To beat the market means consistently earning superior returns than the average market return while taking less risk.
This article seeks to answer one question, that is, can you use Edward Thorp’s strategy to beat the Nepal stock market? Is he the man for NEPSE?
Who’s Edward Thorp, you may ask.He’s an American mathematics professor, author, hedge fund manager, and blackjack pioneer.
This math genius famously beat the casinos and earned millions by inventing the blackjack card counting system and wrote the book on the subject, Beat the Dealer.
He then turned his focus on the stock market, earning an annualised rate of return of 20 per cent after fees for over two decades, without a single down quarter with his hedge fund Princeton/Newport Partners (PNP).
How did he beat the market?
Luckily for us, he shared his core strategy in his 2017 book, A Man For All Markets, published in 2017.
In its simplest form, he identified and took advantage of any mispricing between two inversely related assets by hedging. Hedging, put simply, means using one financial instrument to offset the risk of adverse price movements..
“To form a hedge, take two securities whose prices tend to move together, such as a warrant and the common stock it can be used to purchase, but which are comparatively mispriced. Buy the relatively underpriced security and sell short the relatively overpriced security. If the proportions in the position are chosen well, then even though prices fluctuate, the gains and losses on the two sides will approximately offset or hedge each other. If the relative mispricing between the two securities disappears as expected, close the position in both and collect a profit.”
To find securities that were mispriced, he used the Black-Scholes formula.
Can you beat the Nepal stock market?
Theoretically, yes. But our market neither has call options nor are most of us an expert in applied mathematics or statistical probability. So, what can we do?
His main idea is not that you need a complex mathematical model to beat the market but rather a demonstrable edge or advantage.
In blackjack, by counting the cards, he knew when he had an advantage over the dealer. Similarly, in the stock market, when he found two securities that were mispriced he had an edge.
Now the edge can be anything, e.g. early or insider information, a superior method of security analysis, statistical arbitrage etc.
How to beat the Nepal stock market?
According to the author, there are a few ways to beat any stock market.
- Get good information early. How do you know your information is early enough? If you’re unsure, then it probably isn’t.
- Be a disciplined rational investor. Follow logic and analysis rather than rumours, whims or sales pitches. Assume you only have an edge when it stands all attempts to tear it down. Don’t gamble if you don’t have the edge. Like Buffett says, only swing at the fat pitches.
- Find a superior method of analysis. Statistical arbitrage, convertible hedging, Black-Scholes formula and card counting worked for the author. Or find and follow the winning strategies of the gifted few.
- Invest ahead of the crowd when you’ve identified an opportunity. When securities are known to be mispriced and people take advantage of this, their trading tends to eliminate the mispricing. It looks like the early bird does get the worm.
However, most market participants have no demonstrable edge or advantage.
And since information flows down a food chain, be aware that those who get in first, eat and those who get in late get eaten.
And finally, statistical arbitrage at least the way the author used it is not possible as of yet in NEPSE.
To beat the market, the author recommends focusing on investments well within your circle of competence. And to ensure that the information you analyse is current, accurate and complete.
Mistakes to avoid
Don’t make an investment unless you can demonstrate by logic and if appropriate by a track record that you have an edge.
- Avoid anchoring. When you buy a stock at say 200, that price only has significance to you but the market neither cares nor asks about this fact. But nonetheless, we are anchored to this price which only has any meaning to us. So, when the price drops to 150 and we are at a 25% loss, we say to ourselves, I will get out when we break even.
- Do not assume a momentum/trade/upswing will continue unless you can make a sound case that it will.
- Not all stocks that are cheap are a good investment, i.e. Upper Tamakoshi share prices are wildly overvalued.
But what if I don’t have an edge…
His advice for those of us who don’t have an edge is to invest in a low-cost index fund. At least this way, you’ll see the same market return less cost.
The closest match to an index fund for us here in Nepal will be mutual funds. Among them, the funds with lowest management fees are:
- Nabil Equity Fund 1% p.a. (2% p.a. if NAV growth is more than 10%). Personally, I like this performance-based fee structure the most. And wish that more funds follow this path.
- Global IME Samunnat Scheme 1 with 1.75% p.a.
- Sanima Equity Fund with 1.75% p.a.
There is no doubt to me that our market has plenty of traders/investors who are beating the stock market handily every year in private, i.e. those with an edge.
So it seems to me that if you can’t find an edge, the only way to consistently beat the Nepalese stock market is to be a stockbroker or a market maker. PS, I’ll be covering market making (scalping) as a strategy next.
Joking aside, the author’s concept of an edge also matches one of Peter Lynch’s idea, which is to invest in things you know about.
Who do you think has the biggest edge in the Nepalese stock market?