Alvin Chow writes informative articles on themes of interest to investors. He is the founder of BigFatPurse.com , loves the financial market, and curious to find out what work and what doesn't work in investing.
What is your edge in the market?
I came to realize casinos, insurance companies, lottery operators, and market makers are the ones consistently making a lot of money. As a young boy, my mum always taught me about “十赌九输”, which means you tend to lose 9 out of ten times in gambling. I have avoided gambling like plague and I thank my mum for that.
Many Singaporeans love to buy 4D and go to the casinos. They are lured by big profits by risking a small amount of money. The risk-reward ratio of a first prize in 4D is 1:2000. It definitely look profitable by risking $1 to make $2,000. What about the probability of winning? Let’s just make the calculation to hit first prize and we ignore the starters and consolation prizes. The probability to win first prize would be 1/10000 and the probability of losing becomes 9999/10000.
Now, here is the secret why Singapore Pools make money – expectancy. The expectancy of YOU making money = (1/10000 x $2000) – (9999/10000 x $1) = -$0.7999
This means that for every $1 you bet, you tend to lose $0.80. It may look small, but over the long run your wealth will slowly bleed away. Singapore pools is happy to risk $2000 to make your $1, because they know they will make $0.80 in steady state. The more frequent and the higher amount you bet, the more they earn.
It would be more obvious with casinos. The house always has an edge over the gamblers. The playing rules and payouts are always calculated such that the house has an edge. It does not need a big edge. Just $0.01 advantage and they can make tons of money. Another important concept is about the number of opportunities to exercise your edge. The faster the opportunities arise, the more money you will make.
Likewise for insurance companies. They hire bright mathematicians, statisticians and a actuarial science graduates to underwrite policies for them. They can offer you $1 million payout in exchange for your insurance premiums. You would happily offset the risk to them and accept the premiums they charge. Of course, the premiums would be calculate in such a way that they will make money from a pool of clients.
Please do not get me wrong. I am not saying the insurance company is bad. It is in fact a great idea and a win-win situation for the client and the company. Company earns profits and the client gets covered financially.
This brings back me back to the financial markets. I notice the proliferation of brokers who are market makers in recent years. What made them so aggressive to attract clients with their advertisements? These market makers usually take the opposite side of the client’s trade. In other words, the brokers earn what the clients lost and vice versa. They are keen to give you leverage and encourage you to trade more by offering low commissions. Do you see the similarities of the operating concepts stated in the paragraphs above?
Most people lose money in the markets and that is the edge that the market makers have, by taking the opposite side.
What is your edge in the market that would give you profits over the long run? If there’s no edge, you are as good as buying 4D with a negative expectancy.
Let me recap. First, your edge comes in the form of knowledge or skills you possess, which you apply to the market that yields a positive expectancy. Second, you must have sufficient opportunities to apply your edge in the market. You make money faster with more opportunities.
- See more at: http://www.bigfatpurse.com/2011/06/what-is-your-edge-in-the-market/#sthash.9kRsSRCh.dpufSource: http://www.bigfatpurse.com/2011/06/what-is-your-edge-in-the-market/
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