A Man for All Markets, By Ed Thorp By Jesse Koltes, TheCharlieton.com
When I was eight years old, my dad caught me trying to cheat at blackjack.
“People get shot for doing that,” he said. If I wanted to win, he told me I needed to count cards. My dad became calm as he methodically explained a simplified counting method involving the five card.
Even as a boy, I sensed his fascination, and caught an early glimpse of my dad’s gambling streak. I wanted to connect with him about whatever this was.
Seeing that I wasn’t quite following, and still reeling from the casual death threat, my dad handed me a dog-eared copy of Ed Thorp’s book Beat the Dealer, and said that that was how he had learned.
Twenty years later, Ed Thorp’s autobiography, A Man for All Markets, was the only book Charlie Munger recommended at the 2017 meeting of the Daily Journal Corporation. That recommendation was my most important takeaway from the 4-hour affair. *
While Mr. Munger’s own comments from the meeting are worth reading, I’d suggest reading Thorp’s book first. In many ways, Thorp is a second Charlie in terms of both intellectual power and scope, which is perhaps the highest praise I could offer another person. Thorp’s book is chock- full of knotty lessons for investors, thinkers, and business people, but because Thorp is far less well covered than Munger, many of these ideas felt new and let me see them with fresh perspective.
My biggest takeaways are below.
Extreme Knowledge and Circles of Competence
“We often find that winning systems go almost ridiculously far in maximizing or minimizing one or a few variables” – Charlie Munger
“I’m no genius. I’m smart in spots—but I stay around those spots.”
— Tom Watson Sr., Founder of IBM
One of my favorite ideas from Charlie is that the secret to winning systems is the maximization or minimization of one or two key variables. Think of the minimalism at Costco, fee reductions at Vanguard, or portfolio concentration in the Kelley formula: In order to have better than average results, you need to have different than average behavior.
But one of my other favorite ideas from Munger is that investors should stay within their circle of competence, and only bet big when they have a high conviction understanding. As Buffett has said, he greatly prefers stepping over one foot hurdles to heaving himself over ten foot hurdles.
Both of these ideas are fantastic advice, but Thorp’s book made me realize that when you combine them there is a tension. In knowledge work fields (like investing), the variable you want to maximize is actionable understanding. You have to constantly improve your probabilistic understanding of how events will unfold in the future, while at the same time constraining your faith in your own abilities to understand the things you’ve learned about. You are forced to push and pull in opposite directions—to an extreme degree—at the same time.
Ed Thorp is an excellent and understudied example of how to thread this needle between growth and humility. When Thorp began to study the stock market, he was surprised and encouraged to discover “how little was known by so many.” He quickly recognized that the stock market was full of the same ignorance and lazy analysis that had pervaded the gambling world. Where others saw an unbeatable game of chance, Thorp saw a system of probabilities and payoffs masked by a veil of psychology and whim. If he could maximize his understanding of the system, perhaps he could beat the market, just as he had beaten Vegas.
His ambitious endeavor paid off. By applying the tools of physics, computer science and math to finance, Thorp created the world’s first “quant shop,” and a trading system that functioned profitably for decades with few drawdowns.
What I find incredible about Thorp’s example is not only that maximized his understanding and beat the market, but that he avoided the quackery and hubris that can so often bedevil people who have ventured so far from the average.
To make this point clear, consider how Thorp’s example compares with inventors of the Black-Scholes model. Thorp, and later Fischer Black, Myron Scholes and Robert Merton, stretched their understanding of the world to the extreme, and were able to deduce a theoretical model for pricing derivatives. Thorp took his discovering and traded it profitably for years. Merton and Scholes won the 1997 Noble price for the same discovery, but were unable to control themselves and use it safely within their circles of competence. Their hedge fund, Long Term Capital Management, blew up in 1998 and had to be bailed out by a government led consortium.
Thorp’s example is like an anti-Icarus, skilled enough to balance hubris and humility, flying neither too low nor too high.
Ed Thorp - Nontransitive Odds
Although Munger’s observation that winning systems often maximize one or two variables, Thorp’s book points out an an important exception: non-transitive games.
In Thorp’s telling, Warren Buffett introduced him to the subject at a fateful meeting of the two greats. Buffett would offer a guest their pick from a set of three dice. The guest was asked to pick the “best” die, and Warren would pick the “second” best. Both players would roll the dice at the same time, and the highest number would win. The trick was that no matter which die the guest selected, Warren could always beat them by picking second.
“This puzzles people because they expect things to follow what mathematicians call the transitive rule: if A is better than B, and B is better than C, then A is better than C. For example, if you replace the phrase “better than” by any of the phrases longer than, heavier than, older than, more than, or larger than, then the rule is true. However, some relationships don’t follow this rule. For instance, is an acquaintance of, and is visible to, do not. The childhood game of Rock, Paper, Scissors, is a simple example of a nontransitive rule.”
A Man for All Markets, page 158.
What’s remarkable about the non-transitive rule is that it bends the mind away from thinking that issues are always about straight-forward maximization or minimization. Sometimes, the edge doesn’t always go to the actor who boldly picks the apparently best option, but to the person who adapts to the first mover, and counters with something better.
Institutions and Resilience
For all the similarities between Munger, Buffett, and Ed Thorp, it is notable that Berkshire stands as a colossal monument to the first pair’s intellectual achievements, while no such entity exists in Thorp’s wake. All three men possessed an enthusiasm for the power of compound interest, and enjoyed great returns and long careers. What explains the difference in institutional outcomes?
Part of the answer has to do with how Thorp and Buffett constructed their backup systems. In Berkshire’s conglomerate model, excellent businesses are acquired, but remain totally unintegrated. This requires that Berkshire forego the “synergies” and cost reductions that typical come with merger integrations.
But decentralization gives Berkshire a valuable firewall against negative contagions. When bad practices pop up at Wells Fargo, they can’t quickly spread to Kraft-Heinz or even to Omaha.