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22d • General discussion
Ed Thorp, 2 podcasts summarized
Who he is and what he did
Edward Thorp was born in August 1932, in the middle of the Depression. He grew up in a working-class family with parents on defense-industry shifts, which left him and his brother mostly on their own. He was an early reader who found most of his interests were shared only by adults, and he started earning money young: Kool-Aid for a penny a glass, then a paper route. He did a physics PhD, switched into math, and ended up an instructor at MIT, then New Mexico State, then UC Irvine. Along the way he worked out how to beat blackjack, built a wearable computer to beat roulette with Claude Shannon, and then moved into markets. There he priced warrants and options, ran what he describes as the first quantitative market-neutral hedge fund, and compounded at roughly 19 to 21 percent a year for decades. Both hosts open by stressing how extreme the record is: 227 profitable months out of 230.
Blackjack and gambling
In 1959 he read a statistics paper on a near-break-even blackjack strategy and took a $10 gamble on a Vegas trip. At the table he noticed that neither the players nor the casino understood the game. The key insight was that the deck isn't reshuffled after every hand, so as cards leave, the odds shift. He had a computer remove four aces and saw the casino's edge jump by almost three percent, which told him that a deck rich in aces and tens favors the player. He then needed an IBM 704 at MIT because the calculation was far too large to do by hand. The rest was betting: big when the deck favors you, small when it doesn't. The AMS abstract committee assumed he was a crank, since theorems said casino games couldn't be beaten. A member who knew him vouched for him. Manny Kimmel then bankrolled a $10,000 trip, and Beat the Dealer became a bestseller. He says gambling was the best training ground for investing, because it teaches you to compute odds, manage money, and act when you have an advantage.
Mathematics and probability
He shows an instinct for turning a vague belief into a calculation. The roulette idea came from physics: the ball orbits like a planet, so if you can measure the position and velocity of the rotor and ball, you can predict a useful region of the wheel. The warrant idea came from realizing that most of the uncertainty in a warrant's price comes from the underlying stock and the time left. In the transcript he says he derived the option formula himself by reasoning about the hedge, and that it matched Black and Scholes when their paper came out in 1973. He is also very comfortable with the limits of probability: in markets you often know the payoffs but not the probabilities, so you estimate a distribution and think through how bad things could be compared to your most likely case. If even the bad case looks good, he says, you have something worth playing.
Kelly criterion
He explains Kelly as the answer to a tradeoff between risk and return. If you bet too little you barely grow. If you bet everything on a favorable bet, you eventually go broke even though your expected value is highest. Kelly is the optimal compromise for someone who will be making a lot of bets over a lifetime. His examples: a coin with a 2% edge, where you bet about 2% of your bankroll, and a 60/40 coin with even payoffs, where you bet 20%. The rough rule is edge divided by variance. He recommends half Kelly, which gets you about three quarters of the growth with about half the risk, and the 20% bet on the 60/40 coin is scary enough in practice. He co-edited a 700-page book on the subject, and he says it applies at the level of nations, because most big disasters (1929, 1987, LTCM, 2008) came from too much leverage.
Beating inefficient markets
He doesn't believe the market is perfectly efficient, but he's careful about where the inefficiencies are. His starting point was the over-the-counter warrant market in the 1960s, which he describes as a telephone market with wide bid-ask spreads and sloppy pricing. He says there was every reason to expect those prices to be wrong often. His view is that the hard part is finding a situation where you have an edge, and that this changes over time and depends on who you are. Buffett found bargains in balance sheets. High-frequency traders get faster information. He says there are many different games and he can't tell someone which one suits them, but you have to find one that works and fits you.
Arbitrage
His warrant strategy is the template: if a warrant is overpriced relative to the stock, sell it short and buy the stock. If it's underpriced, buy it and short the stock. The stock risk largely cancels because the two move together, and you adjust the ratio as the price moves. What remains is the mispricing. He describes this as removing most of the risk while still capturing extra return. The same idea led to Beat the Market with Sheen Kassouf and, in his telling, helped inspire the Black-Scholes approach of hedging in tiny increments until the position is effectively riskless. His fund was set up as a limited partnership to run this kind of market-neutral strategy. In the transcript he says his book also covers statistical arbitrage, but he doesn't go into detail in these two episodes.
Psychology and discipline
The discipline in these interviews is about sizing, patience, and humility. He bets half Kelly so he doesn't get scared and abandon the plan. He likes the JP Morgan line to sell down to the sleeping point. He distinguishes between knowing and not knowing: when asked if central banks would cause the next crisis, he said he didn't know and put it at 50/50. He cites Tetlock's Superforecasting: the confident experts who make bold claims get the press, while the better forecasters weigh many possibilities. He also says speculating is still worth doing, because it prepares you psychologically for a range of outcomes even if you can't bet on them. On the human side, he says he never played for the money, he wanted adventure, learning, and smart people.
Why he distrusts conventional investing
His main objection is to the industry's incentives. He says that about 90% of investors do worse than an index, because they pay fees to advisors. At the top end, he says the people who make the big money usually have large staffs and large capital, and often charge other people fees, and the fee chargers make most of the money. On forecasting, he says so-called experts have little of value to say, and are rewarded for strong claims rather than accuracy. On the banking system, he is openly critical of rolling back regulations that limit leverage, and describes the result as heads the risk takers win, tails the public loses. Because bubbles are hard to time, he'd rather keep risk at a level where he can survive them.
Advice to younger quantitative investors
There are two parts to making money: finding an edge and managing the money. Kelly and similar tools handle the second part, and the first is harder and changes over time. He tells people to look for a game that fits their abilities rather than copying someone else's. He thinks gambling and blackjack-style training, learning to compute odds and bet sensibly, is a good foundation. He warns small investors not to expect to go out and make a big killing. For people who want to dig in, he points to the Kelly book and the early quantitative papers, in particular The Random Character of Stock Prices, which helped him figure out the option formula. If you want to quote this section, I'd frame it as "what he says to people who want to try" rather than a direct piece of advice.
Personal philosophy
He keeps coming back to doing what you enjoy and are good at, and letting money and success follow. He says that if you chase money or success directly you're looking at it the wrong way. He tells the story of a billionaire friend who is getting divorced because he won't stop working, and says that if you can never have enough, no advice will help you. His view is to enjoy the people you love and who are worth being with, and not spend your life piling up money. On a lighter note, in ep. 128 he says he wants to stay alive and keep doing things, learning, and traveling. He ran marathons for about 20 years, now walks and trains in the gym, eats in limited quantities and mostly healthy food, never smoked, avoided contact sports to protect his head, and gets regular medical tests.
Two notes: the transcripts are auto-generated and messy in places, so check names and numbers before publishing. Do you want these tightened into one-liners for captions, or kept as paragraphs for the article?
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Ed Thorp, 2 podcasts summarized
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