Published in: 2017
Edward Thorp is the MIT professor who solved blackjack, roulette and baccarat and won over Las Vegas. At the age of 32, he went on to Wall Street to outperform the stock market for the next 30 years. Through his company Princeton Newport Partners, Thorp did arbitrage with shares, warrants, options and convertibles and showed positive results every quarter for a period of 20 years. The annualized return was 19.1% (compared to the S&P 500 10.2%). He then started Ridgeline Partners, which had an annualized return of 21.0% for the next ten years.
IDENTIFY INEFFICIENCIES, EXPLOIT & REPEAT. Thorp’s career can be divided into phases; (1) he identified a game with a theory that it was “beatable”, (2) he learned how to beat it, (3) he practiced it and made a fortune and (4) moved on when the inefficiency disappeared. Thorp was driven by intellectual curiosity rather than money.
“We did not ask: ‘Is the market efficient, but rather, in what ways and to what extent is the market inefficient? And how can we exploit this?”
MENTAL MODELS AND RATIONALITY. Thorp learned early on to think not only in pictures, words or numbers but also in models – simplified versions of reality. He strives to be constantly rational in all aspects of his life. For example, he refrains from taking a position on any topic or issue before he can make a decision based on facts. Another example is that he considers it important to keep track of his hourly wage and to strive to outsource the services that have a lower cost level – it is like time repurchases below market value.
PERFORMANCE BEFORE PERFECTION. According to Thorp, gambling is an excellent entrance into asset management. You learn to control your emotions, calculate odds, solve logical problems and stick to your strategy. He believes that an imperfect solution that can be used in practice is better than a perfect solution that is difficult to implement in practice. The strategy he used to beat blackjack was not the most effective he developed, but it was easy to apply and had enough of an edge.
START SMALL AND SCALE UP. When Thorp took on a new “game”, he always started with small bets that he was emotionally comfortable with. He did not raise the stakes until he was comfortable with the system and the betting process. He adopted this approach in Las Vegas as well as on Wall Street.
“I was lucky in that I came at investments through blackjack tables. And the blackjack tables are an amazingly good training ground for learning how to invest, how to think about investments, how to manage them. And the reason is that they teach you, on the one hand, to use probability and statistics to evaluate things. And on the other, they teach you discipline.”
PURSUE YOUR EDGE. Thorp’s strategies for gambling and investing had many similarities. He was looking for a small edge to exploit over and over again. In this way, the “law of great numbers” guaranteed that he would win over time. He used Kelly’s formula (a formula for theoretically optimal bet size) to optimize betting levels. Thorp believes, however, that it is important to constantly question one’s edge. Competitors are adapting and markets are changing. It is important to continue to develop and ensure that one’s strategies remain relevant.
DO NOT SKIMP ON THE SPREAD. Thorp questioned his traders who boasted that they “scalped” the spread when they traded. He claimed that they earned $0.25 ten times and lost $10 once – a calculation he did not like. Traders only saw what they earned from the stingy bids and did not think about the opportunity cost the times the stock was not traded down.
THE GOAL IS PEACE OF MIND. After his time in the financial industry, Thorp realized the value of independence. It is much less stressful to only do your own business than to run a large fund with powerful clients who question your decisions. Thorp believes that one should construct their activities with the goal of having peace of mind. Then you are most clear-minded and the happiest. He believes that what is most important in life is how you spend your time and the answer to that question depends on where you are in life and where you want to be in life.
“When I was 35, I had lots of time and less money, so doing 10% or so better than the index, with little risk, was attractive and fun. At 85, the marginal value of time is higher, and the marginal value of money is lower. These are strong disincentives when I can make a long-run 10% or so by doing nothing.”