There are many parallels between blackjack and the stock market. They are both about It is a game of strategy and knowledge of the odds. Similar to the market, the edge is narrow and can disappear at any time.
In blackjack you can actually have an advantage as the player by using counting cards and employing high-low strategies.
Famous mathematician Edward Thorp was the first to devise this strategy for gaining a statistical edge in blackjack. Thorp later rose to fame as a legendary fund manager who closed his fund after compounding returns of over 20 percent for more than ten years.
What led Thorp to believe that, after defeating the casino at blackjack, he may also outperform the market? Most probably because he saw that there are many parallels between the market and the game of blackjack.
There are three lessons to take away from Edward Thorp’s victory over the casino at blackjack that also apply to the stock market.
- Establish your edge. What determines your chances of winning in the long run?
- The mere fact that your return is higher than the market’s does not prove that you have outperformed it.
One is founded on chance, but the other is founded on an advantage.
- Money is important. In order to succeed over the long run, your financial situation is crucial.
You give yourself a chance to outperform the market if you pay attention to these three principles. If this essay piqued your interest, you should also read Edward Thorp’s book “A Man for All Markets.”
1. Establish your Edge
One of the most perplexing ideas in the world of investing is edge. Let’s begin by considering this from the angle of probability.
Edge in probability refers to any situation in which the long-term expected value is positive. For instance, the green bet in roulette is what gives the casino the advantage over time. The casino would not have an advantage in the game of roulette if the green bet wasn’t there and the only options were black and red.
Edge is a statistical advantage that, over the long term, produces abnormally high returns.
The fact that the casino draws last gives it an advantage in blackjack. Before the casino plays, you’ll probably bust yourself. However, if you use the high-low method of card counting and adjust your stake size in accordance with the count, this advantage will vanish.
If you’re interested, you can look up blackjack card counting on YouTube and find plenty of videos that explain it. The casino’s edge can be reduced and you can gain an advantage over time by using card counting and adjusting wager sizes. The same principles apply to both trading and investing in the market. Your competitive edge needs to be clear and understandable. Do you possess a knowledge advantage? Do you have a statistical advantage when employing your own model?
2. Beating the market and outperforming the market in terms of return are not the same.
Many people spend their weekends or travel to Vegas to gamble and win a few hundred dollars. Do they now play cards professionally? Unlikely because they ultimately won due to randomness. Due to volatility, you can occasionally win in a game where you have no advantage.
Does it suggest that the head has an advantage over the tail if you toss a coin and receive seven heads? No, it was just chance. Blackjack is the same. In the short term, you might succeed, but it is solely due to chance.
The market is the same. Although your returns were higher than the market for a few years, that does not always mean you outperformed it. Where did you get your excess return? Possibly as a result of leverage – if so, you were simply increasing your risk with no edge.
Only when you have a clearly defined edge can you assert that you have outperformed the market.
3. Your financial situation
In blackjack, your financial situation plays a significant role. Despite having an edge, you could lose early if you lack the necessary funds. That is if you keep getting bad cards and run out of money before the card count is in your favor and you start upping your stake size.
Many traders also disregard this variance principle. Despite having a successful strategy and the correct attitude, you could nevertheless lose for a period of time as a result of variances in your performance.
Do you have enough cash to get through these droughts? For long-term success in blackjack and the stock market; you must have adequate cash.