Dr Ed Thorp, born in 1932, tells his incredible life story1. After starting out as an American mathematics professor, he soon became a very successful quantitative hedge fund manager as well as a blackjack and roulette player.
His Principal Newport Partners (PNP) hedge fund outperformed the S&P500, on a gross basis, by about 9% per annum from 1969 to 1988, without one negative year. His XYZ statistical arbitrage fund outperformed the S&P500 by 10.4% per annum for the ten year period 1992 to 2002, on an unleveraged basis.
In the book’s Foreword, Nassim Taleb’s divides practitioners of mathematical finance into two groups. Dr Thorp pioneered the information theorists group who successfully apply theories such as the Kelly Criterion and option pricing models to financial markets. Opposed to this are the followers of “impractical” academic theories such as the utility theory and the capital asset pricing model, with Long Term Capital Management (LTCM) a case in point.
The book is filled with practical wisdom. As Dr Thorp describes his career, he explains the insights he came to while putting his theories to work. He imparts valuable advice on a broad range of topics including his approach to investing, managing market risk, investing in hedge funds, how to protect and generate wealth for the long term and how to set up a successful charitable endowment. He gives a detailed critique of the efficient market theory and he also discusses the strategies he used in the hedge funds he ran. I will devote a future post relaying his wisdom and advice on these topics.
How does one lead a fulfilled life? Or, in Dr Thorp’s words: ”Is the winner really the one who dies with the most toys?” Dr Thorp deals with this question frequently as his life story unfolds. I do get the impression that he continuously had to refrain himself from getting caught up with “success as measured by Wall Street”. Instead, he believes success is having the best life and therefore “it matters what you do and how you do it, the quality of time you spend, and the people you share it with.”
Dr Thorp also advocates for fairness and merit in life and markets throughout his book. For example, he treated the limited partners in his hedge funds, as he would have liked to be treated if he were in their shoes. Unfortunately, he does not discuss his views on fairness with regards to concluding transactions.
For, example, is it fair to take a concealed “wearable computer” into a casino to play blackjack? Likewise, in some of his financial market transactions which he discusses, there might have been an asymmetry of information. This is the altruistic active investor’s conundrum which I mention on my About page. Dr Taleb deals with this issue in his Medium post: “Why Each One Should Eat His Own Turtles: Equality in Uncertainty”.
Also, Dr Thorp discovered the Bernard Madoff fraud early in 1991 during a due diligence. It is unclear from the book how much effort he put in to bring this to the attention of the SEC and the wider market.
The book broadly consists of four parts.
Dr Thorp grew up during the Great Depression and the hardships endured during these times stayed with him throughout his life. Although his parents were poor and worked long hours they valued books and instilled in him a love for reading. His father taught him arithmetic from a very young age.
Dr Thorp’s 12 years of pre-college schooling was difficult as he considered himself to be a misfit in a high school where physical ability was more important than academics and brains.
Despite the fact that graduates from his school were not expected to go to College, Dr Thorp gained his PhD in mathematics from the University of California, Los Angeles in 1958.
The second part of the book tells the story of how he got interested in the theoretical aspects of gambling. He went to great lengths to calculate the results of his mathematical analysis of blackjack on early mainframe computers. He also relates his joint project with Claude Shannon to built the first “wearable computer” used for calculating a roulette ball’s trajectory. Dr Thorp’s accounts of how these theories were put into practice are highly entertaining. He wrote a book on this, called “Beat the Dealer”2.
Noteworthy is that Dr Thorp was first to use the mathematically sound Kelly Criterion to determine bet sizes. He is a co-editor of a recent theoretical book on the topic3.
The practical experience he got from gambling was valuable to him in becoming successful as a hedge fund manager. It taught him how to use probability as well as discipline when managing investments. Moreover, participants often do not play by the rules of the games and in the financial markets he encountered a far greater scale of dishonesty.
Dr Thorp met Warren Buffett through a mutual acquaintance. He recounts that Mr Buffett influenced him in two ways. Firstly, it helped him to move along the path to his own hedge fund. Secondly, it gave him the insight to make a very profitable investment in Berkshire Hathaway. However, in contrast to Mr Buffett, Dr Thorp was not interested in the fundamental worth of businesses, but rather in using his mathematical skill in finding relative mispricing among securities.
In the third part of his book, Dr Thorp covers his career in the financial markets. Initially, Dr Thorp was intrigued by the mathematics of valuing warrants. He described his valuation methods in his 1967 book “Beat the market”, co-authored with Sheen Kassouf. Later in 1967, by applying Occam’s razor, he made a major breakthrough to come up with a formula for pricing warrants and options “correctly”. He used this knowledge to start trading mispriced warrants and options profitably. In 1969 Fisher Black and Myron Scholes published the identical formula, called the Black-Scholes equation, which was motivated in part by “Beat the market”4.
In 1969 Dr Thorp launched PNP, the first ever quantitative market-neutral hedge fund. The fund traded in warrants, convertible bonds, convertible preferreds and their associated stocks, with valuations based on Dr Thorp’s theoretical pricing models.
PNP closed in 1988 when it got caught up in the government’s case against Michael Milken and Drexel Burnham for violation of security laws. A number of PNP’s employers, including Dr Thorp’s principal partner, were also charged, but later cleared of any wrongdoing.
The final part of the book is more general. Dr Thorp expands on his life philosophy and discusses his charitable endowment. He also gives his opinions on life, politics and economics. For example, he is of the view that the dominant political and economical power in the US resides in the group, which he calls “the politically connected rich”.
For Dr Thorp’s wisdom and advice refer to my following post. Also, refer to a recent interview with him on The Investor’s Podcast and William Poundstone’s book “Fortune’s Formula”5 explaining how Ed Thorp and Claude Shannon applied the Kelly Criterion to gambling.
1Thorp, Edward O. (2017). A Man for All Markets. One World Publications.
2Thorp, Edward O. (1966). Beat the dealer. Vintage Books.</span.
3MacLeane, Leonard C., Thorp, Edward O., Ziemba, William T. (eds) (2012). Kelly Capital Growth Investment Criterion: Theory and Practice. World Scientific Handbook in Financial Economics Series Paperback.
4Thorp, Edward O, Kassouf, Sheen T. (1967). Beat the Market: A Scientific Stock Market System.
5Poundstone, William (2005). Fortune’s Formula. Hill and Wang