Edward Thorp: Beating The Market And Casinos With Mathematics And His Encounters With GIulani, Buffett, Madoff, Griffin And More

Edward Thorp: Beating The Market And Casinos With Mathematics And His Encounters With GIulani, Buffett, Madoff, Griffin And More

An interview and Q&A with mathematician and hedge fund manager, Edward Thorp. In this interview Edward discusses his life and becoming successful at gambling and investing. Edward also talks about meeting Warren Buffett, Kenneth Griffin and Bernie Madoff.

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

This Top Value Hedge Fund Is Killing It This Year So Far

Stone House Capital PartnersStone House Capital Partners returned 4.1% for September, bringing its year-to-date return to 72% net. The S&P 500 is up 14.3% for the first nine months of the year. Q3 2021 hedge fund letters, conferences and more Stone House follows a value-based, long-long term and concentrated investment approach focusing on companies rather than the market Read More

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

Edward Thorp: Beating The Market And Casinos With Mathematics


Edward Thorp Beating The Market and Casinos With Mathematics.mp3

Please welcome to the stage Ron Biscardi CEO of context Capital partner and John Culbertson CIO of contex Capital Partners. Thank you everyone for being here. And welcome to our biggest summit yet part of this event. John and I are very excited to interview someone who really is a legend in the industry is considered to be the father of quantitative trading and we're going to talk tonight a lot about a book that he's recently published which is in essence an auto autobiography titled A Man for all markets. As many of you know he also plays a mean hand of poker. I'm sorry of blackjack. So before before we get into the interview we just want to show a quick video. Now let's meet our third team of challengers. What is your name please. My name is Edward Thorp. My name is Edward Thorp. My name is Edward Norton. All right don't please take the next copy if you will and follow along. Edward Thorp I'm an associate professor of mathematics. I am especially interested in the laws of probability in gambling games. I applied some theories of my own and the findings of a computer to the game of blackjack or 21 and came up with a preliminary report which I delivered before a scientific meeting. The results were astonishing 300 copies of my report was snapped up by the scientists and I was besieged by people who wanted to help me profit from my system to big time gamblers. I actually did.

Back me in an experiment at the blackjack table in two hours of play we broke the bank twice and won seventeen thousand dollars. The book I wrote expounding my system is called Beat the Dealer. A winning strategy for the game of 21. It is currently the most requested volume in the Las Vegas Public Library signed Edward Thor here we bring you three gentlemen Sinulog claiming to be Edward Thorp as you heard the author of what is called the most popular book in the Las Vegas Public Library. DIAMOND Thank you. Thank you. Thank you. Q Whose time gone. Do you mean Gorney. Well I don't know how to pronounce it I read the book that I wrote a book about gambling at number three in blackjack he tells me to stand on a certain number. You know what number that is. I'm sorry I don't know you know number one who tells you that. When he took to the book my black taking to get to him. You can even stand on as low a number as a certain number. I don't recall you. No. No I know what I've been hearing him to he would have been shrinking black jacket and taking turns. Well that means that he either has an aim and you can see the. Then you can put out a little bat to protect your bet against an arson. And number two you broke the bank twice in two lines of play with the other times who tried it and failed. There were other times we broke the bank other times we did you lose value money sometimes. No never. Number one how much money would you need to go into this. Would you have to have a certain reserve behind you.

Well I started with ten thousand dollars with my two gambling friends. I only dipped into thirteen hundred dollars. I see number three with these gambling friends are they still walking free on the street. Do you know them by name. I call them x and y in my book. X Factor having done this extraordinary thing I want to know why. Why are you working at number one. We had a man on this show one who had a computer. I think it was black that you know his name. I think I know who you are. Me But I don't believe he used the same types of computers as I used. I used digital computer. I think now number two how long did it take you to work this out. The entire theory yeah close to a year. Number three I'm not going to question seriously why don't you just do it all the time. I'm not a popular up that. That number one where to play down votes. Number one they wouldn't think of keeping you out of Las Vegas would they. Oh they sure would have won. What is that. What do you mean they don't want you to come to Las Vegas gambling as a business. I know. But it's also supposedly a free society. There's nothing free under the sun. You start winning. You're in trouble. Well thank you. Number two. Number two what is a bank one determines a bank that determines the bank. It's up to the casino.

They will have as much your assets Alipour as we stop and go right to the if and but as we please mark our ballots that one please without any change of course and without any consultation just vote now for number one. Number two our numbers re all ballots marked no please Mark. We haven't much time there. All right Tom. I voted for number three. And I'll tell you if we've got to straighten this out right now because I don't think that Vegas or any other place that's a public good place like that is allowed to bar people from their homes just because they win and maybe I'm wrong but I think it's number three. Hey I voted for them because I don't think they could keep you what you wanted to bet. But it could never see insurance is when you have your wages and you double them up and get it. It's not that insurance that you said or at least where I paid that was insurance. And I think it was nice that we had a chance to hear the number one story about how to read from before and it come from. Number three because they were not from a charity is my joy. Well I think Peggy and Tom are naive I'm sure they want to keep them out of Las Vegas. I voted for number two about that book and if you made a book I'm going to say oh I voted and I'm pretty evenly split. That's more of the way you do as a rule to don't really think we're going out for the truth and find out who's right and who's wrong.

You learn which one of these gentlemen actually is the author of the most popular book The biggest library the rail. Dr. Edward Tharp please stand up. Let's welcome from the state. Dr. No I thought it was interesting that we were talking a minute ago I found out that was not Ed's only game show that actually appeared on a few others in which others were you on. I've got a secret kind of What's My Line. Steve Allen very well. I'm interested to hear how you go from college professor to game show contestant to hedge fund manager so that's what we're here to talk about. OK. So but I want to rewind a little bit and really go back to your childhood you talk a lot in the book about your childhood and one of the things that I found really interesting was from a young age your ability to really focus on whatever it is you were you were doing. Can you talk a little bit about that. It was kind of odd when I was very young I didn't talk until I was about 3 and people worried about me and my parents particularly they were trying to get me to say something. And then one day I was sitting in Montgomery Ward a big department store in Chicago and ladies were friends of my mother who were along and they kept asking me questions as they always did hoping I would say something. So I got off the elevator and they said where is he going. And I said something rather like going to buy a shirt. And it really startled and then a couple of ladies got off.

They said Where are they going and I said oh they're going to the bathroom to do P.P. and be here all three of them blushed beet red. And I was very surprised by that. And it left quite an impression upon me. So then I started talking and my father decided that this kid might be able to learn things and he started trying to teach me whatever he could. So in rapid succession there was reading and math and I seem to gobble up whatever he showed me but this was during not long after we moved to Southern California. The war broke out and my parents were in defensins industries working itan day and working with swing shift. One of them was working on the graveyard shift so I didn't see much of them and I was pretty much on my own. And so I was going to school that was academically rather backward it was 31 out of 32 in the L.A. City school system. So I ended up with my interest in science having no where to go unless I taught myself. So I did that and that was one of the things that helped me focus on things very intensely and it gave me a very good education because I could just move from one suburb to another fairly easily and start learning it whether or not I'd had any formal training. Another common theme was clearly your tenacity. It seemed like once you had set your mind on solving a problem you would stay pretty committed to finding that solution. I assume that had to be a critical component of your success. Yes.

If I wanted for example to go to college I had a set my mind on that because nobody from this high school went to college and we didn't have the money to send me. So I had to go out and earn it myself with over newspapers at 2:00 or 3:00 a.m. and finding other odd jobs and trying to get them what were then rather small scholarships from there and piece them all together. So it took a lot of determination that time because this was an era when people were much poorer than they are now and in which many fewer people went to college. And from this particular M.O. if nobody went so you're in college you actually started to Berkeley. I believe you transferred from Berkeley to UCLA because Berkeley was too expensive. And you graduate from UCLA and eventually get a job at MIT where you met Claude Shannon. Yes. So I know you began talking to Shannon about a variety of gambling problems that you were interested in and of course everyone knows you for blackjack but you actually started with roulette. Correct. That's right. What happened was I changed from chemistry after my freshman year at Berkeley to physics and moved to UCLA and I got a bachelor's and master's in physics and then I ran into a lot of there was a thesis in quantum mechanics and the roll out of math problems that I had to solve and I need more math in order to do it. So I went over to the math problem and started taking courses without a lot of the prep courses that I would have needed had I been a math major and I learned that when I was doing this that I could get out in math sooner than in physics.

So I did that and however while I was working on my master's in physics I had thought about Roulet an idea it had way back in high school and thought that it was predictable. But I decided I would try to build a machine to actually predict where the ball would fall. And that's what got me interested in gambling and that led by chance to getting interested in blackjack because I went out after I got my Ph.D. I was teaching at UCLA for years. I went out to the casinos in Las Vegas with my wife for them as an expensive vacation. But my real goal was to look at roulette wheels and see if they were as well machine and perfect as I believed them to be. And if the experiments I had done were would confirm that if they were that way the experiments I just suggested that I'd be able to build a machine to predict and have a huge edge. So anyhow I was there to look at roulette wheels and I happened to hear about a way of playing blackjack that was almost even though I decided to risk ten dollars at the blackjack tables partly to get some experience in the casino which I had never gambled in and you had a feeling for the environment because I thought I'd be playing roulette there for substantial stakes that sometime in the future. And what I learned during that blackjack experience and it is me that I could be that game. I went back to UCLA and read the article very carefully. That had given me the little system for playing almost even.

And I saw from reading the article that in fact it was almost certain I could beat it using some of the math I had learned. That set me on that track. And then when I went to MIT by they had an IBM 074 computer that I as a faculty member could use. I shared it with the MIT faculty and three new england universities. Computers were scarce in those days. This thing was refrigerator sized and probably not anywhere near as powerful as your phone that you're carrying around. But I learned to type out type holes and punch cards. And I learned programming Fortran and in about oh a year I had worked out the theory for blackjack. And that led me to Claude Shannon as it happened because I wanted to get very rapid publication. My experience had been that if you don't publish something really interesting rapidly other people will claim they did it and maybe published before you did. And the way to publish very quickly was to get your article in The Proceedings of the National Academy of Sciences which published short unusual articles that they thought were significant and to do that you had to have somebody from the National Academy approve the article and send it in on your behalf. No the only person in math in the National Academy at MIT was Claude Shannon but I looked him up and I was told if you have an appointment with him the only to you for a few minutes at the most. Unless he gets interested for some reason or another. And so we talked about blackjack and he agreed to send the paper in and then he said what else are you working on.

I said well I have this idea for roulette and I've already carried it far enough to know that it's almost certain to work. And he was. You may know that he's the founder of information theory which is a major underpinning for the whole digital age. And he also has a great gadget here. And he was one of the two distinguished professors on the MIT faculty than the other being Norbert Wiener and so the fact that we can build the gadget really appealed to him. And so we spent about nine months in his basement outside Cambridge in his big three story house working on the computer while I was busy teaching and also dealing with blackjack and its fallout and the upshot was that we actually built a computer that worked and it turned out to be the first of the wearable computers according to the MIT timeline on the subject. Although we weren't thinking about that we were just thinking about building something that would be amazing and having a lot of fun with it. I like that you invented the first wearable computer as just like a side thing. Yes. Just just as an aside on that I was at a meeting a couple a couple of decades later. It was a biotechnology meeting and somebody said you know you invented the first wearable computer. And I said what's the wearable computer. I lost track of this subject. Never never thought about it again until that time. So Shannon also led you to a critical component of what became your ultimate sort of theory of how to beat blackjack. That's a really interesting question.

The Shannon was the most famous person at Bell Labs which was one of the great historical think tanks and the probably the second most interesting person there was a physicist named John Kelly. So John Kelly learned about Shaman's information theory from Chanon and he wrote a paper called a new interpretation of information rate that came out in 1956 and that paper had to do with interpreting a communication line that had defects in it interpreting it as a betting scheme. And the upshot was that he devised a method by which if you followed it your capital would grow in the long run faster than anybody else's. So I said this is the Shannah and told me about it. And I said this is the perfect thing for betting a blackjack if I want my bankroll there in the casinos to grow at the maximum possible rate. So anyhow I use that for blackjack and I've earned a great deal about it at the time and over the years I use it in investing very successfully. And then I and two others we're editors of a book Ball came out in 2010. It's called The Kelly capital growth investment criteria and it's a collection of about 700 pages of papers some of which we the editors wrote and then connect even explanatory material. So it it takes the subject from this early. I am when I was basically using it for about blackjack Battey up to the present where you can use it for a very wide range of investing problems. So one of the my recollection of sort of how you came up with the best way to be blackjack there were two significant insights.

One was clearly Kelly that control your bankroll but another really had to do with the expectancy that a player had and how that was actually a moving target. Unlike it was in all the other casino games Yeah that's exactly right Ron. The key initial key insight was can you get an edge. And what I realized was that as the deal down through the deck some of the cards are now out of the deck as you get to the second and third rounds of dealing. And that will shift the odds one way or another. The insight was that I could see right away the shift in the odds was going to be very large in some instances which meant a winning system because the edge I had to overcome in the casino initially was very small. It was believed to be points minus point 6 2 percent for the player and it turned out actually when I've finished analyzing the game I thought it was minus point to 1 because the computer couldn't do all the computing but I knew that was a low number. It had to be better and just playing flat with no accounting. It turned out to be plus point 1 3. Then when you start counting you get situations where it's 2 3 4 or 5 percent in your favor. And so the obvious thing is you bet a lot when it's in your favor. You bet a little when it's not in your favor so you can keep your seat or not attract attention if you're always popping up and down and looking for another game. It can focus the casino on you and they may ask you to leave.

So the Kelly system tells you how much about any favorable situations. Basically the idea is more favorable. The more you bet the more risky the less you bet. And so it's a tradeoff between those two things and it's easily easy tradeoff to calculate when you know exact probabilities of things more difficult when you only have rough probabilities like you do in investing situations or even very rough probabilities and you have to sort of cut back and not bet as much OK so all this culminates in the paper they get that get submitted to the National Academy of Sciences and it's obviously a huge head. You know there's there's huge interest in it and the Boston Globe runs a big story on it. Papers around the country are running stories on it. And shortly after that you get a visit from an interesting guy. And as I understand it his two nieces there what happened was lots of people showed up to my talk before the American Society in Washington which I explained all this to the audience and the audience was a collection of rather unusual people in addition to many mathematicians and some of the people there wanted to bankroll a venture showing this actually work. I was an academic I wasn't particularly interested in doing that. But the Washington Post ridiculed me in an editorial saying this is you know a lot of poppycock and they went into some detail about why they thought that and the casino said they would send cabs for people like me and they loved to have us come. So with that I said you know I claim it works but I haven't actually going out there and proved it works.

And I kind of owe it to the people who have heard about this to prove that what I said is so theoretically actually collects money in the casinos. But I thought about it for a while and I was contacted persistently by a wealthy businessman in quotes who lived in New York City. His name was Emmanuel Kimmell. I didn't know who he was at the time. Other than that he was a wealthy businessman and he also had a friend named Eddie hand who moved trolley cars and trucks for Chrysler. You think it was absorbed by Ryder in 1974. Got a lot of money for that many case. These two wanted to buy 100 thousand dollars and bankroll a trip to Las Vegas. And I thought to myself you know I've never really played with any significant money. I don't want them to put up a hundred thousand dollars in case something goes wrong. If something goes wrong with the bankroll something might go wrong with me. Talking doesn't attend our ten thousand dollars and they were extremely disappointed but they went anyhow and we've spent a week out there and I messed around with betting one dollar to ten dollars two dollars to twenty dollars because I wanted to get used to playing and handling the money. And then I found I learned the feeling of scaling up when you knew what you were doing and that there's sort of no limit to scaling up once you understand what you're doing and you have a disciplined approach and you know it works though after 20 hours of scaling up. I got to but the limits were then 50 to 500.

And so we turned their 10000 dollar bankroll into twenty one thousand dollar bankroll. We'd won a net of 11000 and that was right. Forecast I'd forecast a win of 10000 before the trip. And so I was satisfied that I'd prove in principle that what I did was right the casinos weren't terribly happy with me though. This is a side. What can you tell everyone how you communicated with your wife. Thought that was hilarious. Well my wife was much more nervous than I was. I was naive about what casinos were like. And you probably know if you've read the book Casino in the 70s or seen the movie how rough it was that beatings killings and so on in the 60s were even worse. But this is all unknown to me but my wife was more savvy and so she wanted me to call every day and say how we were doing but we didn't have any significant amount money. And I decided that I would make phone calls. That didn't cost anything. I would recollect each day and ask for Edward middle initial Thorp and if I asked for a middle initial it meant that we were ahead between zero and a thousand dollars a b between 1000 and 2000 and so on. So that would take us up to 26000 if we got busy and if we're losing I would just say put the initial first. I'd ask for a Edward Thorp if we're losing between zero and a thousand and so forth. Does she say is not home and all she got were pluses as it happened because it turned out that between calls.

Even though we had a dip down of minus 30 hundred we got back up in time. I call that one point and said. As for Edward M. Thorp she was very happy. So last night at dinner you told us some really interesting Las Vegas stories which unfortunately we don't have time for but I'd love to tell the story about what happened to your car. If he had been playing for a while. Well I got interested in other games as well as blackjack and you know about roulette. Another one was Bacharach play Nevada style and I happened to notice at one point that they had some side bets that were unusual. So I am a Ph.D. student of mine at New Mexico state which I was teaching at that time. Analyze the side bets. I knew that there was a card card system that would work. It was a matter of working out all the details that we figured out how to beat them and then I went out there during it was a spring break in New Mexico state with the chairman of the math department the Comptroller of the university and our wives and we set up shop in one of the hotels and then we went to the dunes casino which I'm happy to say has been destroyed since then. And I came up to the back red tables the first night and nobody noticed me.

I sat down and then after I was playing somebody in the crowd said there's the guy who wrote the book and the pit got very excited and the pit boss ran over the phone and called upstairs and one of the wives said that she overheard the conversation and the upshot was the fool thinks he can beat another game. Let them play. They were all smiles and very pleasant that we went to our projected amount so much per hour that night. And then we came back the next night and they figured something was up. Somehow the Fool seemed to be winning steadily. So they had Shils on each side of me and the Shils monitored my every move. They thought maybe I was marking the cards and I helped them along by burning by from behind by your peers. Periodically with a daub for marking the cards would be and the Shils were sitting in place very upset because I had a kind of dry throat chicle and I was coughing. They thought it was something terrible that they were going to get if they had to sit right by me. They were they were commanded to stay in place and so we went again. Second night and the third I say we because I played two shoes if the issue has eight decks takes about 45 minutes they have to count three things eight nines in total. So that was fairly hard for people. So I I I wanted to be relieved every third shoe. So my two companions the maths department head and the control I'd trained up to count eights in total for one of them and nine in total for the other. So they each half of the side bets that were available and then I'd come back after him after a one shoe break and play two more. So that's how we went through the evening. Well the third evening they came out.

I'd been refusing drinks and they offered me what I like coffee with cream and sugar. I said fine. And after a while I drank some of the coffee and I found that I just couldn't think or count and I felt really terrible. I got up and left the table and the wife of the comptroller was a nurse at the local hospital and she said you know your pupils are gigantic you look just like people who are drugged who have been brought in to avoided they said we better walk you. So they walked me for hours took me like five or six hours of walking and coffee to come back to some sort of state of normalcy. So the other two guys played on and then the fourth night I came back and they offered me cream and sugar with a big smile again and so I said no just bring me a glass of water. So they brought the glass of water and my campaigns don't know. I decided that I was clever enough not to drink the glass I would just put a drop on my junk. I put a drop on a chase of life that emptied a box of baking soda into the glass and that drop was enough to do the same thing with me again a swallow I think and I we wouldn't be having this conversation. So the four after the fourth night they told my companions they were barred.

So it was I never to bring anyone else to that Bachelorette table again but I said well there's one more game in town is at the Sands will multiply the win rate by 10 and see how long we last won't be very long. So I went down. I played two and a half hours and then Carl Cohen who is on the floor of the sands basically managing the operation and one of the partners came over and said you know we want you out of your. And I said why. And I said no reason and he headed gigantic security guard so I said well OK I'm going on became famous among other things for disciplining Frank Sinatra. Frank had a 1 percent interest in the sands and he did something that I guess car off thought was out of line. So Carl whacked him in the mouth and loosened his teeth and told me he couldn't be on the floor anymore. He didn't you he was a no nonsense casino manager. So anyhow we were driving home after that the next day and I was on a narrow road in Arizona two lane road going downhill about 60 miles an hour. And suddenly the accelerator locked the floor. And I couldn't stop the car I pushed the brake as hard as I could and we got up to 80 wasn't slowing down. I thought you know it's got to slow down because there's no way to control this car at this speed on this road.

So I downshifted to first gear burned off the key press the foot brake as hard as I could and also use the handbrake that slowly brought the car down and we pulled into a turn out and put up the hood but a white flag up on the antenna and about an hour later because we didn't know what to do some good Samaritan came by and stopped. Knew all about cars. He said I've never seen anything like this with this accelerator linkage but I know how to fix it. So he did. And then we were on our way again. This was a sobering experience I can't say who was responsible or why but that's what happened. The mine. My question to you before I heard the story was going to be why write the book when you have figured this out and you can just stay in the casino making all this money. But I think you've already answered why you didn't want to stay in the casino. So how did you get from. I mean I guess it was around the same time obviously that you did your appearance. You write the book you do the appearance on the game shows and it's all part of the book promotion. Tell us how you went from solving the gambling problems and promoting a book to experimenting with stocks and bonds. OK I'll just back up one second to pick up a thread that you commented on which is I'd like to do things because they're interesting not because they made money. And the reason I got interested in gambling was because mathematicians had studied gambling since 15 20 and tried to work out a theory of whether you could win or not with various schemes and systems of betting. And they concluded that it was not possible to prove that for almost all the classical gambling games.

So what got me interested was I said this to be big news in the math world if they realize that there are some games that are exceptions to this rock solid proof that they have. And people would send in papers to mass meetings saying they had methods that would work. And they all turned out to be bogus and they were all fell under the power of these theorems mathematicians have proven which showed that they couldn't work. So anyhow that was my motivation rather than trying to get rich. I was interested in academic life and when I'd made some money from playing blackjack and from book royalties I said well I've got to invest this money for the first time in our life. We actually are solvent and we have a small amount of savings though I made terrible investments and then I said I've got to learn how to do this properly because I'm not doing well at all making these awful investments. I mean ones that worked out awfully. I listen to stories believe some of them put some money down. Terrible. So I sat down in the summer of 64 and spent the whole summer in a big bookstore in Beverly Hills reading every finance book and newspaper they had in the store and I didn't see where to go I saw there were a lot of ways you could go it and see what would work and then I sat down again. Starting the summer of 65 and right away it happened to read a little book about warrants which are like like options only they're issued by companies rather than on the exchange. And I saw how to make a theory for those options. And I realized that I could set up very low risk hedges using that theory and those options hedging against common stock.

And so then I decided to follow through on that and actually try it out and I ran into an economist at UC Irvine when I came there in the fall of 65 when the campus opened and burned out he was doing the same thing. And he's written a Ph.D. thesis about it about three years earlier and I said Well well. Well Professor Souf if we get together and put our minds to this we can make this a much more powerful much more effective. So we sat down and work on the ideas for about a year about once a week. We wrote it up in a book called beat the market and meanwhile we started investing money for people around campus. And it all worked just fine. But that led me into the financial world. So so you developed an option model in 1967. Yes. The model now is called Black-Scholes. Yes. You developed this five years before Fischer Black and my initials published that research. Well talk a little bit about that. Sure. I actually in 67 after Suphan I had gone on to our separate ways in the investment world. I worked on the theories some more and I did something that people at MIT had done about three years earlier which is I use something called the normal distribution and integrated it and got an option model and I after I did that I found that already been done at MIT. There are two missing things and the option model one was the drift rate on the stock and the other is the discount rate.

But the uncertain payoff in the Warren so everybody was stuck there they didn't know what to do about those two things which by the way between Black and Myron Sholes figured out what to do. And that of course made them famous. I said I sat down and thought about it and I said What if I live in a risk neutral world. What would the answer be then. Well the drift rate would be the riskless rate and the discount rate would be the riskless rate that pop into the formula. And I got this beautiful formula. I said this has to be the right formula and I'm going to be living in a neutral world because I know how to hedge these things. So there's virtually no risk. I'm not going to continuously adjust them because it's too costly. But if I have a whole pot of these option and Warren hedges in my portfolio the little random deviations from perfect hedging are going to wash out. And so my portfolio will rapidly converge toward a totally riskless portfolio. If I have a set up with quite a few positions so I had this all up and running in 1967. Later when I talked to Fischer Black I found that he and Sholes had actually figured out their option model in 1969. But they didn't believe that they were right. And so Fischer Black and Myron Scholz Heather publication rejected.

I think more than once they finally managed to get something in print in 1972 with I believe the intervention of maybe Paul Samuelson somebody at MIT anyhow so I had this couple of years earlier and I was looking forward to the opening of the CBOE figuring I'd be the only guy who had that and it was all set up with a little Hewlett-Packard 98 30 computer which was wonderful because it drew Colored Diagrams of ink pens and I could condense huge amounts of information into colored pictures that I had diagrams you could just look at them plot point option stock price option price and know what the head ratio was and how much overpriced or underpriced it was. But all the stuff running. I get this paper it's mimeographed is from somebody called Fisher Blacklow I've never heard of because I'm not part of the financial community. I'm not part of the wall academic community at that well I'm not part of the academic silos in finance and economics. I don't know any of these people and I said this looks a lot like my formula. Do I draw I draw a graph from a program very quickly and draw a graph from the black. Black controls paper and I see oh it's not. It's not like my former like it but it has to be the same. And then I look at it again I say Oh I know why Santha say it's because I have three formulas not one. And I put the wrong one in I put the right one in and yes it's the same. Why do I have three formulas. It's because in those days if you shorted the stock or the option you did not get to use the short sale proceeds whereas on your changes now you get full cash usage of them.

So I had to write a formula one formula for the case when I shorted the stock and bought options and was deprived the short sale proceeds a second formula when I got it from when I was able to use them Minner third formula when I was I had to hedge the other way and was to derive it deprived of the short sale proceeds. So the Chicago was coming out of me. I'm talking very quickly though anyhow. That's where that came from and to me it was just a tool for investing it. I was unaware of any greater importance in the formula not being part of the communities that were aware of how important it was. But that story there it's great. It's great. Princeton New poor partners starts in 1969. Yes wrecked. What were some of the early strategies that you were that you were trading. Well first we had warned hedging and then we followed it with that. At the same time with convertible bond hedging and the principles pretty much the same a convertible bond looks like a regular bond with some so-called latent warrants attached. You can't cut them off but it's a combination of a regular bond and a bunch of warrants or options attached. So we have that going and then when we heard about the options of change coming up we were ready for that. And then we kept expanding the things we could do beyond that when things like futures in DSP 500 came on. We began arbitraging that we were among the first to do that on a large scale and we got into something else in 1979 1980 that became pretty interesting later.

It led to a lot of trading and a lot of profits and I think ultimately the high high speed trading and this thing we got into statistical arbitrage. And one of our researchers we started the project that I called the indicators project and one of our researchers working on this project by a set of random idea out he looked at stocks that have been the most up in the last few weeks and noticed that they underperformed in the next two weeks and the reverse happened for stocks with the most down he said Well why don't we make the portfolio bets short the most up stocks in law and the most down stocks. And I said yes well we'll do it with one or two hundred companies on each side and diversify away market risk. Maybe we can do it even better by diversifying. Other factor risk. And so we are ready to do that but we didn't at the time because we had our capital employed in hedges of various kinds fully and so this didn't look as good as the hedges it seemed to have a higher risk than the hedges which seemed almost low risk they almost always made money but we deferred it and then we came across somebody who was a refugee from Morgan Stanley were discovered the same notion and improved it somewhat felting Jerry Bamber back in 1982 1983 and discovered this. We were advertising for people with good quant ideas. And so in 1985 he saw the ad he left Morgan Stanley came over and worked for us. We then did statistical arbitrage.

From then on and I only discontinued it in 2002 but it was a great profit center all that time and some of the people who worked for me broke off and did it on a giant scale and made actually billions of dollars. It's great. So Princeton Newport ran for 19 years. Yes. And you compound that money at 19 percent roughly yes in that time period which is about twice what the S&P was. Yes that time period. Pretty spectacular track record. However Rudy Giuliani wasn't so impressed with your track record. He tells us some of the story around that. OK. Well we we were very averse to risk and we tried to avoid a risk in any way we could. Goldman Sachs for example once I once asked them what happens if a freighter with a nuclear bomb is set off in New York they said what happens. Our capital on our records they said well we have duplicate records in Iron Mountain. And I said well what happens if there's a generous quake in Tokyo what will happen to our positions. And I checked things like that. What will happen suppositions if the market drops 25 percent in one day. He said no not going to happen the worst day we've ever seen is 12 or 13 percent. I said yep but we're safe with a 25 percent drop in one day and we work. So we made money every year every quarter and all but three months and the Fremont's Roll 1 percent or less in negative territory. But there was one risk that I hadn't foreseen.

Call it a Rudy Giuliani risky the way we operated was we had at our peak about 40 people in Newport Beach which was the research and development area and then we had about 40 people in our Princeton office and that was trading back office and taxes and so on though Rudy Giuliani was making his name on Wall Street by a process prosecuting people who he thought sometimes correctly sometimes not and broken various securities laws. And he was after Michael Milken and a fellow named Bob Freeman at Goldman Sachs Bob Freeman happened our bad luck to have been the roommate for Jay Regan my partner my Copart and I was managing the Princeton office. Giuliani thought he could squeeze Reagan for information. Freeman and we'd done a lot of trading with Drexel Burnham too so he thought we could he could also squeeze him for information on Mike Milken so he raided the Princeton offices and captured about 30 300 cartons I think of information of and then went through it all and they happened to find some old trading tapes. There were three tapes that had four days each on them and they come through all the tapes. They found a couple of things on those tapes that gave them some leverage. One of them was a stock parking issue and the other was a stock manipulation issue. And they were fairly minor as far as numbers go but they were illegal and so we decided to use RICO on Prince Newport and threatened to confiscate everything living apart as a money and so forth. And the upshot was that it wasn't feasible to operate the partnership under these circumstances though we closed it down at the end of 1988 when all the smoke cleared two or three years later the defendants had spent roughly 20 million dollars defending themselves and the whole result after the government pretty much dropped the case as sole result was fines for two individuals.

That was a but it did scare Milken and Freeman into pleading guilty before they saw the outcome of the prince and to work as and of course he went on to fame and notoriety as you know ordinary and extraordinary. So as you were having some success at Princeton Newport you started investing in other hedge funds. And you stumbled across a manager a trader who was trading Japanese warrants out of his dorm room. Yeah. And tell us a little bit that story. Yeah I have a friend Frank miner whose son I think is in the audience here today and beat Burt about a fellow at Harvard undergraduate who is trading securities out of his dorm room and doing very well. And he was into warnt hedging and convertible securities as fellow Harvard though Frank followed up and saw that he was doing very well and Frank decided he would set him up in business. They came out to talk to me in California and I told him how Princeton Newport worked. And I turned over a number of cartons of prospectuses for Warren S. convertible bonds. Those were valuable because they had been around some of them for 15 years you couldn't get them anymore and you wanted to trade a warrant or convertible bond. You were well advised to know exactly what the terms were. No prospectuses were the best summary source of information. So after I described how Prince Newport worked profit centers the fees and so on they pretty much set up a firm called Citadel that became what it is now starting from a very small amount. I think they had the energy to start with. I was the first regular investor.

Frank was the managing general partner and it went on from there and did great track record. So anyhow Citadel is a good example of what Princeton Newport would have evolved into had we not encountered the Giuliani. So in 1991 you stumbled across another extraordinary track record this window system something called split Strache trading. Yeah that was sort of interesting. I had a little old sabbatical between the end of Princeton Newport and starting another sophistical arbitrage hedge fund and one of my friends who was a fund of funds manager well-known and made a lot of money at it was consulting for a international consulting firm on the East Coast and he said we're reviewing their portfolio in alternative investments and they would like you to come and have a look at it. So I did and everything looked fairly reasonable. There were things like Elliott Associates in their portfolio I went out and kick the tires there. Everything seemed fine. But then I had there was one track record that seemed very strange. The person who had this track record of the firm that had it was making money every month. And my client had been in the investment for a couple of years. They made money every month one or two percent a month. The strategy was to put a collar on stocks put they would buy a foot below the stock price and sell a call above the stock price and the money from the car would pay for the foot would pay for the push. So they had zero net money up in options.

You expected in the long run that the rate of return would be zero on the options that it would all be attributable to the stocks. However they did much better than investing in stocks. And when market was down this strategy should lose money in a month but it didn't. So I wondered why I looked at their monthly statements in the statements. There was a magical trade in a month where this thing would have lost money that was a big short of the S&P 500 stock index said. The only time they do that is in a month's worth. The rest of it loses money. I held my nose and I started asking more questions. I found out that the head of information technology was the operator's brother. I found out that his accountant was a guy who lived down the street. He'd known for years and years I then found out that he told everybody that if you were an investor with him you shouldn't tell anyone else well then I said I want to go over there and kick the tires and see what's going on. No my client called and said they're going to send me over to the Lipstick Building in Manhattan where this operation was going on and the head guy's brother Peter said I will not let him in the front door. Peter was the guy who was printing all the con firms and running the operation. I said I've got to look at this more closely for you this. This looks fake to me though I asked for two months of their confirms I checked the accounting firms like any of 13000 other investors could have done up and check them against newspapers.

The con firms showed trays that never occurred because the conference showed what the exchange was what the volume was and so on. These were often trades that never occurred. The stock trades could have occurred because the big liquid stocks that I looked at another I looked at the remaining com firms and I found that half of those out of 160 over 160 total half of those had volume. That was less than the volume that my client alone had in two accounts of about 25 million each. So I said these trades are fake. You need to get out of this. They said yeah we're making 20 percent a year I said Well there are two cases you can move out of this fake 20 percent a year into your next best alternative which currently we're producing 16 present a year bore. You can stay in your fake 20 percent year if I'm wrong. It'll be a real 20 percent and you'll be happy. But if I'm right and you stay in the 20 percent your jobs maybe history if this thing blows up they were out in two months and they understood what was important. And of course this is 1991. No one else I've ever ever heard of this. I was I had reported to a client who was up to them to say anything further. They did not want to say anything further. One of their fears kept quiet but I sat on my hands for 17 years waiting for something to happen and knowing it was it was getting bigger and bigger and bigger. We identified about half a billion in through there through our great of that time.

In 1991 there was investment manager Bernard Madoff. And then of course in 2008 when it blew up there was something like 65 billion in supposin money invested and probably maybe 40 or 50 billion in real money. I'm not sure the number was and an amazing side bet of the hat. The underfunds guy who invited me to consult with the client. You heard all this. He knew it was fake or he should have known it was fake. But the weight of everybody else believing I think may have convinced my had to be wrong somehow. And as the years went by became more and more evident that I must be wrong. And so the very week that Madoff confessed the person had told me about this was listed along with family trusts in the 13000 accounts that the S.E.C. published as then being current with Madoff and he was actually selling Madoff the week of the blow of though this is an amazing exercise in just denial. And just as a footnote this is the kind of thing that you need to think about when processing information. And one of the things that been very helpful to me is having what somebody else called a very good bullshit judge actor and I think that's one of the most valuable things you can possibly have when evaluating investments or investment managers. Amazing. Our time is out and I have one last question for you in your book there's a theme of of introspection and knowing what is most important to you personally. He devoted a couple of chapters to thoughts in your epilogue in industry that's not always known for its moral code.

You talk a little about that and some of the some of the thoughts you expressed in that one chapter. Sure. I thought about life from a number of different perspectives. And some people are so money driven that they never have enough and so they won't stop until the end whenever that is and they will die with the pile of money and they'll spend all their precious lifetime chasing it and things. And my view is that the most important thing in life is the way you spend your time. And the people you spend it with and just how you just how you experience things as you travel along. But Meat money and things are just auxiliaries that make things more pleasant but they're not the main goal in life. Excellent. Thank you. Oh great do we have time for a few questions. Any questions from the audience back there. We get a microphone at to find inefficiency and edge. I know that's the trillion dollar question where you think there might be opportunity today that there's some inefficiency left well a lot of people ask this because they want to know what to do with their money. People with small amounts of money amounts and large amounts and so to me it's a it's a three phase thing. If you don't want to spend a lot of time then the obvious thing to do is to index. And that gets you a big advantage is probably almost everybody here knows versus the average investor because you're not paying transactions costs on the same scale that the active investors are and you're not paying for advice which can be very expensive.

You're also if you're taxable not it generating as much taxable income as early. So it's that's a simple solution and just a matter of how you want indexed you want all equities you want small stocks of those big stocks you want to have bonds in there. You want a REIT and so forth. There was a discussion of that in my book as to the pros and cons and the historical returns what you might expect and the next-level is maybe your as small to medium investor but you just can't sit still. You've got to do something or you want to learn something about the markets. So sure go going and have fun but realize that it's going to cost you if you spend time paying your educational tuition to the market. You may actually evolve into situations where things are really good. I mean there's some obvious things that I mention in the book. One of them is closed end funds that are discount. You want to spend some time studying that is not a very hard problem. You can get a few percent edge I believe. And the other one is that everybody knows about is mutual savings and loans. Converting into publicly traded companies. But that is so heavily done now that it's hard to make significant amounts of money. This is good stuff for small people who happen to have had accounts in a particular mutual savings and now when they do offer an IPO those people should wake up and take advantage of it.

Then there is the bigger level where you have a fair amount of money that you can bring to bear and that is a complex difficult problem because so many other smart people are doing the same thing. You have a lot of competition in all these areas and there are two ways to go. You can try to find somebody who's running a successful alternative investment operation picking those is probably as hard as picking stocks or close to it. It's basically the same problem in another setting. You can try to go into business for yourself. And what I find is that if you want to go into business for yourself you need some thing that will be a solid base that will make you a profit. And then once you have this foothold you can begin to expand into whatever else comes along. But it will give you enough profit flow in the beginning so you can build an entity or an organization to them is expandable because those are the three ways that I would look at it. Around on the side mutual the Harvard I couldn't understand all that good risk parody. Any thoughts on risk weighted risk balanced testing. Well I'm not sure if I'm talking about the same thing but there is a notion that has received a fair amount of press about how people pay too much for high risk securities versus low risk securities. Is that what's behind this. It's probably more of a generalized question. It's an investment strategy that Bridgwater like strategy sort of weighting your investments by their risk. Oh I see. I'd say the way to answer that is first to look at data and see if it supports that methodology and then ask whether the extent to which it supports it is statistically significant.

And I don't I don't know the answer because I haven't done that job. Mr. Thorp I have a question about your investment in Berkshire Hathaway. Could you talk tell us about your meetings with Mr. Buffett and how long you've held the stock and whether you've been able to accumulate a big position early on. Sure. What happened was when I started setting up Warren hedges back in 1967 1968 people around campus heard about it and they wanted to invest. And so I manage some individual accounts I was limited to 14 by the Investment Advisers Act so I kept that under that. One of the people who invested was the dean of the graduate school at UCI as was Ralph Waldo Girard and turned out that he was a cousin of a fellow named Benjamin Graham and Gerard had been an early investor in the partnership called Buffett Partners Limited and he'd had a very happy experience but the market was manic in 1968 and pretty far in 67 to as I recall. And Buffett said you know we're out of good situations I'm shutting down though he was giving money back to his partners and Gerard was looking for another place to invest. So he started with me with a Warren hedge. And he also introduced me to Warren Buffett. Warren Buffett spent summers in the Newport Beach area where I lived.

So we had some dinners with Buffett Warren Buffett a Suzy Buffett a Ralph and his wife Frostie and me and my wife Vivian and then I had some bridge sessions with Ralph and Warren and I forget who was the other who was the fourth though Warren asked me a lot of questions and we chatted away. And I realized at that time that he would be one of the richest people in the United States because he had been at this game a long time. He already had twenty five million or so in 1968 coming out of Buffett Partners Limited. And he understood long term compounding and he was willing to devote his life to doing just that. I personally would not have made that choice but everybody makes a different choice that suits them so anyhow he apparently approved of me and Gerard gave me a large amount of his money to manage and ended up in Princeton Newport partners until the end there and actually Gerard and then his wife died during that 19 years we were running in and Newport and so there state remained invested in Prince Newport until we finally came to the end of Prince Newport and made a lot of donations to UC Irvine. That's where he was leaving a lot of the money. In any case one day in nineteen eighty three I was reading something or other and I came across Berkshire Hathaway there some article about it and I realized that Warren Buffett was running that as a zone of moment in 1982. Not sure of the date. No I think it's 83 in the book. So I realize that Warren Buffett had been running this as his own private mutual fund all these years. Unknown to me and this When Berkshire Hathaway when he first invested in it was something like 12 dollars I don't remember the exact number.

And then when he shut it down it was maybe in the 20s or 30s in nineteen 68 and he wanted to capture as much stock as he could at that time to take control of the company. So when I saw it it was a nine hundred eighty two dollars and fifty cents. So I started buying and I held it ever since. I've given some of the UC Irvine to endow a chair in mathematics. I gave them a little over a million and I told them only take 2 percent of your or less out and it will grow. So it's about two point six million now even after they've been spending. I think we endowed it in 2004 and course has been the over all figures anyhow. It has a lot of advantages to it. There are the things that people consider disadvantages one of them is that the rate of return hasn't been much greater than that in the S P 500 pretty close in fact over the last seven or eight years. In the book I break it into into Faison's or Prairie's. You can see our data in each of those periods. But then people worry about KIEM in risk Charlie dies Warren dies and so forth. But it has a lot of pluses going. One is that it doesn't pay dividends which many people consider are negative but I consider it a huge positive because you pay dividends. You're more likely to pay taxes. And so it compounds tax deferred.

And when you actually cash some of it in if you need money you're going always spend a little bit here or there you will pay long term capital gains tax under current law as opposed to some higher rate of tax so there has a lot going for it. And also I'm stuck in it because I have a low a low basis. And so I take it for when you're 25 percent hit when I sell it. And so I've I've got to have something really good in order to take that hit and change from it. The Warren strapper thank you. We have to leave it there. It's book is a man for all markets he will be at the event tomorrow with a suite and plenty of books if anyone's interested in buying and getting a signature and chatting with them. So thank you again for for being here with us.

Updated on

No posts to display