Saturday, April 5, 2008

Fortune's Formula

I recently read Fortune's Formula by William Poundstone. I enjoyed it a lot. The title refers to a formula for determining how much you should risk on a gamble when the odds are in your favor. The formula determines the wager amount that will give you the maximum return over time. It's surprising to me that there even is such a formula.

The book consists of a sequence of events related to the formula. Poundstone carefully connects the dots between many disparate things to form a comprehensible story. The story has computer scientists, gangsters, casinos, Wall Street, huge corporations, investing strategies, gambling strategies, politicians, etc.

The formula from the book is described on this Wikipeida page: Gambling and Information Theory.

Some of the main characters from the book include: John Kelly, Claude Shannon, and Edward Thorp.

A lot of ideas were presented and explored in the book. One of my favorites is called "Shannon's Demon". It's a sort of theoretical method for making money off a stock with a randomly fluctuating price and no overall upward or downward movement in price. You build a portfolio that is half cash and half stock. Periodically, you rebalance the portfolio to have this ratio of cash and stock. Over time, this will result in a profit. The method is described on this page: The Shannon Method. The method is theoretical because transaction costs and taxes would eat up much of your profit. Also, you'd need a stock that fluctuated fairly wildly without losing or gaining too much over time.


mike barton said...

The last part is cool. I've been interested in things that can extract forward momentum from noise for a while. Stuff like the diode, ratchet, and genetic algorithms.

I wonder if rebalancing has any advantage over just using a stoploss to make sure your stocks only ever go up.

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