Edward Thorp: Beating The Odds – The First Quant (A Man For All Markets – Summary And Lessons)

Last Updated on August 26, 2021 by Oddmund Groette

Edward Thorp is by many regarded as “the first quant”, at least one of the first who successfully used quantitative models for risk-taking. He became famous when he wrote the book Beat The Dealer, in which he documented a rational way of betting to beat the casinos in blackjack.

He later went on to study the financial markets, and in 1967 he published Beat The Market – a book about arbitrage. Profiting from arbitrage is very difficult today but was ingenious when this was written.

This article has my own very brief opinion of the book plus I give excerpts of my main lessons and takeaways from the book.

Ed Thorp has one of the best investing track records – purely by quantified strategies

However, outside the inner circles of hedge funds and academic researchers, Thorp is not well known, despite a stellar track record for his hedge fund, Princeton Newport Partners (PNP). PNP never had a losing year from 1969 until 1988 when he decided to close because of a rogue employee (for reasons that had nothing to do with Thorp).

PNP compounded at 19.1% from 1969 to 1988, almost more than double that of the S&P 500, with significantly less drawdowns. After the unpleasant encounter in 1988, Thorp decided to manage his own money and stop serving investors except for friends and family. Managing outside money was not worth the time and hassle.

In 2017 Thorp published A Man For All Markets: Beating The Odds, From Las Vegas To Wall Street, a personal odyssey in science, gambling, and financial markets. In the introduction, Thorp writes that he aims to show that a simple approach beats most investors and experts. Unfortunately, he doesn’t reveal much of his findings from his arbitrage trading.

Thorp argues you can do well with simple strategies, but for most investors, he recommends long-term passive investing.

A Man For All Markets: Beating The Odds, From Las Vegas To Wall Street

The first part of the book is mainly about Thorp’s youth where he developed skills by reading and experimenting (trial and error). This applies to trading and investing: be curious, never take a fact for a fact, and do your own research by trial and error:

Chance can be thought of as the card you are dealt in life. Choice is how you play them. I chose to investigate blackjack. As a result, chance offered me a new set of unexpected opportunities.

The second part is about how he developed his betting systems in blackjack, roulette, and baccarat. This resulted in the book Beat The Dealer and sparked his interest in the greatest casino of them all: the stock market.

The third part of the book is the longest one: his involvement in the financial industry – which he mostly despises because of frequent fraud and low ethics:

There is another kind of risk on Wall Street from which computers and formulas can’t protect you. That’s the danger of being swindled or defrauded……..the point being that hedge fund investors don’t have much protection and that the most important single thing to check before investing is the honesty, ethics, and character of the operators.

Unfortunately, he doesn’t go into detail about any of his strategies except they all involved some kind of arbitrage.

The last part, the fourth, is more of a philosophical nature where he spends some time explaining basic investment principles and general advice on how you should go about life and investing. One interesting part was that he already in 1991 concluded that Bernie Madoff was a fraud.

We recommend the book if you are interested in gambling, probabilities, and finance.

However, don’t expect any great details or special knowledge. As Nassim Taleb writes in the foreword: Thorp’s contributions are how you can succeed by keeping things simple.

Thorp ends by explaining what should be your guide in life: not wealth and fame, but how you spend your time on the things you enjoy. Nassim Taleb writes in the introduction:

True success is exiting some rat race to modulate ones’s activities for peace of mind.

Quotes, takeaways, and lessons from A Man For All Markets: Beating The Odds, From Las Vegas To Wall Street:

Below are some lessons and takeaways from the book.

From Nassim Nicholas Taleb’s foreword:

Thorp’s contributions are vastly more momentous than he reveals. Why? Because of their simplicity. Their sheer simplicity.

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The 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.

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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.

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Now money management – something central for those who learn from being exposed to their own profits and losses. Having an edge and surviving are two different things. The first requires the second. As Warren Buffet said: in order to succeed you must first survive. You need to avoid ruin. At all costs.

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True success is exiting some rat race to modulate one’s activities for peace of mind.

From Thorp’s book:

A trait that showed up about this time was my tendency not to accept anything I was told until I had checked it for myself. ….From the beginning, I loved learning through experimentation and exploration how my world worked.

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For the rest of my life I would meet Depression-era survivors who retained a compulsive, often irrational, frugality and an economically inefficient tendency to hoard.

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Understanding and dealing correctly with the trade-off between risk and return is fundamental, but poorly understood, challenge faced by all gamblers and investors.

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Chance can be thought of as the card you are dealt in life. Choice is how you play them. I chose to investigate blackjack. As a result, chance offered me a new set of unexpected opportunities.

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This plan, of betting only at a level in which I was emotionally comfortable and not advancing until I was ready, enabled me to play my system with calm and disciplined accuracy. This lesson from the blackjack tables would prove invaluable throughout my investment lifetime as the stakes grew ever larger.

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Many were good and some would go on to make their living from blackjack, but for the majority the effort and persistence required to practice card counting, the restraint and discipline needed, to say nothing of the temperament, were obstacles to success.

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Betting too much, even when though each individual bet is in your favor, can be ruinous…..On the other hand, playing safe and betting too little means you leave money on the table. The psychological makeup to succeed at investing also has similarities to that for gambling. Great investors are often good at both.

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Once again, just as with casino games, I was surprised and encouraged by how little was known by so many. And just as blackjack, my first investment was a loss that contributed to my learning.

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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.

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As I would learn, most stock-picking stories, advice, and recommendations are completely worthless.

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I learned from this that even though I was right in my economic analysis I hadn’t properly evaluated the risk of too much leverage.

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There is another kind of risk on Wall Street from which computers and formulas can’t protect you. That’s the danger of being swindled or defrauded.

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Portfolio insurance was designed to protect investors from large market declines. Ironically, the cure became the cause. (the crash of 1987)

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As Princeton Newport Partners closed I reflected on the proposition that what matters in life is how you spend your time.

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Heller said he had something the rich man could never have….”The knowledge that I’ve got enough.”

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Then again, people tend to make the error of seeing patterns or explanations when there aren’t any, as we’ve seen from the history of gambling systems, the plethora of worthless pattern-based methods, and much of story-based investing.

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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.

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It’s difficult to get an edge picking stocks. Hedge funds are little businesses just like companies that trade on the exchanges. Should one be any better at picking hedge funds than we are at picking stocks?

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You need to know enough to make a convincing, reasoned case for why your proposed investment is better than standard passive investments such as stock or bond index funds. Using this test, it is likely you will rarely find investments that qualify as superior to the indexes.

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In fact, hedge funds frequently start out small and build spectacular records, later turning ordinary as they grow.

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…the point being that hedge fund investors don’t have much protection and that the most important single thing to check before investing is the honesty, ethics, and character of the operators.

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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.

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In my experience, superior stock-picking ability is rare, which means almost everyone should make the switch. (to passive investing)

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The threat to a buy-and-hold program is the investor himself. Following his stocks and listening to stories and advice about them can lead to trading actively, producing on average the inferior results about which I’ve warned. Buying an index avoids this trap.

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The EMH is a theory that can never be logically proven. All you can argue is that it is a good or not-so-good description of reality. However, it can be disproven merely by providing examples where it fails, and the more numerous and substantive the examples, the more poorly it describes reality.

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Be a disciplined rational investor. Follow logic and analysis rather than sales pitches, whims, or emotion. Assume you may have an edge only when you can make a rational affirmative case that withstands your attempts to tear it down. Don’t gamble unless you are highly confident you have an edge.

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Be aware that information flows down a “food chain”, with those who get it first “eating” and those who get it late being eaten.

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Thorp on dividend investing:

Curiously, he thinks he can only spend income, in the form of dividends and interest, and he views capital appreciation as something less real. I tried, and failed, to convince him that a higher total return (after tax) means more money to spend and more money to keep, no matter how it divides between realized income and unrealized capital gains or losses. To own a stock like Berkshire Hathaway, which has never paid a dividend, and therefore produces no “income”, would be unthinkable for him. This investor’s costly preference for realized income rather than total return (economic income) is common.

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In recent years, especially in a crisis, world markets, reflecting the increasing globalization of information through technology, have tended to move much more in tandem with the US market, limiting the amount by which diversification overseas reduces risk.

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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.

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Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.

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On betting size:

William Poundstone points out that for a favorable bet that pays odds of $A for a bet of $1, the optimal Kelly bet is the percent of your capital equal to your edge, divided by the odds, A. In blackjack, the typical favorable edge was usually between 1 and 5 percent and the odds, or payoff per dollar bet, averaged a little more than 1. So, following the criterion when the card count was good, I bet a percentage of my bankroll that was a little less than my percent advantage. Kelly’s criterion is not limited to two-value payoffs but applies generally to any gambling or investing situation in which the probabilities are known or can be estimated.

As I pointed out in the Wilmott magazine, Warren Buffett’s thinking is consistent with the Kelly Criterion.

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What if you want the payouts to continue “forever” as you might for an endowment? Computer simulations showed me that with the best long-term investments, such as stocks and commercial real estate, annual future spending should be limited to the inflation-adjusted level of 2 percent of the original gift. This surprisingly conservative figure assumes that future investment results will be similar in risk and return to US historical experience. In that case, the chance that the endowment is never exhausted turns out to be 96 percent……The 2 percent spending limit is so low because, if the fund is sharply reduced in its early years by a severe market decline, a higher spending requirement might wipe out.

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Again, an investment in corporate bonds more than doubled on average over this period and long-term US government bonds almost did so, showing that diversification into asset classes other than equities, though possibly sacrificing long-term return, can preserve wealth in bad times.

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Making a profit is trickier. Like a Ponzi scheme, it’s not easy to tell when it will end. If you bet against it too early you can be ruined in the short run even though you are right in the long run. As Keynes said, the market can remain irrational longer than you can remain solvent.

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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…..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 roulette, or launch a market-neutral hedge fund.

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Most of what I’ve learned from gambling also is true for investing. People mostly don’t understand risk, reward, and uncertainty.

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Simplistically, there are two types of rich, those who use government to tilt the playing field in their favor and those who don’t….Another theme for dealing with public policy issues is to simplify rules, regulations, and laws. Get the government out of the business of micromanaging.

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As Benjamin Franklin famously said: “Time is the stuff life is made of,” and how you spend it makes all the difference.

 

Disclaimer: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.