between March and October of 2009.  While the DOW is still down 32 percent from its all time high, buying right now, in our opinion, is worse than a Martingale.  We have no snazzy computer model to tell us the likelihood it will be profitable, but our gut tells us that, until long after you plan to retire, the odds are strongly against it.   

Sincerely,

M.N. Gordon
Great Depression Online

P.S.  It’s near impossible for total morons to blow big money.  To succeed at such a feat you must be a genius.  We highlighted in today’s GDO how, a little over 10 years ago, a Greenwich, Connecticut hedge fun, which boasted two Nobel Prize—winning economist, lost $4.6 billion.  Poof…gone.  The fascinating tale of financial folly and of a zealot belief in mathematical models was documented by Roger Lowenstein in the National Bestseller, When Genius Failed: The Rise and Fall of Long-Term Capital Management.  You can pick up a copy from Amazon for a song.

When Genius Failed

 

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