December 19, 2006

Fortune’s formula

I have been reading this book : Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street.

I have found this book quite good especially if one wants to learn about odds, betting etc.

I am just halfway through the book. The book discusses about the kelly’s formula.

F = edge/odds. I have written about this formulae earlier (see
here).

I found the above formula intersting although I have yet to figure out, how to use it directly in investment management. The formulae works well for betting situations like blackjack, horse betting which have limited outcomes. Its diffcult to work out mathematically the value of edge and odds in a common stock situation.

I have also been doing some analysis on the NSE data and have the following data



The above is the distribution of PE ratio for the last 7 years. It clearly shows that the only for around 8% of the trading days has the PE ratio been higher than 22.

If we take the above numbers as proxy for probability of occurrence and multiply that with the gain/ loss ( current PE – PE of the particular day / current PE) for each day, the expected value is around –19%.

To cut a long story short, the market seems to be overvalued by historical measures (which may not mean that the market is overvalued if the future performance is better than expected). Overall, I am planning to be more cautious especially in investing in the index (via index funds or ETF)

update : 8-Jan : Found this interesting discussion thread on the Berkshire board on MSN on the same topic. For those interested in kelly formulae, i would recommend reading the thread

http://groups.msn.com/BerkshireHathawayShareholders/general.msnw?action=get_message&mview=0&ID_Message=26958&LastModified=4675605385636001835

5 comments:

Anonymous said...

What do u think about asset allocation right now, in terms of cashholding and stock holding? Is it advisable to get into shorting?

Rohit said...

i am personally not comfortable with shorting. i would prefer a put option rather than short a stock. also in case of shorting not only one has to be right, one has to get the timing right too. personally i find that diffcult to do

Anonymous said...

Rohit,
Where can I find historical information for earnings/PE/PB etc. for the Sensex? Thanks,
Bharath

Rohit said...

you can find it on the nse website. i think it is nseindia.com

Vidyanshu said...

Hi Rohit,

Would you have this book(Fortune's Formula) in an ebook format?

If so, pls. email it me -
vidyanshu@gmail.com

Thanks.