The Mihir Chronicles

A Man For All Markets | From Las Vegas To Wall Street, How I Beat The Dealer & The Market by Edward O. Thorp

January 28, 2024

I. Brief Summary

Edward Thorp recalls his life starting from childhood while sharing valuable lessons about gambling and investing. He always had an inclination towards science eventually gravitated towards mathematics. He applied math to a variety of domains with tremendous success including poker and investing. His curiosity led him to key discoveries in how to beat the dealer in blackjack and other games of chance, and eventually led him down the path to make key discoveries to arbitrage the markets in finance. He is one of the greatest quantitative investors.

II. Big Ideas

  • Thorp argues that markets are not always efficient and there are ways to exploit it.
  • Thorp once focused on arbitrage opportunities. But despite having extraordinary intellectual capabilities, he concludes that investing in an index is safer, and he does not try to beat the market through individual stocks anymore. That is because he values his time and freedom.
  • Those who cannot remember the past are condemned to repeat it.
  • 7.3% average annual market return doubles your investment in 10 years. This is how compounding works.
  • Long-term holding with little dividends and high re-investments by companies reduce your tax liabilities and improves your net performance.
  • The more complicated systems while theoretically better are difficult to use in practice and prone to error. An imperfect solution that can be used in practice is better than a perfect one that cannot.
  • Get information early (if you are not sure how valuable your information is, then it probably is not). Few people occasionally listen to some information at the right time and the right place.
  • Be a disciplined investor. Follow the logic and analysis rather than sales pitches, whims, or emotions. Don't gamble unless you are highly confident you have the edge. In real markets, the rationality of the participants is limited.
  • When securities are mispriced and people take advantage of this, their trading tends to eliminate mispricing. The earliest traders gain the most.
  • Thorp knew what Buffett and Graham have both preached repeatedly: temperament is more important to successful investing (and gambling) than pure brainpower or brilliant strategy.
  • Exploiting a small edge repeatedly can be extremely profitable in the long-run.
  • Thorp exploited the Kelly Criterion (% of Capital Wagered = Expected Net Winnings/Net Winnings If You Win) to size his bets appropriately. In other words, when you have a greater edge (greater expected net winnings) place a larger bet.
  • Markets adapt to trading strategies when copycats enter the market and advantages evaporate. It’s important to keep innovating and making sure that strategies are still relevant.

III. Quotes

  • Some think in words, some use numbers, and still others work with visual images. I do all of these, but I also think using models....Physics, chemistry, astronomy and biology revealed wonders of the world, and showed me how to build models and theories to describe and predict. This paid off for me in both gambling and investing.
  • Learning is like adding programs, big and small, to this computer.
  • Character is destiny.
  • Gambling is investing simplified.
  • The lesson of leverage is this: Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.
  • It doesn't pay in negotiations to push the other party to their absolute limit. A small extra gain is generally not worth the substantial risk the deal will break up.
  • I also learned the value of withholding judgement until I could make a decision based on evidence.
  • Life is like reading a novel or running a marathon. It’s not so much about reaching a goal but rather about the journey itself and the experiences along the way.
  • I wondered how my research into the mathematical theory of a game might change my life. In the abstract, life is a mixture of chance and choice. Chance can be thought of as the cards you are dealt in life. Choice is how you play them. I chose to investigate blackjack. As a result, chance offered me a new set of unexpected opportunities.
  • What appears random for one state of knowledge may not be if we are given more information.
  • Our corporate executives speculate with their shareholders’ assets because they get big personal rewards when they win—and even if they lose, they are often bailed out with public funds by obedient politicians. We privatize profit and socialize risk.
  • Simple probability and statistics should be taught in grades kindergarten through twelve and that analyzing games of chance such as coin matching, dice, and roulette is one way we can learn enough to think through such issues.
  • Do not assume that what investors call momentum, a long streak of either rising or falling prices, will continue unless you can make a sound case that it will.
  • How can we prevent future financial crises driven by the systemic and scarcely regulated use of extreme leverage? One obvious step is to limit leverage by requiring sufficient collateral to be posted by both counterparties when they trade. That’s what is done on regulated futures exchanges, where contracts are also standardized. This model has worked well for decades, is easy to regulate, mostly by the exchanges themselves, and has had few problems.
  • This phenomenon has been called the wisdom of crowds. But like most simplifications, this has a flip side, as in the Madoff case. Here there were just two answers, fraudster or investment genius. The crowd voted for investment genius and got it wrong. I call the flip side to the wisdom of crowds the lunacy of lemmings.
  • A trait that showed up at about this time was my tendency not to accept anything I was told until I had checked it for myself.
  • The list of issues goes on, the point being that hedge fund investors don’t have much protection and that the most important single thing to check before investing is the honesty, ethics, and character of the operators.
  • Shakespeare might advise, “The fault is not in our markets, but in ourselves.”
  • The most important reason to wind down the operation was that time was worth more to me than the extra money.
  • Success on Wall Street was getting the most money. Success for us was having the best life.
  • As Keynes said, the market can remain irrational longer than you can remain solvent.
  • With time, lucky managers tend to fade.
  • Write down everything you spend. The waste in your daily spending should soon become apparent.
  • I intensified my focus on competing with the wave of mathematicians, physicists, and financial economists who were now flocking to Wall Street from academia.
  • But I found factionalism and backstabbing as bad there as it had been in the Math Department. Both had endless committee meetings, petty squabbles over benefits, people who wouldn’t pull their weight and couldn’t be dislodged, and the dictum of publish or perish. I decided it was time to leave academia. Even so, it was not an entirely easy decision.
  • One problem in large bureaucracies is that many of the members decide it is better not to cross people, instead of standing on principle. I asked a good friend, whom I had helped to get an appointment in our department, to become my vice chairman and help me. Although he was now a full professor with tenure, he declined, saying, “I have to live in the same cage with these monkeys.” I did understand his point. On the other hand, I was not confined to the cage. I had PNP. I thought, Why try to fix this if no one will even back me up? I was in the Math Department by choice, not by necessity. It was time to move on.
  • Routine financial reporting also fools investors. “Stocks Slump on Earnings Concern” cried a New York Times Business Day headline. The article continued, “Stock prices fell as investors continued to be concerned about third-quarter results.” A slump? Let’s see. “The Dow Jones Industrial Average (DJIA) declined 2.96 points, to 10,628.36.” That’s 0.03 percent, compared with a typical daily change of about 1 percent. Based on the historical behavior of changes in the DJIA, a percentage change greater than this happens more than 97 percent of the time. The Dow is likely to be this close to even on fewer than eight days a year, hardly evidence of investor concern. The DJIA is calculated by adding the prices of the thirty stocks that currently make up the average, then multiplying by a number that continually is readjusted to incorporate the effects of dividends and stock splits. The current multiplier was a little over five, meaning that if just one of the thirty stocks had closed an additional point and a quarter higher, the closing DJIA number would have been over six points larger, for a rise of over three points, or 0.03 percent. DJIA stocks reportedly would have jumped, not slumped. The S&P 500 Stock Index was down a mere 0.04 percent, a lack of change almost as tiny as that of the Dow. The only real move was in the NASDAQ composite, which fell 32.8 points, or 0.9 percent. Even this volatile index was having larger daily changes two-thirds of the time. What’s going on here? The story said stocks with earnings that didn’t meet expectations had been penalized the previous day. But the impact on the indexes was so small as to be meaningless. The reporter had made two errors. First, he thought statistical noise meant something. Second, he missed the other half of the story—the one about the stocks that must have gone up, and why they did—as they must have done to offset the effect of the ones that dropped. Offering explanations for insignificant price changes is a recurrent event in financial reporting. The reporters often don’t know whether a fluctuation is statistically common or rare. Then again, people tend to make the error of seeing patterns or explanations when there aren’t any, as we’ve seen from the history of gambling systems, the plethora of worthless pattern-based trading methods, and much of story-based investing.
  • Neither Jerry nor I believed the efficient market theory. I had overwhelming evidence of inefficiency from blackjack, from the history of Warren Buffett and friends, and from our daily success in Princeton Newport Partners. We didn’t ask, Is the market efficient? but rather, In what ways and to what extent is the market inefficient? and How can we exploit this?
  • I prefer to think in terms of the inverse of P/E, or earnings divided by price, sometimes known as E/P but perhaps better described as earnings yield. When the P/E is 20, for example, the earnings yield is 1/20, or 5 percent. An investor who owns the S&P 500 Index could think of it as a low-grade long-term bond, comparing the earnings yield of this “bond” to the total return from some benchmark for actual bonds, such as long-term Treasuries or corporates of a particular quality grade. When the earnings yield on the stock index is historically high relative to the bond benchmark, the investor sells some of his bonds and buys stocks. When bond yields are high compared with stocks, he shifts money from stocks back to bonds.
  • Stories sell stocks: the wonderful new product that will revolutionize everything, the monopoly that controls a product and sets prices, the politically connected and protected firm that gorges at the public trough, the fabulous mineral discovery, and so forth. The careful investor, when he hears such tales, should ask a key question: At what price is this company a good buy? What price is too high?
  • I apply this to the trade-offs among health, wealth, and time. You can trade time and health to accumulate more wealth. Why health? You may be stressed, lose sleep, have a poor diet, or skip exercise. If you are like me and want better health, you can invest time and money on medical care, diagnostic and preventive measures, and exercise and fitness.
  • Gambling now is largely a socially corrosive tax on ignorance, draining money from those who cannot afford the losses.
  • For financial titans who aggressively continue to seek tens of millions, hundreds of millions, and sometimes billions, you can ask, “Is the winner really the one who dies with the most toys?” How much is enough? When will you be done? Often the answer is “Never.”