Transcript
Introduction
Ed Thorp's memoir reads like a thriller, mixing wearable computers that would have made James Bond proud, shady characters, great scientists, and poisoning attempts. The book reveals a thorough, rigorous, methodical person in search of life, knowledge, financial security, and not least of all, fun. Thorp is also known to be a generous man, intellectually speaking, eager to share his discoveries with random strangers. Yet, he is humble. He might qualify as the only humble trader on planet Earth. So unless the reader can reinterpret what's between the lines, he or she won't notice that Thorp's contributions are vastly more momentous than he reveals.
Why? Because of their simplicity, their sheer simplicity, for it is the straightforward character of his contributions and insights that made them both invisible and academia and useful for practitioners. My purpose here is not to explain or summarize the book. Thorp, not surprisingly, writes in a direct, clear, and engaging way, “I am here as a trader and a practitioner of mathematical finance to show its importance and put it in a context for my community of real-world risk-takers”.
That context is as follows: Ed Thorp is the first modern mathematician who successfully used quantitative methods for risk-taking, and most certainly, the first mathematician who met financial success doing it. Thorp's method is as follows. He cuts to the chase in identifying a clear edge. That is something that in the long run puts the odds in his favor. The edge has to be obvious and uncomplicated. For instance, calculating the momentum of a roulette wheel, which he did with the first wearable computer and with no less a co-conspirator than the great Claude Shannon, father of information theory. He estimated a typical edge of roughly 40% per bet. But that part is easy, very easy.
It is capturing the edge, converting it into dollars in the bank, restaurant meals, interesting cruises, and Christmas gifts to friends and family. That is the hard part. It is the dosage of your betting, not too little, not too much, that matters in the end. For that, Ed did great work on his own before the theoretical refinement that came from a third member of the information trio, John Kelly, the originator of the famous Kelly criterion, which is a formula for placing bets that we discuss today because Ed Thorp made it operational.
A bit more about simplicity before we discuss dosing. For an academic judged by his colleagues rather than the bank manager of his local branch or by his tax accountant, a mountain giving birth to a mouse after huge labor is not a very good thing. They prefer the mouse to give birth to a mountain. It is the perception of sophistication that matters. The more complicated, the better. The simple doesn't get you citations that bring the respect of university administrators as they can understand that stuff, but not the substance of real work.
Ed was initially an academic, but he favored learning by doing with his skin in the game. When you reincarnate as a practitioner, you want the mountain to give birth to the simplest possible strategy and one that has the smallest number of side effects, the minimum possible hidden complications. Ed's genius is demonstrated in the way he came up with very simple rules in blackjack.
Instead of engaging in memory-challenging card counting, something that requires one to be a savant, he crystallizes all of the sophisticated research into simple rules. Go to the blackjack table, keep a tally, start with 0, add 1 for some strong cards, minus 1 for weak ones and nothing for others. It is mentally easy to just bet incrementally up and down, bet larger when the number is high, smaller when it is low. And such a strategy is immediately applicable by anyone with the ability to tie his shoes or find a casino on a map.
Now, money management, something central for those who learn from being exposed to their own profits and losses. Having an edge and surviving are 2 different things. The first requires the second. As Warren Buffett said, "In order to succeed, you must first survive”. You need to avoid ruin at all costs. Thorp's ideas were rejected by economists in spite of their practical appeal because of economists love of general theories for all asset prices, dynamics of the world, et cetera.
The famous patriarch of modern economics, Paul Samuelson, was supposedly on a vendetta against Thorp. Not a single one of the works of these economists will ultimately survive. Strategies that allow you to survive are not the same thing as the ability to impress colleagues. So the world today is divided into two groups using distinct methods.
The first method is that of the economists who tend to blow up routinely or get rich off collecting fees for managing money, not from direct speculation. Consider that long-term capital management, which had the crème de la crème of financial economists and blew up spectacularly in 1998, losing a multiple of what they thought the worst-case scenario was.
The second method that of the information theorists as pioneered by Ed is practiced by traders and scientist traders. Every surviving speculator uses explicitly or implicitly this second method. I said every because those who don't will eventually go bust. Some additional wisdom I personally learned from Thorp, many successful speculators after their first break in life get involved in large-scale structures with multiple offices, morning meetings, coffee, corporate intrigues building more wealth while losing control of their lives, not Ed. After the separation from his partners and the closing of his firm for reasons that had nothing to do with him, he did not start a new mega fund. He limited his involvement in managing other people's money.
But such restraint requires some intuition, some self-knowledge. It is vastly less stressful to be independent, and one is never independent when involved in a large structure with powerful clients. It is hard enough to deal with the intricacies of probabilities you need to avoid the vagaries of exposure to human moods. True success is exiting some rat race to modulate one's activities for peace of mind. Thorp certainly learned a lesson. The most stressful job he ever had was running the math department of the University of California, Irvine. You can detect that this man is in control of his life. This explains why he looked younger, the second time I saw him in 2016 than he did the first time in 2005.
That was Nassim Taleb writing in the forward of the book that I just re-read and the one I'm going to talk to you about today, which is A Man for All Markets: From Las Vegas to Wall Street, How I Beat the Dealer and the Market, and was written by Ed Thorp. This is the autobiography of Ed Thorp.