Chapter 14 - A Man for All Market: From Las Vegas to Wall Street, How I Beat the Dealer and the Market
Today's Chapter is based on the book “A Man for All Market: From Las Vegas to Wall Street, How I Beat the Dealer and the Market” an autobiography by Edward Thorp.
Buy it on Amazon here:
https://www.amazon.com/Man-All-Markets-Street-Dealer/dp/1400067960
Here's what I have learned from the book:
Loving to Learn
“The doer alone learneth.”
— Friedrich Nietzsche
From an early age, Edward Thorp had a special trait: he had a tendency to not accept anything he was told until he tested it out himself. This obviously had some bad consequences at times:
“When I was three, my mother told me not to touch the hot stove because it would burn me. I brought my finger close enough to feel the warmth, then pressed the stove with my hand. Burned. Never again.”
— Edward Thorp
However, this habit lead him to love learning through his own experimentation and exploration. This also led him to question and test every theory that were deemed to be true by the crowd. It is by doing this that he was able to find an edge over others both in gambling and in investing. This is very similar to the Edisonian Approach taken by James Dyson which encourages learning through trial and error rather than through a more theoretical approach. Furthermore, Dyson was also known for inventing and improving daily-use products that were deemed unimprovable.
“Pranks and experiments were part of learning science my way. As I came to understand the theory, I tested it by doing experiments, many of which were fun things I invented. I was learning to work things out for myself, not limited by prompting from teachers, parents, or the school curriculum. I relished the power of pure thought combined with the logic and predictability of science. I loved visualizing an idea, and then making it happen.”
— Edward Thorp
For example, while it was deemed impossible to predict the game of roulette, even by famous physician like Richard Feynman, Thorp was able to find a significant edge through experimentations. Similarly with the game of Blackjack, Thorp was able to create a card-counting system that allowed him to have an edge over the casino. And yet he did this at a time when it was deemed impossible to have a winning system for casino gambling games.
“If anyone knew whether physical prediction at roulette was possible, it should be Richard Feynman. I asked him, “Is there any way to beat the game of roulette?” When he said there wasn’t, I was relieved and encouraged. This suggested that no one had yet worked out what I believed was possible. With this incentive, I began a series of experiments.”
— Edward Thorp
“Attempts to find winning systems over the following centuries stimulated the development of the theory, eventually leading to proofs that winning systems for casino gambling games were, under most circumstances, impossible. Now I benefited from my habit of checking it out for myself.”
— Edward Thorp
Similarly, when Thorp got interested about the financial market, the efficient market hypothesis was very predominant in the financial field. In summary, this theory mentions that markets are efficient and that it is impossible to make excess profits through investing since everything is already fairly and accurately priced by the market. And yet, Thorp was able to find ways of beating the market consistently through statistical arbitrage.
“When I became interested in the stock market, I heard the same claims about investing. Academics had developed a series of arguments known as the efficient market hypothesis (EMH). Using financial market data, they showed that tomorrow’s prices looked like random fluctuations around today’s prices, therefore they were not predictable.”
— Edward Thorp
“After these lessons from Mr. Market, I was tempted to believe that the academics were right in claiming that any edge in the markets is limited, small, temporary, and quickly captured by the smartest or best-informed investors. Once again, I was invited to accept the consensus opinion at face value, and once again I decided to see for myself.”
— Edward Thorp
Learn When to Bet Big
“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.”
— Charlie Munger
Due to his knowledge of probabilities, Thorp understood the importance of betting big when you odds are in your favor. As such, he was known for betting bigger amount when he had a significant edge while playing blackjack and while investing in the stock market. Not only is this applicable in investing, I believe this is also relevant in life decisions; rare are the favorable opportunities in life and it is important to take action when it comes to you.
“Our experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime.
A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables.
And then all is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past”
— Charlie Munger
This thought of betting big when odds are in your favor is the basis of the Kelly Criterion which is a mathematical formula to calculate what percentage of your money you should allocate in a bet or investment idea. The formula is based on two criteria:
Win Probability
Win/Loss Ratio
Warren Buffett is known to be a user of the Kelly Criterion strategy:
“Warren Buffett’s thinking is consistent with the Kelly Criterion. In a question and answer session with business students at Emory University, he was asked, in view of the popularity of Fortune’s Formula and the Kelly Criterion, to describe his process for choosing how much to invest in a situation. 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.”
— Edward Thorp
As such, considering the rarity of having an opportunity where odds are in your favor, Thorp learned that it isn’t worth it to be nit-picky in those situation. As a matter of fact, he believes that it isn’t worth to push the other party to their absolute limit when negotiating. A small gain is most likely not worth the risk of the deal breaking up. Similarly, it is ill advised to pass on an investment opportunity due to being stubborn on a set price:
“Here’s the idea. Suppose we want to buy 10,000 shares of Microsoft (MSFT), currently trading at, say, 71 bid for 50,000 shares, and 71¼ asked for 10,000 shares. We can pay 71¼ now and buy our 10,000 shares. Or, as our trader would do, we can offer to buy our 10,000 shares at 711⁄8 and see if we have any takers. If this works—and it does most of the time—we’ll save $1⁄8 × 10,000 or $1,250. This sounds good. Is there any risk? Yes. By trying to save $1⁄8 per share we may miss a big winner if the stock always trades at 71¼ or higher for however long we’re trying to buy. Those stocks we miss, which run away to the upside, would have given us windfall profits. Put simply, you might scalp $1⁄8 twenty times but lose $10 once. Do you like that arithmetic? I don’t.”
— Edward Thorp
Power of Compounding
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it."
— Albert Einstein
According to Warren Buffett, the understanding of compounding interest is the first and most important mathematical concept to learn. Not only is it important in investing, but it is also useful in terms of seeking wisdom and obtaining good habits. As a matter of fact, a one percent improvement every day leads to 37x improvement in a year. Similarly, it is very possible to become wealthy even if our investments grow at a small rate as long as it happens on a long period of time:
“Over a sufficiently long time, compound growth at a small rate will vastly exceed any rate of arithmetic growth, no matter how large!”
— Edward Thorp
The power of compounding reminds me of Charlie Munger’s Lollapalooza Effect where multiple forces are even more powerful when combined together:
“… really big effects, lollapalooza effects, will often come only from large combinations of factors. For instance, tuberculosis was tamed, at least for a long time, only by routine combined use in each case of three different drugs. And other lollapalooza effects, like the flight of an airplane, follow a similar pattern.”
— Charlie Munger
The rules of compounding are very simple once you get the concept: start early and do not ever interrupt it. As Charlie Munger famously said, “The first rule of compounding: Never interrupt it unnecessarily.” Thorp understood the importance of compounding beyond the stock market. As a matter of fact, it is this principle that encouraged him to lead a healthier lifestyle. For every hour he spent on fitness was one less day he would spend in a hospital:
“If you are like me and want better health, you can invest time and money on medical care, diagnostic and preventive measures, and exercise and fitness. For decades I have spent six to eight hours a week running, hiking, walking, playing tennis, and working out in a gym. I think of each hour spent on fitness as one day less that I’ll spend in a hospital. Or you can trade money for time by working less and buying goods and services that save time. Hire household help, a personal assistant, and pay other people to do things you don’t want to do.”
— Edward Thorp
“Americans supposedly spend an average of forty or more hours a week watching television. Those who do have plenty of “junk time,” which they can use instead for an exercise or fitness program. Five hours a week for this can add five years of healthy life.”
— Edward Thorp
How to Beat the Market
“Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.”
— Howard Marks
While Edward Thorp doesn’t believe in the efficient market hypothesis, he still believes it is incredible difficult to find superior investments relatively to a low-cost index fund. As a matter of fact, Warren Buffett, possibly the greatest investor of all time, is also a believer that most individuals are better off investing in an index fund. Thorp thinks that it is difficult because the biggest challenge to buy-and-hold investing is the investor himself. It is difficult to make rational decisions with all the noises surrounding the stock.
“The issue here is the same as for those buying stocks, bonds, or mutual funds. 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.”
— Edward Thorp
“The main disadvantage to buy-and-hold versus indexing is the added risk. In gambling terms, the return to buy-and-hold is like that from buying the index then adding random gains or losses by repeatedly flipping a coin. However, with a holding of twenty or so stocks spread out over different industries, this extra risk tends to be small. 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.”
— Edward Thorp
Nonetheless, despite this challenge, Thorp was able to find a way to beat the market. And, as he once said, “Doing better than the market is not the same as beating it. The first is often simply luck; the second is finding a statistically significant edge that makes sense, then profiting from it.” Luckily for us, Thorp tells us what it takes to beat the market In his book:
Get good information early.
Be a disciplined rational investor: don’t invest unless you are confident you have an edge. As Buffett once said, “Only swing at the fat pitches”.
Find a superior method of analysis: find a niche where you have superior knowledge i.e. microcaps, statistical arbitrage, special situations, etc.
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.” Be sure your information is current, accurate, and essentially complete. Be aware that information flows down a “food chain,” with those who get it first “eating” and those who get it late being eaten. Finally, don’t bet on an investment unless you can demonstrate by logic, and if appropriate by track record, that you have an edge.”
— Edward Thorp
Beyond the Book
Read "Understanding your Circle of Competence: How Warren Buffett Avoids Problems" by Farnam Street
Read "Compounding Knowledge" by Farnam Street