A Man for All Markets: From Las Vegas to Wall Street, How I Beat the Dealer and the Market

Ed Thorp’s incredible biography. Great stories about his times counting cards in Vegas and moving to finance at Princeton Newport Partners. Loved the stories about his intersections with Buffett.

My Notes

also learned the value of withholding judgement until I could make a decision based on evidence.

It is the dosage of your betting—not too little, not too much—that matters in the end.

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.

It is vastly less stressful to be independent—and one is never independent when involved in a large structure with powerful clients.

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

I fell asleep at night mentally reviewing the material, a habit that proved, both then and later, remarkably effective for understanding and permanently remembering what I had learned.

If you do this, what do you want to happen? and If you do this, what do you think will happen? I wouldn’t have liked either answer. These two questions became valuable guides for me in the future.

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

I also believed then, as I do now after more than fifty years as a money manager, that the surest way to get rich is to play only those gambling games or make those investments where I have an edge.

Had I been more knowledgeable about the history of gambling and the centuries of effort devoted to the mathematical analysis of games, I might not have tackled blackjack.

What intrigued me was the possibility that merely by sitting in a room and thinking, I could figure out how to win.

In the abstract, life is a mixture of chance and choice. Chance can be thought of as the cards you are dealt in life. Choice is how you play them.

I felt then, as I do now, that what matters is what you do and how you do it, the quality of the time you spend, and the people you share it with.

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

my lifetime of playing was just one long series of hands, and chopping it into sessions and playing them at various times and in various casinos should not affect my edge, nor the long-run amount I could expect to win. This principle applies in both gambling and investing.

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.

Anchoring is a subtle and pervasive aberration in investment thinking.

Lesson: Do not assume that what investors call momentum, a long streak of either rising or falling prices, will continue unless you can make a sound case that it will.

though I was right in my economic analysis I hadn’t properly evaluated the risk of too much leverage. For a few thousand dollars I learned from this to make proper risk management a major theme of my life

Warren gave one of his favorite examples of its remarkable power, how if the Manhattan Indians could have invested $24, the value then of the trinkets Peter Minuit paid them for Manhattan in 1626, at a net return of 8 percent, they could buy the land back now along with all the improvements.

A preferred stock’s dividend is paid first—in preference—before any payments due to the common stock.

In the typical case, where the dividend amount is fixed, the preferred is like a bond but more risky because the dividend payments and the claim on assets upon liquidation are only paid after the corresponding bond payments.

They also adopted a notion we rejected, called VaR or “value at risk,” where they estimated the damage to their portfolio for, say, the worst events among the most likely 95 percent of future outcomes, neglecting the extreme 5 percent “tails,”

The defect of VaR alone is that it doesn’t fully account for the worst 5 percent of expected cases. But these extreme events are where ruin is to be found.

We took a more comprehensive view. We analyzed and incorporated tail risk, and considered extreme questions such as, “What if the market fell 25 percent in one day?” More than a decade later it did exactly that and our portfolio was barely affected.

I call the flip side to the wisdom of crowds the lunacy of lemmings.

small extra gain is generally not worth the substantial risk the deal will break up.

Offering explanations for insignificant price changes is a recurrent event in financial reporting.

Using our model, our computers calculate daily a “fair” price for each of about one thousand of the largest, most heavily traded companies on the New York and American stock exchanges. Market professionals describe stocks with large trading volume as “liquid”; they have the advantage of being easier to trade without moving the price up or down as much in the process. The latest prices from the exchanges flow into our computers and are compared at once with the current fair value according to our model. When the actual price differs enough from the fair price, we buy the underpriced and short the overpriced.

To control risk, we limit the dollar value we hold in the stock of any one company.

Our entire holding of stocks, long and short, turns over about once every two weeks, or twenty-five times per year.

Our average trade size is $54,000 and we are placing a million such bets per year,

We didn’t ask, Is the market efficient? but rather, In what ways and to what extent is the market inefficient? and How can we exploit this?

Among the scores of fundamental and technical measures we considered were the ratio of earnings per share to price per share, known as the earnings yield, the liquidation or “book” value of the company compared with its market price, and the total market value of the company (its “size”).

The stocks that had gone up the most did worse as a group than the market in the next few weeks, and the stocks that were the most down did better.

Historically, the annualized return was 20 percent from buying the one-tenth of stocks that had fallen most and selling short the tenth that had risen most. We called the system MUD, as it was constructed from the “most-up, most-down” stocks.

Every stock market system with an edge is necessarily limited in the amount of money it can use and still produce extra returns. One reason is that buying undervalued securities tends to raise the price, reducing or eliminating the mispricing, and selling short overpriced securities tends to lower the price, once again shrinking the mispricing.

The most important reason to wind down the operation was that time was worth more to me than the extra money.

Ms. Scheiber was leaving them $22 million for the benefit of women students.

Were Anne Scheiber’s choices unusually lucky? How would an average investor have done? Taking the period from the start of 1944 until the end of 1997, allowing a couple of years for the settlement of the estate and the delivery of securities to Yeshiva, $5,000 invested in a large stock index grew to a mere $3.76 million; but the same amount invested in small stocks grew, on average, to $12.31 million. Starting with a little more than Anne, investing $8,936 instead of $5,000, the average small stock investor would have achieved her $ 22 million result.

Over a sufficiently long time, compound growth at a small rate will vastly exceed any rate of arithmetic growth, no matter how large!

For instance, if Sam Scared made 100 percent a year and put it in a sock and Charlie Compounder made only 1 percent a year but reinvested it, Charlie’s wealth would eventually exceed Sam’s by as much as you please.

This is true even if Sam started with far more than Charlie, even $1 billion to Charlie’s $1.

To get an idea of what your time is worth, take a moment now to think about how much you work and the income you get from your effort. Once you know your hourly rate you can identify situations where buying back some of your time is a bargain and other situations where you want to be selling more of your time. As you get used to thinking this way, I predict that you will often be surprised at how much you can gain.

They are called closed because this sale of shares happens one time only, at the launch of the fund.

The “sell side,” the Wall Street promoters, have just captured 8 percent of the money. Notice that an investor could have bought gold stocks directly and, for each $10, owned $10 worth of stock.

NAV represents the liquidation value of POG shares but, as long as management controls the fund, they are worth substantially less. That’s because management collects fees and incurs expenses, thereby reducing the benefits of ownership for the shareholders, compared with an investor who owns the underlying portfolio directly.

In the case of POG, the first investors pay $10 per share. Wall Street’s selling charges cut this to $9.20. Then management takes 15 percent of future earnings, which reduces the value to the investor by another 15 percent, leaving a value per share for him of 85 percent × $9.20 or $7.82. He’s immediately lost $2.18 of his $10 or 21.8 percent of his investment to his helpers.

If POG was trading at a 40 percent discount with shares at $6 each and an NAV of $10, we could attempt to buy enough shares to force and win a vote to convert the fund to an open-end mutual fund, allowing shareholders to redeem at net asset value. Then we pay $6 a share and cash out at $10 a share, for a profit of $4 or 67 percent on our $6.

An unusual opportunity to buy assets at a discount arose during the financial crash of 2008–09, in the form of certain closed-end funds called SPACs.

By December 2008, panic had driven even those SPACs that still owned only US Treasuries to a discount to NAV.

At Thursday’s closing the market priced PalmPilot at $53.4 billion, yet it valued 3Com, which still owned 94 percent of PalmPilot, at “only” $28 billion. But that means the market valued 3Com’s 94 percent of PalmPilot at $50 billion, so it valued the rest of 3Com at negative $22 billion!

Buying 135 shares of PalmPilot outright cost $14,850, but if we paid $9,000 for 100 shares of 3Com we got both 135 shares of PalmPilot and 100 shares of the 3Com “stub” company. (Think of each 100 shares in 3Com as a ticket having two parts, one labeled 135 SHARES OF PALMPILOT and the other piece or stub labeled 100 SHARES OF 3COM POST-SPIN-OFF. )

Our portrait of real markets tells us what it takes to beat the market. Any of these can do it:

Get good information early. How do you know if your information is good enough or early enough? If you are not sure, then it probably isn’t.

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 the edge. As Buffett says, “Only swing at the fat pitches.”

Find a superior method of analysis. Ones that you have seen pay off for me include statistical arbitrage, convertible hedging, the Black-Scholes formula, and card counting at blackjack. Other winning strategies include superior security analysis by the gifted few and the methods of the better hedge funds.

When securities are known to be mispriced and people take advantage of this, their trading tends to eliminate the mispricing. This means the earliest traders gain the most and their continued trading tends to reduce or eliminate the mispricing. When you have identified an opportunity, invest ahead of the crowd.

To beat the market, focus on investments well within your knowledge and ability to evaluate, your “circle of competence.”

don’t bet on an investment unless you can demonstrate by logic, and if appropriate by track record, that you have an edge.

The investor who is willing to do a little thinking, along with the investing work that follows, has many ideas to check.

a high P/E ratio suggests stocks are overpriced and are likely to underperform, whereas a low P/E indicates the opposite. An investor who is diversified among asset classes might exploit this by decreasing his allocation to stocks when P/Es have been historically higher and shifting more into stocks when the P/Es have been lower.

I prefer to think in terms of the inverse of P/E, or earnings divided by price, sometimes known as E/P but perhaps better described as earnings yield.

An investor who owns the S&P 500 Index could think of it as a low-grade long-term bond, comparing the earnings yield of this “bond” to the total return from some benchmark for actual bonds, such as long-term Treasuries or corporates of a particular quality grade.

When the earnings yield on the stock index is historically high relative to the bond benchmark, the investor sells some of his bonds and buys stocks. When bond yields are high compared with stocks, he shifts money from stocks back to bonds.

Stories sell stocks:

The careful investor, when he hears such tales, should ask a key question: At what price is this company a good buy?

Typically you’ll avoid investing in stocks when they are trading above your buy price but, if you follow many companies carefully, from time to time some will be attractive purchases.

In recent years, especially in crises, 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.

According to economist Robert Shiller, average US home prices after inflation increased from 1890 to 2004 by about 0.4 percent a year, with the rate being about 0.7 percent in the later 1940–2004 period.

The question was, how much? The answer was in a 1956 article by Bell Labs physicist John L. Kelly,

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.

Some key features of the Kelly Criterion are: (1) The investor or bettor generally avoids total loss; (2) the bigger the edge, the larger the bet; (3) the smaller the risk, the larger the bet.

Three caveats: (1) The Kelly Criterion may lead to wide swings in the total wealth, so most users choose to bet some lesser fraction, typically one-half Kelly or less; (2) for investors with short time horizons or who are averse to risk, other approaches may be better; (3) an exact application of Kelly requires exact probabilities of payoffs such as those in most casino games; to the extent these are uncertain, which is generally the case in the investment world, the Kelly bet should be based on a conservative estimate of the outcome.

He and his associate Charlie Munger, when managing $200 million, put most of it into just five or so positions. Sometimes he was willing to bet 75 percent of his fortune on a single investment. Investing heavily in extremely favorable situations is characteristic of a Kelly bettor.

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 it out.

In my experience, it has been easy to spot a bubble after it is well under way, as prices and valuations far exceed historical norms and seem to have no economic sense.

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.

In March 2009, when the S&P 500 had fallen 57 percent from its peak, I could not tell whether to buy stocks or to sell what I had.

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.

what a person earns is determined not by what that person has produced but by that person’s bargaining power.

A simpler and more effective solution is to empower the shareholders. They are the owners of the company and the ones looted by their officers and directors.

The company rules are deliberately designed to make it difficult or impossible for independent shareholders to nominate directors or place issues on the ballot. Instead, corporations—their legal existence already being permitted and regulated by the state—should be required to conduct democratic elections following the usual voting rules in our American democracy. Moreover, any block of shareholders that together holds some specified percentage of the shares should have the unrestricted right to nominate directors and to put issues on the ballot, including the replacement of board members and top executives.

Some companies disenfranchise shareholders by having two or more classes of shares with different degrees of voting power.

Management may, for instance, own A shares with ten votes each and the public may own B shares with one vote each. How would you like to live in a country where any “insider” could cast ten votes and any “outsider” got only one? Abolish this and make it one share, one vote.

Another problem arises because, currently, institutions that hold shares in custody for their owners can cast proxy votes for those shareholders who decline to vote. These proxies usually perpetuate current management and ratify its decisions. Change this so that the only votes that count are those cast directly by the shareholder; so-called proxy votes would not count.

These two measures—democratic elections and shareholder rights to put issues to a vote—would allow the owners of the company, namely, the shareholders, to exert control over the compensation of top executives, their so-called agents, and would, in my opinion, be far more effective and accurate than direct government regulation.

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. Their investment results could be much better if they did.

The solution for society illustrates another neat unifying concept, that of “externalities.”

Berkshire Hathaway’s Charlie Munger presents his list of such thinking tools in the engaging Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger.

This multidisciplinary collection of insights includes a favorite of mine for understanding deals and relationships, namely, “Look for the incentives,”

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.

Let me be clear. I don’t object to some people being richer, even much richer, than others. I object to gain of wealth through political connections rather than earning it by merit.

Another theme for dealing with public policy issues is to simplify rules, regulations, and laws. Get government out of the business of micromanaging.

A revenue-neutral flat tax could make the tax code simple and fair, and would catch those who currently are getting a free ride from the rest of us. All income would be taxed equally, with an exemption set at, say, one and a half times the poverty level. Those below this cutoff would pay no tax.

Of great importance for long-term investors is whether the US will be the dominant world power in the twenty-first century, or whether we have peaked, dissipating our strength in costly foreign wars, financial mismanagement, and domestic strife. The first scenario could lead to another century of equities returning 7 percent a year after inflation. The other outcome could be far less pleasant. I reassure the pessimists by noting that we’re still rich, still innovating, and besides, Rome wasn’t destroyed in a day.

To the optimists I mention the obvious: endless deficits, massive wastage of lives and wealth in wars, political subsidies (pork, bailouts, corporate welfare, paying the able-bodied not to work), and destructive partisanship in all three branches of government. Meanwhile, the rise of China is transforming the geopolitical and economic landscape.

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 preserve the quality of my life and to spend more of it in the company of people I value and in the exploration of ideas I enjoy, I chose not to follow up on a number of business ventures, although I believed that they were nearly certain to become extremely profitable. Once I worked out the major concepts in a subject and proved them in action, I liked new mental challenges, moving on from gambling games to the investment world, with warrants, options, convertible bonds and other derivatives, then statistical arbitrage.

Life is like reading a novel or running a marathon. It’s not so much about reaching a goal but rather about the journey itself and the experiences along the way.

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

Whatever you do, enjoy your life and the people who share it with you, and leave something good of yourself for the generations to follow.