A good read--especially if you're interested in gambling, probability or unusual investing problems--and still a tolerable read even if you're not. The book grabs you early on, but by the last third it loses some of its momentum and becomes a bit too didactic. All in all an interesting autobiography of a rigorous thinker: Thorp is a sort of Richard Feynman of the mathematics world--uh, just without mashing all the young coeds.
It's instructive to read Thorp's extensive thoughts about Bernie Madoff (see pages 213ff). Thorp identified the Madoff fraud many, many years before the truth came out, and not only is it one of the most interesting parts of the book, but it shows how "experts" and "authorities" (like the SEC, or the supposedly "watchdog" media) fail to act on or even perceive a fraud, while an outsider with critical thinking skills can easily identify one. It's a staggering embarrassment that the Madoff fraud lasted as long as it did and got to the scale it did, and today's SB-F/FTX fraud adds just another chapter in the book on how corrupt and incompetent media and regulators never seem to find what they refuse to look for.
If you're fascinated by blackjack and other casino games (like I am), you'll find a lot of meat in Chapters 4-8 where Thorp talks about various systems to improve player odds--as well as quite a few shocking events that happened to him across his journey, as he made a lot of money at the casino tables, published his famous book Beat the Dealer, and was victimized by outright casino cheating. These are the best chapters of the book. You'll also see (both from this book and from other books like Ben Mezrich's wonderful Bringing Down the House) how casinos can be run by a bunch of real dicks: they seem willing to do almost anything to stop successful players.
Investing geeks will enjoy Thorp's unusual path through the investing world, as he arbitrages convertible bonds and options, invests in "thrift conversions" and so on. Thorp has intelligent takes on all of these secret corners of investing
I mentioned above that the book loses momentum towards the end: the last third of the book devolves into standard vanilla advice on investing, information better drawn from books by Jack Bogle or anything by William Bernstein.
Finally, I wanted to link here two long-form interviews Tim Ferriss did with Ed Thorp, here and here for any readers curious to hear more from a very smart and unusual thinker.
Notes:
Preface:
x "Rather than subscribing to widely accepted views--such as you can't beat the casinos--I checked for myself." ["I checked for myself" is a sort of distillation of Thorp's entire intellectual modus operandi: he never accepts received wisdom, never automatically believes the consensus view on anything. He checks for himself. And often finds the consensus view hilariously wrong, judging by how much money he made beating casinos at various games. I love this guy's attitude, and I take this phrase as a metaphor for being a truthseeker, being an autodidact, being a rigorous (and utterly anti-lazy) thinker who does not automatically assume or adopt conventional ways of thinking about anything.]Foreword by Nassim Nicholas Taleb:
xiv "As Warren Buffett said: 'In order to succeed you must first survive.' You need to avoid ruin. At all costs."
xiv "And there is a dialectic between you and your P/L: You start betting small (a proportion of initial capital) and your risk control--the dosage--also controls your discovery of the edge. It is like trial and error, by which you revise both your risk appetite and your assessment of your odds one step at a time."
Chapter 1: Loving to Learn
3ff Thorp doesn't speak until his third birthday and then speaks in complete sentences. A savant as a child: curious and relentless, experimental, reading anything he can get his hands on.
11ff He grows up during the Depression, money was very tight, he comments on the irrational frugality and hoarding tendencies of Depression-era people; also he figured out the idea of shoveling driveways around the neighborhood, but other kids copied him--thus he learned quickly about how competition drives down profits. [Also an indirect lesson about "moats"/barriers to competition]
19ff Fascinating to see his opportunism and his sense of right and wrong when it came to his newspaper route; the paperboy's supervisor started taking a cut from their income, and collectively the paperboys went on strike (which led to the supervisor being replaced ultimately) but Thorp had already moved on to delivering the Los Angeles Daily News, a different newspaper.
Chapter 2: Science Is My Playground
22ff He gets his ham radio license, learns Morse code; members of his extended family comes back from internment (by the Japanese military in the Philippines) and not everyone survived; he experiments with weather balloons, radio, gunpowder, "guncotton," nitroglycerine.
36ff He's also a genuine self-starter: takes the statewide chemistry test to try to win a scholarship; he starts a science club; deals with being one of the outs in his high school class (not wealthy, doesn't have a car), he gets together with other students to start a student government political party; at a high school reunion 46 years later he notes how the "cool" students hadn't changed: high school had been the apex of their lives [this is pretty common observation for those who were not the coolest kids in high school!]; he blasts through a list of great novels between his junior and senior year; he wins a statewide physics contest; he is a nationwide finalist in the Westinghouse science talent search; he even gets to meet Harry Truman: "I remember the feel of his hand as we shook: firm, compact, and with the sensation of a leather chair lightly dusted with talcum powder."
[You can see another example of the grievous inflation in education costs--and how what used to be significant driver of peoples' social mobility in Thorp's day is now a cruel barrier against social mobility in the modern era: when Thorp goes to UC Berkeley in the 1940s his annual tuition is $70. That is not a misprint! If you adjust it for inflation it would be maybe $1,000 or at most $2,000 a year today in inflation-adjusted dollars. Guess at what Berkeley's tuition (not room and board, just tuition) is today? $14k, or more than 7x what would be an inflation-adjusted "real" price for tuition in his day.]
Chapter 3: Physics and Mathematics
45ff 1949: he heads off to Berkeley. His parents recently divorced, he also learned that his mother cashed the war bonds he had bought with his paper route and she spent the money, this estranged them for years. He's totally broke as a student and lives off of $100 a month.
46 His chem professor offers 10c per misprint to report errors in his school textbook; Thorp finds quite a large number of errors and retroactively the professor changes the rules and doesn't pay up; Thorp talks about how he later encountered other examples of a "unilateral retroactive change in the deal" both off and on Wall Street. Somebody also sabotages his chemical sample in a final exam; the teaching assistant took no action even when when the sabotage was proven and it cost Thorp his position as first in his class; so he changes majors to physics and mathematics, which turned out to be a great decision in hindsight.
50ff He butts heads, aggressively, with his physics professor, almost gets expelled; had he gotten expelled he would have been promptly drafted to Korea.
51 Two good heuristics/questions he asks himself as guidelines:
1) If you do this, what do you want to happen?
2) If you do this, what do you think will happen?
51ff He graduates, treats himself to a six-week road trip to Manhattan; stops in Las Vegas on the way, leaving him "with conflicting, but vivid, images." His travel companion is a weightlifter, he tells a story about how Thorp stumbled into a gym with other students and discovered an interest in fitness and health. [just take one look at the book's jacket photo at about age 84 and you can see the dude is a healthy, youthful guy. He's now 91.]
53 On the martingale system for doubling up on bets at roulette: you bet red or black and after each loss you bet twice as much on the next spin on the same color. Eventually you will win, and that win covers the previous string of losses, plus a profit of $1. Then start again at $1 and repeat the whole doubling process. "The catch is that after many doublings, your required bet can be so large that either you have run out of money or the casino won't allow it." [Also imagine the volatility in "ending wealth" using this system, it's sort of the diametrical opposite of the Kelly Criterion.]
54ff Thorp ends up working towards a PhD in physics and math; he gets back together with his prior girlfriend Vivian.
58 He comes into contact with Richard Feynman and asks him if there was any way to beat the game of roulette. "When he said there wasn't, I was relieved and encouraged. This suggested that no one had yet worked out what I believed was possible." [!!! A great example here of practicing "I checked for myself" and deriving a correct, but counterintuitive, conclusion from a confidently declared statement from an "expert." Wonderful!]
60 He gets three letters of recommendation from teachers in the math department at UCLA; one was from his advisor and was rather faint in its praise: it turns out professor Angus Taylor never complimented anyone, was very, very spare with his praise, and this was one of the most complimentary letters of recommendation he'd ever written. It reminded Thorp of his father's reaction when he brought home a 99 on an exam and his father would ask why he didn't get a 100.
Chapter 4: Las Vegas
61ff 1958: Thorp heads to Vegas, learns about a strategy for playing blackjack, continues to work on his plans to beat roulette.
63ff A quick burst of blackjack insight right here from Thorp: "A player may stand at any time. The dealer's edge is that the player must risk busting first, losing immediately, even if the dealer later also goes over 21, though in effect they have tied. Because he loses when they both bust, a player who follows the dealer's strategy for his hands has a disadvantage of about 6 percent." [I don't know how many times I've stood on cards and have made other players at the table quite angry with me for "not following the rules," but I totally agree: you have to avoid busting at all costs! It's a total unforced error.] He loses $8.50 of his $10 stake and quits, but he's hooked on the game. "The atmosphere of ignorance and superstition surrounding the blackjack table that day had convinced me that even good players didn't understand the mathematics underlying the game. I returned home intending to find a way to win."
Chapter 5: Conquering Blackjack
67ff Thorp discovers the contiguous probability of blackjack: that the probability of any card coming out of the deck depends in part on what is still left in the deck and thus the player's or the house's edge can shift--sometimes dramatically--as play continues. Thus you would vary your bets accordingly. Starting with the Baldwin strategy, which depended on nothing being known about the cards which had already been played, he works out some programming on an IBM 704 mainframe that he had access to at MIT (where he had taken his first job); discovers rules that produce a 0.21% advantage to the house if you played perfectly without tracking the deck; Twenty years later, working things out with much more powerful computers, he had developed rules that he went on to put into his book Beat the Dealer with a 0.13% advantage for the player (also without tracking the cards); then he starts testing for changes in odds as cards come out of the deck: with just the aces played, the player disadvantage goes to 2.72%, a tremendous shift; this proves that the odds would shift significantly as certain cards were played, thus an ace-rich deck would give the player a big advantage; the heuristic works such that as small cards (two, three, four, five, six) come out of the deck and are played the player's odds are helped enormously. Thus people started using a running count system based on "little cards" versus "large cards" coming out of the deck: if a little card comes out of the deck that's +1 for each, while if a large card (10 or higher) comes out of the deck that's -1. Note also that fives were particularly valuable to the player if they came out of the deck: a five is what turns a 16 into a 21 when the dealer has to take a hit; the house loves little cards to be in the deck, and the player hates it: the player wants little cards to come out early rather than late.
75ff See also a simple winning system based on "following the fives": the likelihood of all fives being gone increases as fewer cards remain and the odds delta for removing four fives from the deck gives the player an edge of 3.29%, thus you can bet small whenever any fives are left and bet big whenever all the fives are gone. Thorp built a system following "ten richness" as well as "five richness."
76 He had some of his mathematical work stolen after he sent it to a well-known California mathematician for comments, Thorp takes the high road here and doesn't name the guy but the plagiarist ends up giving a talk on it, presenting it as part of his original work and published it under his own name in a major mathematical journal.
77 Thorp publishes his first paper on beating blackjack in a prestigious math journal; also meets with Claude Shannon to get his approval; he expects a brief meeting with him but they end up talking all day long, including discussing roulette: here's where this book intersects a little bit with The Eudaemonic Pie.
Chapter 6: The Day of the Lamb
80ff Thorp presents his "beat the dealer" paper to a big crowd in DC (and to mockery from the casinos); is interviewed by Tom Wolfe for the Washington Post. He's pretty much nonplussed by all the fame and attention from this first paper. You also feel like what he really want is to prove that his theory worked in the real world; he also gets calls from some New York based multi-millionaires who want to bankroll him; ultimately he meets with Emmanuel "Manny" Kimmel from Maplewood New Jersey (the other wealthy businessman was Eddie Hand, from Upstate New York); he starts flying weekly to New York on Wednesdays to practice playing 10-count with him. "At the end of each session Kimmel would give me $100 or $150 to cover expenses and, curiously, a salami. These salamis added an unmistakable aroma to the cabin during my return flight." (!!)
88ff [It's interesting to see how he's fairly slow at getting up to speed with bet size and aggression; this is frustrating to his backers who are much bigger whales at gambling.] He bets "only at a level at which I was emotionally comfortable and not advancing until I was ready," this "enabled me to play my system with a calm and discipline to accuracy." He later transposes this into stock market investing later in his life. Note also how the casinos adapt to him and start shuffling decks sooner once they think he's using a system.
90 "...the Ten-Count System had shown moderately heavy losses mixed with 'lucky' streaks of the most dazzling brilliance. I learned later that this was a characteristic of a random series of favorable bets. And I would see it again and again in real life in both the gambling and the investment worlds." [Holy cow is he ever right.] See also page 96 "blackjack had still more to teach me, about both investing and how the world worked." [Another truism that explains why many investors become fascinated with casino games and vice versa.]
92ff Interesting how one of his backers insists on playing alongside him but doesn't have Thorp's emotional continence, he bets rashly and wildly.
93 Another iteration from the house: they start shuffling the deck every time he raises his bet size (!); [see also the very interesting footnote here for page 93 where Thorp realized later that he "would have had an advantage if I had started each deal with big bets, maintaining them if the count was good and causing the dealer to shuffle when it wasn't." This is exceptional second-order thinking right here, a very very interesting adaptive response to something unfair.]
94 About 30 man-hours of play yielded in $11,000 profit on a $10,000 bank roll with a peak drawdown of $1,300. [To adjust for inflation you could put a 10 or 12x multiple on this, not bad!]
Chapter 7: Card Counting for Everyone
97 He talks about cashing a $100 bill at the MIT cafeteria in 1961, likening it to a $1,000 bill today.
99 Thorp meets and works with an unnamed Harvard Law student using a blackjack method called end play, using single deck games dealt all the way down.
100 He realizes he has to learn much more about methods casinos use to cheat players; these things would inevitably happen to his readers. Many thoughts follow here and elsewhere in the book on breaking your play into shifts, making sure casino employees don't notice you, playing down the fact that you're winning, hiding your stack of chips, etc.
102 "Mathematically, interruptions [in blackjack play] didn't matter, because my lifetime of playing was just one long series of hands... This principle applies in both gambling and investing."
102ff Back to identifying times when he was cheated: some of the techniques involved "peek and second card dealing" ("An expert cheat or magician does this so well that even when you are told in advance and are watching close up, you can't see."); also "Cheating was so relentless during those days in Las Vegas that I spent as much time learning about the many ways it was being done as I did playing."
104ff He discovers that the Gaming Board of Nevada is corrupt; he's assigned a gaming control board agent to watch over him to protect him from cheating, but it turns out the guy was there to finger him for the casinos. "This trip taught me that while playing well, even with experts to warn me of dirty dealing, I could no longer openly win a significant amount." Worse: "Mickey McDougall told the gaming control board that he saw more cheating in Nevada casinos while watching my eight days of play than he had seen in all of his previous five years of working for the board. After his damning report he was never again asked to consult by them." See also in the 1960s tens of million dollars of cash were laundered through the counting rooms, likely to fund mob operations throughout the nation; card counters would be jailed on flimsy pretexts and their money would be taken, some were beaten up; since the 60s and 70s Nevada has cleaned up, cheating by casinos is rare. However casinos began using more and more "non-cheating" countermeasures; ejecting card-counting players, reshuffling more frequently, etc.
108ff "It was becoming clear that there was more to beating blackjack than counting cards and keeping cool as your bankroll went up and down. The green felt table was a stage and I was an actor on that stage. A card counter who wanted to be allowed to continue playing had to put on an effective act and present a non-threatening persona."
Chapter 8: Players Versus Casinos
112ff Other casino and player adjustments:
* Casinos introduced multi-deck shoes (although note that the High-Low system still worked, it didn't matter how many decks)
* Casinos would keep a shared photo gallery of "undesirable" players who were barred on sight.
* Players were forming informal networks: combining bankrolls; see also MIT's blackjack team with Tommy Hyland; see also the "Big Player" method: since if any player makes a big jump in betting it's a red flag to casino personnel, thus one solution was to make a signal to a team member who acted like a big drunk high roller who would make large bets but only when the deck was favorable.
117 Current casino surveillance involves facial recognition software and RFID chips to keep track of players' bets; also machines looking for patterns characteristic of the play of card counters in order to detect and eject these players.
118ff Thorp starts doing research into shuffling: one method is paying attention to where the aces are and what card follows it, this is called "Ace locating" and if you can do this for all four aces this can give you a powerful advantage. "Casinos typically use standardized shuffling techniques, which can be analyzed." You can also keep track of chunks of cards that are rich in aces and tens as they get redistributed in a deck.
119 He gets comped by the Las Vegas Wymm casino: free food, room and shows in return for not playing blackjack. [!!] And then Thorp discovers a new shuffle that would prevent shuffle tracking, but he keeps it to himself.
119 Nevada casinos were permitted to bar players but New Jersey casinos could not.
121 "Can an ordinary player still beat the game? My answer is a qualified yes."
Chapter 9: A Computer that Beats Roulette
124ff Thorp joins forces with Claude Shannon, they end up building wearable equipment not too different from the Eudaemonic Pie team, but many years earlier with much cruder equipment. They found a 44% average profit or benefit to the player. Shannon is a real kook and Thorp really loves working with him.
129ff They discovered the work of John Kelly and start using the Kelly Criterion bet-sizing strategy.
130 They discovered that a lot of Nevada roulette wheels are tilted: "half-chip [meaning half the thickness of a casino chip] and even one-chip tilts were common." This boosted their advantage.
130 Their system is way more effective than Doyne and Farmer's system!! It's also the first wearable computer and this is back in 1961.
133ff Again, the real problem is not beating the game per se, it's beating the game yet not being detected by the counterparty, the casino: it's an arms race with the casino itself to remain disguised, to not be detected, to win in a way that's carefully camouflaged, etc. The need for all this misdirection and disguise is really the gating factor. Note also that Nevada passed a very broad law limiting the use of any computers or equipment to predict outcomes in casinos.
135 There's a weird reference here "We met for the last time in 1968" but Claude Shannon didn't die until 2001: it makes you wonder if they had a falling out or something... there's no other discussion of him elsewhere in the book.
Chapter 10: An Edge at Other Gambling Games
136ff Thorp settles into New Mexico State University in Las Cruces, New Mexico, he meets a bunch of interesting people: Clyde Tombaugh, who discovered Pluto; Stanislaw Ulam, one of the designers of the H-bomb and co-discoverer of the Ulam-Teller concept [the conceptual design behind the H-bomb], etc.
137ff He tries his hand at calculating the odds of (and beating) baccarat; explanation of how the game works (sort of); a discovery that the opportunities come towards the end of a shoe, but their are not very many opportunities in baccarat; the house edge is greater as well. The only place they found a potential edge was in side betting; note also the deck has 416 cards, thus card counting is much more difficult.
139 How do you tell whether a mathematician is an introvert or an extrovert? If he looks at his shoes when he talks to you, he's an introvert. If he looks at your shoes, he's an extrovert.
141ff Disturbing anecdote about Thorp playing baccarat at a The Dunes Vegas casino in 1963: the casino places shill players at the table to coincidentally "open up seats" to maximize player enthusiasm; this casino stationed two shills on either side of Thorp once they figured out who he was. Also: "A baccarat table was twenty-five times as profitable as a blackjack table." It turns out this casino actually drugs his coffee once they see he has a system that works. They tried to drug him again the next night; then they ask him to leave; also it appears that someone tampered and tried to sabotage their car on the way home, jamming the accelerator. [Jesus]
Chapter 11: Wall Street: The Greatest Casino on Earth
145 "Gambling is investing simplified. Both can be analyzed using mathematics, statistics, and computers. ...Each requires money management, choosing the proper balance between risk and return. ... The psychological makeup to succeed and investing also has similarities to that for gambling. Great investors are often good at both."
146ff Clearly he married the right woman! He asked his wife Vivian "What were my mistakes?" with a specific stock that he had bought that got cut in half. She answers "First, you bought something you didn't really understand, so it was no better or worse than throwing a dart into the stock market list. Had you bought a low-load mutual fund [no-load funds weren't available yet then] you would have had the same expected gain but less expected risk." He also notes the arbitrary decision to want to get out at the [arbitrary and meaningless] price he paid (the psychological error of anchoring), and choosing an irrelevant criterion to sell.
149ff He learns other lessons: the fleeting nature of momentum investing; the dangers of leverage (he makes ill-founded bets on silver with 1/3 down); he learns about agency risk as he sees that salesman and promoters willing to lend to "help" him buy more of a commodity don't necessarily have his interests in mind; he's starts to believe that the academics were right in claiming there's no way to have an edge in the markets but "once again I decided to see for myself."
151ff He has a revelation when a pamphlet on warrants arrives in the mail [basically warrants are long-dated call options]; he comes up with the idea of hedging warrants, also at this point he moves to UC Irvine and has a colleague, Sheen Kassouf, who wrote a PhD thesis on warrant hedging. They would short overpriced warrants and hedge by going long the underlying common stock. He ends his collaboration with Sheen and then begins running hedged warrant and convert portfolios for friends and acquaintances.
Chapter 12: Bridge with Buffett
155ff The dean of UC Irvine's graduate school invests with Thorp, using money that he had invested in Warren Buffett's hedge fund (which Buffett was shutting down); this is 1968; also this guy invites Thorp and his wife to meet Warren Buffett and his wife.
157ff Non-transitivity: games like rock, paper, scissors or non-transitive dice, where the transitive rule [if A > B, and B > C, therefore A > C] does not hold, you find this in voting preferences,
162ff Interesting to hear the numbers he's talking about for the amount of capital he has in his investment partnership: only about $1.4m in 1969 dollars. Before he started his official partnership he was running $400k and earning about $20,000 a year from it, about the same as he earned at his job as professor. In the modern area you need at least $10m to run a one-man investment firm to make the numbers make sense, thanks to legal, accounting, bookkeeping requirements and other cost structures that come along with that. And if you think about it looking at the inflation we've had since 1969 (the author includes a CPI chart in the back of the book although it runs only to 2013), but if you extrapolate inflation forward from then, his $1.4m then is actually worth roughly $10m today, about the same.
165: Thorp also invests in Berkshire Hathaway thanks to having met Buffett.
Chapter 13: Going Into Partnership
166ff On his firm Convertible Hedge Associates, later he renames it [more felicitously] to Princeton Newport Partners, which specialized in hedging warrants, options, convertible bonds and preferreds, also working with other types of derivatives, designing hedges and inventing hedging techniques, it was a type of quant fund.
167 "Betting on a hedge I had researched was like betting on a blackjack hand where I had the advantage. As in blackjack, I could estimate my expected return, estimate my risk, and choose how much of my bankroll to bet." [The gigantic nuance here is in a casino a blackjack hand typically would have a $500 maximum bet, with a bankroll of $10,000; now he's got a $1.4 million dollar "bankroll" and can be betting 50k to 100k per hedge.]
170 Using the options pricing formula of French mathematician Louis Bachelier: Also on Einstein citing a paper from Robert Brown talking about Brownian motion, about pollen particles suspended in water, Einstein arrives at statistical properties to describe the random motion of these particles, which he translated to show proof that atoms and molecules were real. Note that these equations were the same essentially as Bachelier's equations five years earlier to describe the irregular motion of stock and options prices.
172 He anticipates the work of Fisher Black and Myron Scholes, who were motivated actually by his book Beat the Market; by using the US T-bill with the same expiration of a warrant expiration to discount it back at a riskless interest rate. Thorp says he started using the same formula earlier, in 1967, when Black-Scholes published the identical formula in 1972.
172ff His fund's performance is genuinely impressive! He outperforms the S&P in 1969, 1970 and 1971, then puts up a 12% return in 1972 (worse than the S&P which printed 18.5% that year); stable, steady returns regardless of the market backdrop. In 1973 his fund was up 6.5% with the market down 15.2% [!!] and in 1974 Thorp was up 9% up vs the S&P being down 27% [!!!]; also his fund had only one down month in 1974 (and even that was less than -1%) despite high volatility in the overall stock market, note also the 1973-74 correction was -48%. His fund never had a losing year and never had even a down quarter! [Holy cow.]
176 With the opening of the Chicago Board of Exchange Options Market and the standardization of options prices, he programs a computer to run his options pricing equation, Thorp then later finds that Black-Scholes were releasing a paper on their options pricing model (the same formula Thorp had already discovered from Bachelier and was already using), thus it was soon to be public knowledge and everyone would soon be using it. "Fortunately, this took a while. When the CBOE open for business we appear to be the only ones trading from the formula. Down on the floor of the exchange it was like firearms versus bows and arrows."
177ff On his wife's uncanny ability to judge people's character and check life stories for consistency. [I'm slow as hell, but am discovering this same thing: if you have a partner who can read the room and cross-check things/notice things while you're dealing with people, it's hugely helpful, it's like a superpower.]
181ff Interesting to see how his lifestyle starts to inflate as his investment partnership does better and better... and he takes himself right out of his circle of academic friends who he was closest to. I bet this is an all-too-common mistake.
182ff He gets involved in UC Irvine's academic bureaucracy and discovers why academics are so vicious [like the old joke "because the stakes are so small!"]. He can't believe the factionalism and backstabbing, the petty squabbles; he ultimately decides to leave academia.
Chapter 14: Front-Running the Quantitative Revolution
185 The CBOE starts trading put options in 1974.
186ff Interesting here: he was about to share a mathematical method for pricing American-style put options with Fisher Black, but he realized Black didn't know the answer/model at all, so he unobtrusively pulled the paper away because he wanted to use it for his investment partners. He realized that if Black didn't know the answer no one did, and realized this was a huge competitive advantage. Fascinating! Thorp had a variety of different edges like these until they were discovered by the academic world and then widely shared.
188 His fund was up tremendously, with stable and positive performance, from 1973 to 1976 when the S&P was roller-coastering down 36% and then up 61% for a net (compounded) gain of just 1%.
189ff Good basic explanation here of a convertible bond, combining a bond with an option to convert.
190ff Stress-testing: although Thorp pays more attention to the tail risks than typical VAR models, other discussions of risk; Thorp trafficking in gold, silver and copper; taking advantage of contango spreads, etc.
Chapter 15: Rise...
194 His fund's performance is amazing: up 409% over the 1970s versus +4.6% for the S&P; this works out to +17.7% per year gross and +14.1% per year after fees. Tremendous outperformance.
195ff They start getting into the prediction game, trying to look for indicators for the overall stock market, the kind of stuff that the team in The Predictors was working on, standard quantitative stuff.
196-7 The AT&T/Seven Sisters trade in 1983 is kind of staggering: Thorp put on $330 million in total exposure, netting (only?) a $1.6 million profit in two and a half months. I wonder about the true risk for a transaction like this?
198 Thorp's response to the 1987 crash is interesting: "Our investments were either safe, thoroughly protected by hedging as I believed them to be, or not." [Talk about binary! But I get it: a stock is either a zero or it's not.] He was already aware of academic finance's dependence on the assumption of normal distribution of stock prices and knew that stock prices were much noisier than that, that they had much fatter tails.
200ff Thorp's next move right after the 1987 crash is to arb the S&P futures with the S&P index itself (the arb spread had widened ridiculously right after the 87 crash; he had to browbeat his head trader into doing the trade, who was frozen with fear; the fund ends the month of October flat compared to the S&P down 22%.
202 Results were amazing for his fund: they crushed the S&P from 1969 to 1988, +22.8% annually before fees, +18.2% annually net of fees, versus +11.5% for the S&P. Wow.
Chapter 16: ...And Fall
204ff Giuliani raids Thorp's PNP offices in New Jersey in an effort to get info on Mike Milken. This first quote...
"In the middle of the day on Thursday, December 17th, 1987, about fifty armed men and women burst out of the third floor elevators to raid our office in Princeton, New Jersey. They were from the IRS, the FBI, and the postal authorities. Our employees were searched before they were free to leave the building. They were not allowed to return. The invaders impounded several hundred boxes of books and records, including Rolodexes. They dug through contents of wastebaskets and crawled through the ceiling spaces. It went on into the early-morning hours of the next day."
...explains clearly the overreach of power of the State--even in the 1980s, long before the current era of today's postmodern adminstrative state tyranny! You have to have backups of all your documentation, you can't leave anything valuable around that the Feds will take and then "lose" and so on. Another mistake Thorp's firm made was they had old audio tapes from the brokers' recorded lines that they failed to erase (it's standard to erase these once the trade settles, usually they're kept for just a few days after they're recorded).
205ff The story of the tapes leads to another story of a conflict they had with a Japanese brokerage firm that tried to screw them: it looks a lot like and analogy for how Vegas casinos screw successful blackjack players. Basically this brokerage firm refused to settle an error that they made, and if Thorp's firm sued they would refuse to do business with them... and they knew that the entire Japanese brokerage industry would therefore not do business with him either, thus then they wouldn't be able to do any of their transactions in Japanese-domiciled warrants and converts.
206ff Giuliani pulls out all the stops that prosecutors use: they subpoenaed Thorp's limited partners [!!!] (although it was never clear for what) just to disturb and upset his firm. Ultimately no one called any of the limited partners to testify, it was a bluff. Examples here also of the government and Giuliani's prosecution team withholding evidence from those they were attacking, imposing extensive legal costs, and creating other disruptions in his business because of this prosecution; he decided he had to wind down his firm and the partnership.
207ff The legal fees for his own guys were between $10 and $20 million, they ended up getting convicted under RICO statutes, but then some of the convictions were thrown out by an appeals court after the DOJ decided to rein in racketeering cases; later a judge vacated many of the fines and prison terms.
209ff Interesting take here from Thorp on the whole Drexel/Milken prosecutions and who the real powers were behind it and what really happened; his take on it is not wrong! Giuliani was hoping to be like Thomas E. Dewey, who used prosecutions of bootleggers to get to the Governorship of New York (and almost to the presidency); [see of course Elliott Spitzer, who used the same gambit to actually get to the governorship, until he was outed as "client number nine"].
211ff Thorp cites Citadel Investment Group, saying that had he not shut down his firm due to pressure from Giuliani that his firm could have been the same size at Citadel. Note also Thorp was Citadel's first limited partner! He decides to shut down the firm for good and finds places for his good people at firms like D.E. Shaw.
Chapter 17: Period of Adjustment
213 On recognizing you have "enough" and spending time living.
213ff Thorp discovers Bernie Madoff's fraud way back in 1991! He was retained by a "well-known" consulting firm to review their hedge fund investments; he does all the right things to find out: he goes to meet the firm (they won't let him in the door), he learns the accountant and auditing firm is a friend of Madoff (huge red flag) and also is a one-man shop (gigantic red flag), and then he analyzes the consulting firm's statements to get a transaction record and determines that many of the trades never actually happened; he sees the smoke and concludes that Madoff's firm was fraudulent. [This is standard due diligence, all firms should do this, but as we saw from the firms who invested with Sam Bankman-Fried's Alameda, not everybody does their proper due diligence].
215 Notice the rhetoric that Thorp has to use with this client to convince them to pull their money from Madoff: the client argues that if Thorp is wrong he would sacrifice his best investment, while Thorp says basically "I have proven from public records that trades never happened" and likewise that if he ignored this his job would be at risk. That latter comment was what was persuasive, that is what is always persuasive unfortunately. People don't get it unless they see their job at risk or their reputation at risk in a tangible, visible, salient way.
216 The SEC looks like a bunch of clowns here, a total Fourth Turning-caliber institution, they slept on many, many warnings and obvious clues. Note that under Gary Gensler, the SEC might be even worse today than ever.
219 Thorp also rethinks the nature of giving opinions to people when he had warned another guy about Madoff but he didn't listen. [I see this rethinking happening in my own head with the people I have (unsuccessfully) tried to warn away from the novel mRNA therapies.]
220 Dialing things back a little bit, Thorp talks about Bruce Kovner, who he met back in the 1980s; they formed a partnership to buy an oil tanker when they were in huge oversupply: they got an older tanker for about scrap value, looking at it as a type of free option; a few years later it was shipping oil, this partnership owned the ship Empress Des Mers and produced a 30% annualized return for nearly 20 years and was ultimately scrapped in 2004 for 23 million "far more than her purchase price of $6 million." [Note that these ships now cost $100 million dollars, double-hulled, using low-sulfur fuel, etc. Tankers can crush you if you are in the wrong part of the cycle, but they might make you wealthy in the right part of the cycle...]
221ff Interesting examples here of the foolishness of haggling over prices for real estate and businesses and alienating the counterparty with in-your-face tactics.
224 On "satisficing" versus maximizing; also the "secretary problem" or the "marriage problem" in mathematics: "Assume you will interview a series of people, from which you will choose one. Further, you must consider them one at a time, and having once rejected someone, you cannot reconsider. The optimal strategy is to wait until you have seen about 37 percent of the prospects, then choose the next one you see who is better than anybody among this first 37 percent that you passed over. If no one is better you are stuck with the last person on the list." Thorp actually gave a talk on this back during his PhD studies and he called the title "What Every Young Girl Should Know" and the auditorium was packed!
Chapter 18: Swindles and Hazards
226 "...bigger stakes attracted bigger thieves." On Wall Street being even dirtier than the casino industry.
229 The author justly criticizes EMH in light of scandals and scams; and then reveals a fascinating example of the embarrassing emotional incontinence of Eugene Fama, the father of the theory.
230 On high frequency trading; HFT traders basically get an early look at order flow by a few milliseconds and can front-run it, this is sort of like a sandwich attack in cryptocurrency.
231 Also pointing out most fluctuations in the stock market don't have "reasons" as typically claimed by financial media, most stock market moves are statistical noise.
Chapter 19: Buying Low, Selling High
233ff On his statistical arbitrage program which started in 1992 and has been running for eight years (now it's 2000 in the narrative here). Whenever any company has some unexpected announcement, a merger or news, he tells the computer to put the stock on a restricted list to close it out or don't initiate a new position. Also interesting that they're paying 0.16 cents per share for commissions (even though this is in the waning days of nickel-a-share institutional trading in those days). Note that the volumes these guys are running through the brokers is huge, something like $54 billion of trading volume a year. [!!] Basically this is like card counting but on a much larger scale.
***236 A good example of avoiding academic/ludic laziness here: instead of asking "is the market efficient?" Thorp rather asks "in what ways and to what extent is the market inefficient and how can we exploit this?" The lazy academic would just say the market is efficient, he wouldn't "check for himself" and see.
237 Their initial indicator was a type of mean reversion in stock prices, stocks that went up a lot over a recent period would do worse in the following period and vice versa; "most up" and "most down" heuristics; see also Gerry Bamberger at Morgan Stanley who developed something similar in the 1980s: his boss took credit for his work, so he resigned...and Thorp hired him.
240 Note that all these models gradually fail, the returns get exploited away or they wane somehow. Morgan Stanley expands their exposure to this statistical arbitrage and allegedly loses money starting in the late '80s.
240 D.E. Shaw appears here as well, he and Thorp's company almost put together an investment firm but Thorp decided that he already had a good enough stat-arb product on his own. Shaw went on to start his firm, and also hired Jeff Bezos before he left to start Amazon.
241 Interesting also on his decision to "enough" and cut back his activity, reduce the complexity of his organization, wind it down, only do investing that can be done with a small staff, etc.
241 Also a blurb here about Morgan Stanley: no one at Morgan Stanley even knew who started statistical arbitrage at their firm: the name Jerry Bamberger was completely erased from their organizational memory. [But don't worry, your corporation really, really cares about you and your family!!]
243 I really admire his sense of fiduciary duty to his co-investors in his funds, something you don't often see with hedge funds.
243 Also see Thorp's take on Long-Term Capital: he saw the magic behind stat-arb positions being liquidated because they were liquid and easily sold in a situation of "sell the good to fund the bad." In stark contrast with Andrew Lo, Thorp, as an "applied academic" could tell right away that it was likely a liquidation when the stock market moved erratically.
244 Note also that he's running a very lean fund with six people, yet running $400 million with really good performance in his fund, Ridgeline Partners. He closes this fund down in 2002 after ten great years of performance, as he notices returns declining as others start to pour money into similar strategies. Once again he recognizes the value of "enough."
Chapter 20: Backing the Truck Up to the Banks
246ff This chapter is about the mutual savings and loan association banks that underwent conversions to publicly traded entities starting in the 1990s, the so-called "thrift conversions." "The depositors owned the association 'mutually,' which meant that the business value that built up during operation was also 'owned' by the depositors. As time passed, depositors came and went, but upon leaving they left their share of the business behind. No mechanism existed for extracting this value."
247ff Describing the mechanics of the process, also the various agency problems as depositors had priority for getting IPO shares but the insiders, officers directors and employees had even more priority, which let them capture some of the depositor's value, this is also an incentive for management to decide to convert to a publicly traded entity in the first place.
248ff Once you get your allotment of shares, you can flip for a 10-25% (and sometimes 50%) profit in the short run, or you can hold and let the company earn even more proceeds off of the new influx of capital.
249"I visualized opening accounts as planting acorns in the hope of getting a crop of oak trees. Only these were strange acorns. They could lie dormant for months or years, perhaps forever; but once in a while, at random, a mighty tree of money would explode out of the ground. Was this 'farm' worth operating?" Here he goes through a discussion of opportunity cost; the foregone interest or returns on money deposited at these institutions; the fact that other people would participate alongside them and capture some of these gains as well; there were costs to go to all these individual banks to make deposits; also administrative and bandwidth costs as well--all things worth thinking about for sure when it comes to making an idiosyncratic investment like this!
Chapter 21: One Last Puff
251ff This chapter discusses Thorp's investment in Berkshire Hathaway which did extremely well; he didn't know about the company until 1983, by then it had already gone up from 42 to 900. Thorp bought his first shares at 982.50.
252ff Comments on the frustrating behavior of many people with whom he discussed BRK stock, but who never bought it.
254ff Thorp does a good job here summarizing BRK's business in a few paragraphs. Also note the gradual diminishing of Buffett's "edge" as the company grows larger and larger.
257 On the benefits of talking to hedge fund managers to get some new investing ideas.
Chapter 22: Hedging Your Bets
258ff On the hedge fund industry; on hedge fund structure; how returns are poor, declining and likely exaggerated because of survivor bias and reporting bias, etc; also on different categories and genres of hedge funds; techniques used to "salt" returns: examples include running a fund with a startup period where fund managers can stuff a very small fund with hot IPOs that skew the results massively positively; also on how sometimes a fund manager will cherry-pick his fund's best ideas and put them into his own assets, which leaves the second-best ideas for his fund; charging expenses to the partnership, etc.
265ff Thorp was offered a chance to invest in LTCM but declined: he thought John Meriwether was too big a risk-taker and the academics behind the partnership were lacking in street smarts. Note also that after Meriwether blew up LTCM he blew up yet again with another fund that he started years later: in 2008 he was down 42% and closed his fund in 2009; then he started yet another fund in 2010, all while retaining his teaching sinecure at Harvard. Note also that Myron Scholes started a new fund later as well.
Chapter 23: How Rich Is Rich?
267ff Prosaic musings here on wealth tiers, what a million dollars is worth, saving and investing, personal finance tips, etc., also on liquidity costs and losses from transaction costs if you try to sell, say, art that you own or an expensive car, etc.; on the difference between "apparent wealth" and the actual wealth you get after transaction costs when you liquidate.
Chapter 24: Compound Growth: The Eighth Wonder of the World
277ff Somewhat more useful (but still prosaic) personal finance advice here; amusing story of 51-year-old IRS auditor Anne Scheiber: after 23 years working for the US government, she retired in 1944 and put her savings of $5,000 into the stock market; living frugally and reinvesting her dividends she died in 1995 at age 101 with a $22 million estate (!); other standard examples of compounding like human population; The Rule of 72; thoughts on the comparative value of time, money and health; on the proper use of your time; balancing the cost of living with commuting time and thinking of it in terms of a value per hour, also offset by the cost of vehicle, etc; on thinking of the cost of watching television as junk time that's wasted; also here's yet another reference in yet another book about the fucking Stanford marshmallow experiment.
Chapter 25: Beat Most Investors By Indexing
282ff [Most of this chapter has been far better explained in any of Jack Bogle's books about the mutual fund industry.] Bill Sharpe getting Thorp to think about the fact that everybody's holdings, in aggregate, replicate the index; on trading costs, market impact costs; Buffett calls those who pay these costs "helpers" for those who index or buy and hold; On tax costs when you sell.
***287 Also note the idea of how mutual fund gains/losses are distributed late in the year: you can "harvest" this by buying a loss-making fund just before the distribution/loss announcement, get the taxable "loss" and yet miss the losses themselves. [!!!]
Chapter 26: Can You Beat the Market? Should You Try?
290ff "What appears random for one state of knowledge may not be if we are given more information." On knowing about what cards have come out of a deck, or knowing that stock prices may not be random as you may think. Criticisms of EMH: it's not really a theory so much as a description of reality that isn't even that accurate, and there are plenty of instances where it fails.
292ff On investing in closed-end funds at prices well below NAV; also noting that EMH does not explain closed-end fund discounts fluctuating; see also SPAC arbs based on timing/closure; the 3Com and Palm arb: note here that there weren't enough Palm shares to short to really fully put on this hedge.
298ff Addressing the claims of the EMH hypothesis one by one:
1) "Information is instantly available to many": in reality it's available to a few at first and then spreads, sometimes taking minutes, sometimes taking months, the first people to act on the information capture the gains.
2) "Participants are rational": in reality we are financially rational only in limited ways.
3) "Participants instantly evaluate all relevant information and determine fair prices of securities": in reality we only have some of the relevant information and there's a spectrum of processing and analyzing ability across investors.
4) "New information causes prices to adjust immediately": in reality price adjustments happen over minutes, hours or months [and can be recursive themselves!].
Chapter 27: Asset Allocation and Wealth Management
302ff A list of major asset classes and subclasses; warnings about chasing results/chasing returns and how costly it can be; on drawdowns: "Many investors do not want the level of risk involved in common stocks or real estate, where the high overall returns are interrupted by savage reductions in wealth." On the costly preference for realized income (dividends and interest) rather than total returns, which includes capital gains (much more tax efficient, gains are taxed only when realized, etc., but this form of gains feels less real to people).
305ff Looking at the P/E ratio of the S&P 500 in terms of a flipped fraction, the earnings yield; E/P expressed as a percentage (thus a 20 PE is a 5% earnings yield) and comparing that to benchmark bond yields and then rebalancing accordingly. Avoiding story stocks, or at the least avoiding the valuation premium that comes with story stocks. Eras in which the US stock market has done well versus poorly, see the 1970s versus the post-1987 boom. Noting that most real estate in the form the your home you live in tends to appreciate at low rates, only slightly more than inflation.
307ff On stocks and how they allow tax loss selling as well as tax gain deferral. Also the long-term capital gains rate is much lower than short-term capital gains rates. Thus if you have a profit in a stock, wait a year, but if you have losses you can recognize those right away--they're more valuable than long-term losses.
***308ff Comments here on lack of liquidity for hedge fund investments, Thorp realized in 2008 many repercussions of the great financial crisis, and so he issued partial withdrawal notices to several hedge funds in which he was invested; [it's interesting here that he got shaken out at the bottom because these funds paid out after the notification period which was at much lower prices.] "Because you can't get out in time when trouble is coming, the excess returns you expect from illiquid investments may be offset by the economic impact of unforeseen future events."
310ff Back to the Kelly Criterion for bet sizing; avoiding ruin; although note that strict Kelly Criterion rules can lead to wide swings in wealth; also in the real world you're not going to exactly know the probabilities of payoffs nor the payoffs themselves when it comes to equity investments (like you would for a blackjack hand); the Kelly system works much better in known payoff games like casino games; Also on taking advantage of times where you have a genuine edge.
311ff On safe withdrawal rates/spend rates: Thorp considers a 2% withdrawal rate as a limit.
Chapter 28: Giving Back
313ff Thorp and his wife structure an endowment of a mathematics chair at UC Irvine; he goes through how he specifies all the stuff in the endowment agreement to keep the University from straying from the point of his bequest! They donated appreciated class A shares of Berkshire Hathaway.
315 Interesting side point here on the durability of universities: since 1520 only 85 institutions have remained continuously in existence, 70 of them are universities. [Interesting. I wonder about the survivor bias or other possible illusions behind this statement?]
316ff Sidebar here on Bill Gross; his car accident, his discovery of the book Beat the Dealer and his time spent in Vegas practicing the techniques, how it set the stage for his investing career, his first job at Pacific Mutual and then co-founding PIMCO, then he and Thorp as well as some others funded a stem cell research facility in California. [Notably here there is absolutely no mention of Bill Gross's later controversies which were well known by the time this book came out, and include some hilarious and embarrassing allegations of him contaminating his wife's house with canisters of "fart smell"--yes this actually happened--his wife, an amateur painter, painting a copy of a jointly-owned Picasso and putting the copy in his house, and various other sordid things that came out of their vicious divorce conflict.]
Chapter 29: Financial Crises: Lessons Not Learned
319ff Comparing leverage used in the stock market in the 1920s with leverage used in the housing market in the 2000s. Then a review of the lead-up to the great financial crisis, something that is better explained (and certainly more entertainingly explained) in the book The Big Short. Then a discussion of some of the instruments used in real estate like CMOs, CDOs and CDS. On CMO risks, Thorp properly notes the dual risks of prepayment rates as well as default rates.
328ff On AIG structuring credit default swaps in a subsidiary without collateral.
333ff Agency problems with modern corporate CEOs; on management extracting more value than they deserve; surrounded by chosen self-prepetuating boards of directors; super-voting shares, etc.
Chapter 30: Thoughts
335ff On the value of education, being self-taught/an autodidact; on the importance of understanding probability and statistics; Thorp teaches the treasurer of his homeowners association the idea of laddering treasury bills held in the HOA capital fund; thoughts and ideas about the complexity of the tax code and his solutions.
To Read:
***William Poundstone: Fortune's Formula
***Connie Bruck: Master of the Game
Mark Stuart: Gangster #2
Ed Thorp: Beat the Dealer
Ed Thorp and Sheen Kassouf: Beat the Market
Mickey McDougall: Danger in the Cards
Russell Barnhart: see his several books on gambling
Agnes Keith: Three Came Home: A Woman's Ordeal in a Japanese Prison Camp
Eric Morris: Corregidor: The American Alamo of World War II
Joseph Bulgatz: Ponzi Schemes, Invaders from Mars and Other Extraordinary Popular Delusions