A Man for all Markets by Edward O. Thorp

Author: Edward O. Thorp

Keywords: biography, casino, investing, gambling,

Review: 9 / 10

Opinion: Edward Thorp has many hats: MIT professor, inventor of first wearable computer, professional card counter, and finally money manager. Most people compare how markets resemble casinos. Well, Thorp, while from academia, is practitioner; he first beat casinos, and then Wall Street - using statistical techniques to identify and exploit pricing anomalies in the markets.

Highlights:

• "...the surest way to get rich is to play only those gambling games or make those investments where I have an edge." (A clear edge is something that in the long run puts the odds in your favor. The edge has to be obvious and uncomplicated).

• "In order to succeed you must first survive" Warren Buffet. You need to avoid ruin, at all costs.

• "For bet sizing in favorable games, Shannon suggested I look at a 1956 paper by John Kelly. I adapted it as the guide for bets in blackjack and roulette, and later in other favorable games, sports betting, and the stock market. For roulette, the Kelly strategy showed that it was worth trading a little expected gain for a large reduction in risk by betting on several (neighboring) numbers, rather than a single number."

• "As I finally had some capital from playing blackjack and from book sales, I decided to let it grow through investing while I focused on family and my academic career. I bought one hundred shares at $40 and watched the stock decline over the next two years to $20 a share, losing half of my $4,000 investment. I had no idea when to sell. I decided to hang on until the stock returned to my original purchase price, so as not to take a loss. This is exactly what gamblers do when they are losing and insist on playing until they get even. It took four years, but I finally got out with my original $4,000. Fifty years later, legions of tech stock investors shared my experience, waiting fifteen years to get even after buying near the top on March 10, 2000... I asked, “What were my mistakes?”“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... My second mistake in thinking, my plan for getting out, which was to wait until I was even again. What I had done was focus on a price that was of unique historical significance to me, only me, namely, my purchase price. Behavioral finance theorists, who have in recent decades begun to analyze the psychological errors in thinking that persistently bedevil most investors, call this anchoring (of yourself to a price that has meaning to you but not to the market). Since I really had no predictive power, any exit strategy was as good or bad as any other. Like my first mistake, this error was in the way I thought about the problem of when to sell, choosing an irrelevant criterion—the price I paid—rather than focusing on economic fundamentals like whether cash or alternative investments would serve better.

• "My individual investors were among our first partners; Regan found more money by going to the courthouse, getting lists of limited partners from documents that had been filed by other hedge funds, and cold calling." (on developing new client prospects)

• "The Compustat database provided historical balance sheet and income information. Of the scores of indicators we systematically analyzed, several correlated strongly with past performance. Among them were earnings yield (annual earnings divided by price), dividend yield, book value divided by price, momentum, short interest (the number of shares of a company currently sold short), earnings surprise (an earnings announcement that is significantly and unexpectedly different from the analysts’ consensus), purchases and sales by company officers, directors, and large shareholders, and the ratio of total company sales to the market price of the company. We studied each of these separately, then worked out how to combine them. When the historical patterns persisted as prices unfolded into the future, we created a trading system called MIDAS (multiple indicator diversified asset system) and used it to run a separate long/short hedge fund (long the “good” stocks, short the “bad” ones). The power of MIDAS was that it applied to the entire multitrillion-dollar stock market, with the possibility of investing very large sums."

• On cognitive dissonance. "That’s where you want to believe something enough that you simply reject any information to the contrary. Nicotine addicts will often deny that smoking endangers their health. Members of political parties react mildly to lies, crimes, and other immorality by their own but are out for blood when the same is done by politicians in the other party."

• "The consensus of industry studies of hedge fund returns to investors seems to be that, considering the level of risk, hedge funds on average once gave their investors extra return, but this has faded as the industry expanded. Later analyses say average results are worse than portrayed. Funds voluntarily report their results to the industry databases. Winners tend to participate much more than losers. One study showed that this doubled the reported average annual return for funds as a group from an actual 6.3 percent during 1996–2014 to a supposed 12.6 percent."

• "One method that leads to this has also been used to launch new mutual funds. Fund managers sometimes start a new fund with a small amount of capital. They then stuff it with hot IPOs (initial public offerings) that brokers give them as a reward for the large volume of business they have been doing through their established funds. During this process of “salting the mine,” the fund is closed to the public. When it establishes a stellar track record, it is opened to everyone. Attracted by the amazing track record, the public rushes in, giving the fund managers a huge capital base from which they reap large fees. The brokers who supplied the hot IPOs are rewarded by a flood of additional business from the triumphant managers of the new fund. The available volume of hot IPOs is too small to help returns much once the fund gets big, so the track record declines to mediocrity. However, the fund promoters can use more hot IPOs to incubate yet another spectacularly performing new fund; and so it goes on."

• "The number of households worth at least $1 million was thought to be about ten million in 2015. With so many millionaire households, the goal of becoming one of them looks within reach. To see what might be done, imagine you’re an eighteen-year-old blue-collar worker with no savings and no prospects. What if, somehow, you could save $6 a day and buy shares in the Vanguard S&P 500 Index Fund at the end of each month? If that investment grows in a tax-deferred retirement plan at the long-term average for large stocks of about 10 percent, then after forty-seven years you can retire at age sixty-five with $2.4 million. But where do you find an extra $6 a day? The pack-and-a-half-a-day smoker who kicks his drug habit saves $6 each day. If the construction worker who drinks two $5 six-packs of beer or Coke each day switches to tap water he can save $10 a day, $6 of which he puts in an index fund and $4 of which he spends on healthy food to replace the junk calories from the beer or Coke."

• "Suppose you invest time and energy to add $1,000 to your wealth. Will you sacrifice as much to make another $1,000? And another? Economic theorists believe that most people won’t and that we typically put less value on each successive $1,000 increase in our net worth. We feel this way about all scarce useful items, or so-called economic goods. We value each additional unit less than the last. 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. For decades I have spent six to eight hours a week running, hiking, walking, playing tennis, and working out in a gym. I think of each hour spent on fitness as one day less that I’ll spend in a hospital. Or you can trade money for time by working less and buying goods and services that save time. Hire household help, a personal assistant, and pay other people to do things you don’t want to do. Thousand-dollar-an-hour New York professionals who pay $50 an hour for a car and driver so they can work while they commute understand clearly."

• "Doing better than the market is not the same as beating it. The first is often simply luck; the second is finding a statistically significant edge that makes sense, then profiting from it."

• "We privatize profit and socialize risk."

• "Studies done both before and after the 2008–09 recession showed that the larger the percentage of corporate profit paid to the top five executives, the poorer the earnings and the stock performance of the company. These superstars tended to drain their companies rather than benefit them. The executives claim that “market forces” determine their salary. However, as Moshe Adler, in his article “Overthrowing the Overpaid,” points out, economists David Ricardo and Adam Smith, writing more than two hundred years ago, “concluded that what a person earns is determined not by what that person has produced but by that person’s bargaining power. Why? Because production is typically carried out by teams…and the contribution of each member cannot be separated from that of the rest.”

• "Education builds software for your brain. When you’re born, think of yourself as a computer with a basic operating system and not much else. Learning is like adding programs, big and small, to this computer, from drawing a face to riding a bicycle to reading to mastering calculus. You will use these programs to make your way in the world. Much of what I’ve learned came from schools and teachers. Even more valuable, I learned at an early age to teach myself. This paid off later on because there weren’t any courses in how to beat blackjack, build a computer for roulette, or launch a market-neutral hedge fund."

• "People mostly don't understand risk, reward, and uncertainty."

• "This multidisciplinary collection of insights includes a favorite of mine for understanding deals and relationships, namely, “Look for the incentives,” which is closely related to finding “Cui bono?” or “Who gains?” Cui bono instantly explains why seven thousand US gun dealers, lining the border with Mexico from Tijuana to Corpus Christi, are allowed freely to provide nearly all the military-level arms used by the Mexican drug cartels. It explains why Congress mandated the wasteful folly of corn-based ethanol, the production of which causes almost as much pollution as it offsets and drives up food prices for everyone. If ethanol use were the goal, why was there, until the end of 2011, a 54- cent-per-gallon tariff to keep Brazilian ethanol out?"

• "More insights come from a much bigger idea of fundamental importance for all investors, the recognition that the group I call the politically connected rich are the dominant economic and political power in the United States. This is a key concept for understanding what happens in our society and why it happens. They are the ones who buy politicians, using campaign contributions, career opportunities, investment profits, and more. As owners of wealth who also control power, they run the country and will continue to do so. We saw how they used the government to bail them out of the financial crisis of 2008–09."

• "Economists have found that one factor has explained a nation’s future economic growth and prosperity more than any other: its output of scientists and engineers. To starve education is to eat our seed corn. No tax today, no technology tomorrow."