Ed Thorp’s journey to investing began in a casino. It started by questioning the conventional wisdom that the game couldn’t be beaten. Thorp proved it could.
The game was blackjack. His strategy for counting cards gave the player an edge over the house. He published the strategy in Beat the Dealer, which became a best seller. It was proof that a tiny edge can compound a small bankroll into a fortune over time.
Less well-known is that Thorp beat the game of roulette too. With the help of Claude Shannon, Thorp created a wearable computer that predicted where the ball would land. It gave them a 44% expected gain playing roulette.
Thorp’s proclivity to question conventional wisdom pushed him toward markets. His early foray into investing was a hedging strategy using warrants, options, and convertible bonds and preferreds, which was written about in Beat the Market. He averaged 25% mostly investing for himself and friends and family.
He started Princeton/Newport Partners in 1969. He continued his warrant strategy while adding an options formula — basically, Black-Scholes before Black and Scholes figured it out — along with a third strategy he could use depending on the situation. It became a race to stay ahead of academia until he closed up shop in 1989.
Five years later, he opened Ridgeline Partners, which he ran until 2002, using a statistical arbitrage strategy. In total, Thorp averaged about a 20% annual return over 29 years.
Of course, the similarities between the gambling world and financial markets were helpful for Thorp. Having a repeatable system was crucial in both. A repeatable system is no more than a set of rules to follow. If you follow the rules, the system wins over time. The key is having an edge, something that tilts the odds in your favor over the long run. You won’t beat the game without it.
Proper money management was important too. The goal is to make the optimally sized bet based on the odds of success in order to maximize profit. Except people rarely think that way. They tend to be either risk-takers or risk-averse. So they bet too much or not enough and ignore the odds altogether. Those who bet too much, go broke. Those that don’t bet enough, get minuscule returns.
Adapting and improving strategies is necessary for both too. Casinos did not take kindly to card counters. Thorp had to adapt himself, rather than his blackjack strategy. He wore disguises, for example, to stay one step ahead of the casinos.
Investing is no different. It’s a constant chase to stay one step ahead of the other big brains because once an edge is found, eventually it will be found by another and another until any outperformance is gone. It’s like scavengers feeding on a carcass. Those who find it first get more than their fill. The last to get there get none. Thorp always searched for the next edge to profit from because scavengers were bound to figure out his existing strategy and reduce his edge to nothing.
That’s not to say all edges disappear. But the lucrative edge that Thorp chased attracts the most scavengers and the biggest money.
Finally, he saw human misbehavior, pervasive in the gambling world, in the stock market. Not only did the typical errors exist in both gambling and the markets but what surprised him was that fraud and cheating were more prevalent. In fact, Thorp suspected Madoff was a fraud, long before he got busted, after analyzing trades in his client’s account.
Thorp was at the forefront of discovering anomalies that existed in markets that nobody else knew about. His investing career was driven by an informational edge over others. It’s not the only edge available to investors but its something to keep in mind when reading what Thorp says below:
I came to somewhat of a compromise in life where I didn’t try to reinvent the wheel just because I thought I could. If there was something to be learned from other people, I would learn that as well as I could, but I didn’t hesitate to go out on my own and investigate an idea or a problem that came to me. That’s the sort of orientation that shaped my career.
It seems to me that people are not just wealth maximizers but seeking to maximize something else, whether they do it accurately or inaccurately, whatever their total satisfaction is from whatever they’re doing. I imagine that’s the explanation for why people will gamble and lose money. They supposedly get an entertainment payout. Part of it, though, is that gambling is a tax on ignorance. People often gamble because they think they can win, they’re lucky, they have hunches, that sort of thing, whereas in fact, they’re going to be remorselessly ground down over time.
Gambling games are, for the most part, an area where you can calculate the odds, the probabilities, in detail and get them rather exact… You can simulate a gambling game a million times if you want because you know the probabilities. It’s much more difficult in the securities markets because we just have one history from which we have to infer what’s going on, and the probabilities that we have are not exact — they’re just estimates. We’re in a world that’s controlled by people, which evolves in complex ways that we don’t fully understand. So you don’t have the same simple rules you have in the physical sciences and in the calculations that are behind gambling games. Nonetheless, the things you learn about gambling games carry over, in large part, to the investment world.
On Money Management
Casino gambling with a system where you have the edge is a wonderful teacher for elementary money management. Bill Gross, one of the founders of PIMCO, learned this early on as well. He read Beat the Dealer and went out to Las Vegas early in his career, and he labored for four months using the Kelly system to increase $200 to something like $10,000… When he went to PIMCO, that thinking guided him. But instead of betting with a $200 bankroll, he was betting billions. Same principles. It’s just a matter of scale.
On His Process
I tend to work on problems that are goal-oriented, such as finding a winning strategy for a gambling game or finding a market inefficiency or devising a way of analyzing something in the market that will give me an edge. Then the fun is building models and series and seeing if they actually work. That’s what I’ve been doing.
I spent a lot of time and energy trying to stay ahead of the published academic frontier. Of course, the unpublished frontier is further along because there’s a time delay between creation and the appearance in print.
On “Beating the Market”
Bridge players know that bridge is what mathematicians call a game of imperfect information… The stock market also is a game of imperfect information and even resembles bridge in that they both have their deceptions and swindles. Like bridge, you do better in the market if you get more information, sooner, and put it to better use. It’s no surprise then that Buffett, arguably the greatest investor in history, is a bridge addict.
People should be putting money into index funds when they can’t demonstrate that an investment with similar characteristics is better. For instance, suppose that they go to a long equity manager. In order to give him money, I think they should have to be able to demonstrate that the index that most closely matches him — small stock, intermediate stock, growth, value — is not as good. It’s tricky to do that with just historical information, because if you have 100 managers out there and none of them is any better than the index — let’s say they’re all the same, just to be charitable — then there will be a random fluctuation around the index return, and you tend to select the managers who did better… Actually, what seems to happen, from what I can see, is that the underperformance roughly matches the fees. I would say that the burden of proof is on the non-index manager.
There are inefficiencies in the market, but they’re not easy to demonstrate, and I think that needs to be done before one shifts money in that direction.
Even though markets aren’t strongly efficient in the sense of EMH, it’s still difficult to find edges. By “edge,” I mean excess return after adjusting for risk, net of costs. Also, when an edge is discovered, the money that’s poured into it makes the edge go away, because it moves prices toward correct pricing. So, I don’t think EMH is quite the right mental framework for thinking about markets, but it’s a good start for almost everybody.
Active investing is a zero sum game on net. For liquid asset classes like US bonds and stocks, for instance, this means that everybody who is active, or not indexing, are collectively a big index fund, on average. That big actively-traded “index fund” is being managed, so it’s also paying costs. So, a couple of percent is being drained out of that pool, compared with the guys who are paying very low amounts for passive indexing… So, all the institutions that are battling for an edge in those liquid asset classes aren’t going to get alpha collectively. They should just index those parts of the portfolio, in my opinion.
Most people don’t have an edge. If you think you have an edge, it needs to be logically demonstrable. You’ve got to be able to defend it against a good devil’s advocate. If you can’t do that, you probably don’t have an edge.
On the Perfect Allocation
The board that I sit on has investment guidelines that allocate in a certain range to various categories, such as real estate, private equity, bonds, domestic equity, international equity, and so forth. They move these guidelines around. They spend a lot of time adjusting the mixes… I’m not sure that the time and energy spent get us very much, though. They’ll debate whether to have 20 percent or 25 percent in domestic equity, and the finance committee will spend a lot of time offering opinions about this. Maybe they’ll decide to move the guideline from 20 percent to 25 percent, but no matter what happens, it will only have an incremental effect on returns that is so small that it’s hardly noticeable and appears to me to be almost random.
On Financial Fraud
When I shifted my focus from beating gambling games to analyzing the stock market, I naively thought that I was leaving a world where cheating at cards was then problematic and entering an arena where regulation and the rule of law gave investors a fair playing field. Instead, I learned that bigger stakes attracted bigger thieves.
Hoaxes, frauds, manias and other large-scale financial irrationalities have been with us from the beginnings of the markets in the seventeenth century, long before the Internet.
Putting the Cards on the Table
Words from the Wise
Bridge With Buffett
My Encounters With Madoff’s Scheme and Other Swindles
- How to Make Peace With Your Stock Market Losses – J. Zweig
- Little Rules About Big Things – M. Housel
- Psychological Underpinnings of Superior Bear Market Returns – Alpha Edison
- The Sages of Wall Street – Verdad
- The Late, Great Sandy Gottesman – Kingswell
- The Lesson of Nobelist Ben Bernanke – R. Lowenstein
- An End to Doomerism – Big Think
- The Economics of Costco Rotisserie Chicken – The Hustle
- The Age of Climate Industrialism – Parachute