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Editor's Note: Below is an excerpt from an Early Look written by Hedgeye CEO Keith McCullough.

Sizing Your Bets: An Investing Note From Keith McCullough - zv

“Gambling is investing simplified.”
-Edward Thorp 

If Ed Thorp didn’t have one of the best track records in the history of the hedge fund community, you might not pay as much attention to why he was good at both Black Jack and beating the market. 

The aforementioned quote was his opening volley in an awesome chapter in A Man For All Markets titled “Wall Street: The Greatest Casino On Earth.” 

“Both gambling and investing can be analyzed using mathematics, statistics, and computers. Each requires money management, choosing the proper balance between risk and return. Betting too much can be ruinous.” (pg 145) 

When I was running my long/short book at Magnetar Capital back in 2006, one of the founders of the firm (Alec Litowitz) would talk to me about sizing my “bets” with an understanding of the Factor Exposures implied in those bets. 

At that point in my career, I had no idea what he was talking about. But that’s why I joined the math guy from MIT – I wanted to learn what I didn’t know about the quantitative risk management of a portfolio. 

I am forever grateful to the guys from Chicago for opening my mind to what The Machine was going to become. 

Today, since almost 90% of daily US Equity trading is what we call “systematic”, we have at least $2 TRILLION in assets under management that is betting on purely quantitative strategies … and at least another $1 TRILLION behind that running “net neutral”, constantly using options and ETFs to delta-hedge portfolios in real-time. 

What does that do to The Machine? It makes it go faster. 

Especially on the most critical Factor Exposure in The Machine (price MOMENTUM)… and on the most critical duration (1 MONTH)… rules-based execution pushes prices up/down faster than ever before.

You can either fight that or try to understand that. 

Especially if you’re not a day-trader or someone whose career is judged on monthly P&L and… God forbid… you can invest your bets over an intermediate-term and TRENDING time-frame (3 months or more), this is great news. You can capitalize on it. 

Why? Because you can use The Machine’s short-term TRADE (3 weeks or less) moves to size up your best bets! 

What are the 3 most causal FUNDAMENTAL research FACTORS that determine the TREND’s path?

  1. ROC (rate of change) of GROWTH
  2. ROC (rate of change) of INFLATION
  3. ROC (rate of change) of PROFITS

That’s why almost 100% of my research team’s time is focussed on measuring and mapping The Cycles of those 3 things.

If you don’t have a research team doing that for you both globally and daily, you aren’t even gambling with a basic level of awareness of either the odds or the probabilities changing as you see cards come out of the deck – you’re just guessing.

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