Alright, I better start with an apology for the title of this post. I know, it’s really bad. But let’s get on to the good stuff, or, perhaps more accurately, the really frightening stuff. The plot shown at the top of this post is a simulation of the martingale betting strategy. You’ll find code for it here. What is the martingale betting strategy? Imagine you go into a a mythical casino that gives you perfectly fair odds on the toss of a mythically perfect coin. You can bet one dollar or a million. Heads you lose the amount you bet, tails you win that same amount. For your first bet, you wager $1. If you win, great! Bet again with a dollar. If you lose, double your wager to $2. Then if you win the next time, you’ve still won $1 overall (lost $1 then won $2). In general, continue to double your bet size until you get a win, then drop your bet size back down to a dollar. Because the probably of an infinite loosing streak is infinitely small, sooner or later you’ll make $1 off of the sequence of bets. Sound good?
The catch (you knew there had to be a catch, right?) is that the longer you use the martingale strategy, the more likely you are to go broke, unless you have an infinitely large bankroll. Sooner or later, a run of heads will wipe out your entire fortune. That’s what the plot at the beginning of this post shows. Our simulated gambler starts out with $1000, grows her pot up to over $12,000 (with a few bumps along the way), then goes bankrupt during a single sequence of bad luck. In short, the martingale stagy worked spectacularly well for her (12-fold pot increase!) right up until the point where it went spectacularly wrong (bankruptcy!).
Pretty scary, no? But I haven’t even gotten to the really scary part. In an interview with financial analyst Karl Denninger, Max Keiser explains the martingale betting strategy then comments:
“This seems to be what every Wall Street firm is doing. They are continuously loosing, but they are doubling down on every subsequent throw, because they know that they’ve got unlimited cash at their disposal from The Fed… Is this a correct way to describe what’s going on?
Karl Denninger replies. “I think it probably is. I’m familiar with that strategy. It bankrupts everyone who tries it, eventually…. and that’s the problem. Everyone says that this is an infinite sum of funds from the Federal Reserve, but in fact there is no such thing as an infinite amount of anything.”
Look at the plot at the beginning of this post again. Imagine the top banking executives in your country were paid huge bonuses based on their firm’s profits, and in the case of poor performance they got to walk away with a generous severance package. Now imagine that these companies could borrow unlimited funds at 0% interest, and if things really blew up they expected the taxpayers to cover the tab through bailouts or inflation. Do you think this might be a recipe for disaster?
No, this is not what “Wall Street” [whatever it means] is doing at all. I am not defending this entity, just saying that it’s not following a martingale strategy, in the loose sense of taking exponentially-increasing risk on uninformed bets. To even quote The Keiser Report or Denninger simply perpetuates and expands the deep ignorance about our banking system.
Very interesting, thanks!
@gappy: Either substantiate your claim that this is wrong, or walk away.
I am not walking away. First the burden of proof is on the person who makes a positive statement. In this case, the only evidence we are given is a statement by someone who himself provides no evidence nor has any credential.
Second, banks (and all corporate treasuries, for that matter) have by all accounts deleveraged heavily in the past three years, and have reduced their tier-3 assets. This is inconsistent with a martingale strategy. And of course, the entire strategy doesn’t even apply to hedge funds and alternative investments, who have not even experienced the kind of drawdowns described by a MBS. For heaven’s sake, not even LTCM followed a MBS.
The first point should suffice. In any case you’re not even wrong.
The essence of the piece is correct: the Banksters are, in fact, taking 0% money from the Fed and trading it. The TARP and subsequent funds, explicitly granted for the purpose of consumer and business lending, have been used for the casino. Make no mistake: trading in stocks and bonds is gambling. The funds pass between third parties, not the corporations named on the instruments. There is no investing in the corporations, since the corporations receive (modulo infinitesimal public offerings) none of the funds. As J. K. Galbraith observed: “genius is a rising market”, nothing more. Paulson (John, Hank is another story) isn’t doing so well now that he can’t load the dice before he throws.
This is in essence what’s happening. Instead of calling what they are doing Martingale betting you should call it picking up nickels in front of a steam roller, or betting on a Taleb distribution, named after teh Black Swan guy. Either way you make lots of small gains with a risk of blowing up, which is the same as the Martingale. If play with other ppls money (plus leverage!!!) and get to keep profits along the way this is the ONLY way to make money off of randomness! Of course they are using it!