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

by Edward O. Thorp

In 1972 the company had warrants that sold for 27 cents when the stock traded at $8 a share. The warrants were so cheap because they were worthless unless the stock traded above $40 a share. Fat chance. Since our model said the warrants were worth $4 a share, we bought all we could at the unbelievable bargain price of 27 cents each, which turned out to be 10,800 warrants at a total cost, after commissions, of $3,200. We hedged our risk of loss by shorting eight hundred shares of the common stock at $8. When the stock later fell to $1.50 a share, we bought back our short stock for a profit of about $5,000. Our gain now consisted of the warrants for “free” plus about $1,800 in cash.

A smart hedge. And a win on volatility either way. This slump was profitable even before the not foreseeable subsequent Atlantic City development that made the warrants hugely valuable.

Another tool used today is to “stress-test” a portfolio by simulating the impact of major calamitous events of the past on the portfolio. In 2008, a multibillion-dollar hedge fund managed by a leading quant used ten-day windows from the crash of 1987, the First Gulf War, Hurricane Katrina, the 1998 Long-Term Capital Management crisis, the tech-induced market drop in 2000–02, the Iraq War, and so forth. All this data was applied to the fund’s 2008 portfolio and showed that these events would have led to losses of at most $500 million on a $13 billion portfolio, a risk of loss of no more than 4 percent. But they actually lost over 50 percent at their low in 2009,

Pah!

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.

When, with our expanding range and size of trades, we moved our account to Goldman Sachs as our prime broker, one of the questions I asked was: “What happens to our account if Goldman Sachs New York is destroyed by a terrorist nuclear bomb smuggled into New York Harbor?” Their reply was: “We have duplicate records stored underground in Iron Mountain, Colorado.

As the era of high interest rates unfolded, savings and loan companies began to lose massive amounts of money. Here’s why. Savings and loans borrowed money for a short term from depositors and lent much of it out long-term for home mortgages at fixed rates of interest. As short-term rates shot up, the cost of money to the S&Ls went up rapidly, whereas their revenue from the existing mortgage loans they had made earlier to homeowners at much lower fixed rates did not.

Still don’t really understand why the banking model makes sense. Unless you have a 20-year (or whatever the mortgage turnover half-life is) horizon and can offset losses in one decade when interest rates are rising against another when they’re falling. But comp and Wall Street don’t work on such horizons. Do any banks still hold mortgages these days? Are they poised for ruin with current interest rates?

I called our first effort the Indicators Project. The object was to study the financial characteristics of companies, or indicators, to see if they could be used to forecast stock returns. The prototype was Value Line, an investment service that launched a program in 1965

He started Value Line? I had no idea! Turns out he’s pretty far from an academic at heart!

Financial models like the Black-Scholes formula for option prices were built using the lognormal. Aware of this limitation in academia’s model of stock prices, as part of the indicators project we had found a much better fit to the historical stock price data, especially for the relatively rare large changes in price. So even though I was surprised by the giant drop, I wasn’t nearly as shocked as most.

Black swanning baby!

Though there was no major outside event to explain this one-day collapse, when I thought it through that evening I asked myself, Why did this happen? Will the disaster continue tomorrow? Will there be profit opportunities created by the chaos? I believed the cause was a new financial product called portfolio insurance.

Hadn’t heard of portfolio insurance. Sounds foolish and the opposite of what you’d want to do in a market decline? (Shifting from equities to treasuries as prices fall—and in proportion to the fall)

At the time of the crash $60 billion or so of equities were insured by this technique and implemented largely by computers. When the market fell 4 percent on Friday the insurance programs placed orders, to be executed at Monday’s opening, to sell stock and buy Treasury bills. When trading began on Monday, these sales drove stock prices down further, triggering more selling from portfolio insurance programs.

Electronic trading curbs were put in place after this incident? Can’t remember.

5. OSM Partners: a “fund of hedge funds” that invested in other hedge funds.

This was one of the partnership’s strategies: why did they bother buying other hedge funds?

Neither I nor any of the forty or so other partners and employees in the Newport Beach office had any knowledge of the alleged acts in the Princeton office. We were never implicated in, or charged with, any wrongdoing in this or any other matter. Our two offices, more than two thousand miles apart, had very different activities, functions, and corporate cultures.

Criminal behavior in the east coast office: how much of their seemingly impossible performance was due to illegal activity?

Legal fees for the defendants were estimated at between $10 million and $20 million. There was no telling how long the case would go on or how it would end. If the defendants were found guilty they would be liable for their own legal bills whereas if they were declared innocent, the partnership would pay. To get closure, I negotiated a flat advance payout to the defendants of $2.5 million, to cover any and all responsibility the partnership had for their legal expenses.

Interesting arrangement. Is the original legal responsibility on the part of the firm a standard arrangement in employment contracts?

Milken’s group underwrote issues of low-rated, high-yielding bonds—the so-called junk bonds—some of which were convertible or came with warrants to purchase stock. The higher yield was the extra compensation investors required to offset the perceived risk that the bonds would default. Filling a gaping need and hungry demand in the business community, Milken’s group became the greatest financing engine in Wall Street history. Such innovation outraged the old line establishment of corporate America,

This is an interesting perspective: that Milken was an innovator and threatened the Wall Street establishment who enlisted the government (and an ambitious Giuliani) to take him down. That every form on Wall Street breaks the rules here and there so they were confident they could find something, but the big players were far less scrupulous and acting far more illegally on a regular basis. “Milken was framed!” he claims. I’m not so sure, will need to read more. Milken have a memoir I presume?

Then I called Fischer Black, who was now at Goldman Sachs, after hearing that he wanted to build a computerized analytic system for trading warrants and, especially, convertible bonds. Our proven state-of-the-art system was for sale, so he flew out and spent two days with Steve and me learning how it worked. He took detailed notes but finally said that it would be too costly to convert the code to run on their computers.

Thorp isn’t this naive is he? Guess he likes nerding out, and didn’t need an IP sale to retire well.

Joseph Heller and Kurt Vonnegut were at a party given by a billionaire when Vonnegut asked Heller how it felt to know that their host might have made more money in one day than Heller’s Catch-22 since it was written. Heller said he had something the rich man could never have. When a puzzled Vonnegut asked what that could be, Heller answered, “The knowledge that I’ve got enough.

Heh. That Heller character.

After analyzing about 160 individual options trades, we found that for half of them no trades occurred on the exchange where Madoff said that they supposedly took place. For many of the remaining half that did trade, the quantity reported by Madoff just for my client’s two accounts exceeded the entire volume reported for everyone.

Wow, this was in 1991. Why didn’t anyone else do this same checking to bring Madoff down sooner? This is among the clearest signs of fraud you could imagine.

Markopoulos concluded that it was impossible on the basis of quantitative financial reasoning, just as I had done before I began my investigation that proved fraud. Though he didn’t establish that the individual trades were faked, even without that smoking gun his arguments were overwhelmingly persuasive. For the next ten years Markopoulos attempted to get the SEC to investigate, but it brushed him aside repeatedly, cleared Madoff after superficial investigations, and quashed a request from the Boston office, prompted by Markopoulos, to investigate Madoff Investment as a possible Ponzi scheme.

Markopoulos was an angry ranter in his letters to the SEC. should’ve used Thorp’s approach (more of a smoking gun) and tone of language.

About this time he realized large oil tankers were in such oversupply that the older ones were selling for little more than scrap value. Kovner formed a partnership to buy one. I was one of the limited partners.

That’s pretty cool. He bought share in an oil tanker at just above scrap value (inherent hedge, a price floor) anticipating that its value would go up. It did, but they held onto it and made a lot of money operating as a tanker, the sold for scrap at large gain to boot.

In addition to what the hedge funds charge directly, the fund of funds manager collects a second layer of fees, typically 1 percent per year plus 10 percent of the profits. —

What a racket!

The journal Tax Notes said the top 0.01 percent of American households expanded their inflation-adjusted income from 1973 to 2007 by 8.58 times whereas the bottom 90 percent gained about $8 per year! This inequality increased further in the next decade.

What conclusions does he draw from this? None shared in the book. Any interest on his part to fix inequality?

Investors who don’t index pay on average an extra 1 percent a year in trading costs and another 1 percent to what Warren Buffett calls “helpers”—the money managers, salespeople, advisers, and fiduciaries that permeate all areas of investing. As a result of these costs, active investors as a group trail the index by 2 percent or so, whereas the passive investor who selects a no-load (no sales fees), low-expense-ratio (low overhead and low management fee) index fund can pay less than 0.25 percent in fees and trading costs.

Like the point of view of all non-indexers acting as a single (very large) indexer who, by having much higher turnover, performs worse than the market and worse than indexers asa whole. So to be an active investor who beats an index fun, you either need to implement the index fund yourself (with lower expense ratio than the fund—is this even feasible as individual?) or beat the average active investor by 2%...and I wonder what percentile in the rankings of active investors you need to achieve to do that? Top 25%? Every year.

Another aspect of the apples-and-oranges comparison is the impact of cash balances. Since fund investors continually add or withdraw money, funds are partly invested in fluctuating cash balances. When the market rises strongly, the interest on this cash doesn’t keep up and the fund return lags the return on the equity portion of its holdings. Conversely, when the market is down sharply, the losses on the fund’s equity position are reduced to the extent it is in cash and by the interest it gets on that cash. The impact of this cash drag is generally small.

Have wondered whether this impacts index funds’ performance as well. I guess I’ll take “it’s small” for now.

The cards dealt at blackjack also seem to appear at random but not if you “track the shuffle,” which is a way to beat the game by watching the order in which the discarded cards are stacked, then mathematically analyzing the particular shuffling technique being used, leading to a partial prediction of the new ordering of the cards for the next deal. The likelihood of any card being the one that is dealt next is not random if you count the cards. What appears random for one state of knowledge may not be if we are given more information.

Wait, so was he one of the MIT blackjack team investors or not? Or the shadowy instructor? Seems like lots of hints here that he’s explored some of the more sophisticated tactics they used.

If the market does a good job of using today’s public information to set current prices, then the only investors who have an edge are those with material private information. The high-profile prosecution of investors in the 1980s for illegal trading on inside information makes the point.

Though it grossly understates it I’m sure. I assume it’s rampant and you’ve got to be flagrant violator, or a juicy target like Martha Stewart. :/

When the P/E is 20, for example, the earnings yield is 1/20, or 5 percent. 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.

If you truly want to compare E/P to bond yields (does literally doing so make sense?), do you look at twelve month trailing earnings? And does volatility of the two asset classes affect price you should be willing to pay? Seems it should.

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.

A) why? Globalization? B) what can you do about it? Not allocate as much to international? Make equity investment overall same allocation as used to suggest for US stocks alone, and split between US and international? Where to seek better diversification then?

This safety net was severely tested in the 1980s, when the savings and loan collapse cost the Federal Deposit Insurance Corporation—that is, US taxpayers—$250 billion, about $1,000 for every man, woman, and child in the country.

How much money did FDIC have at the time of S&L crisis? This wasn’t all funded by taxpayers, some of it came from banks paying into FDIC, right?

Ironically, having passed in 1994 on the chance to invest in LTCM and temporarily get rich, I made money in 1998 by exploiting the distorted market prices left in the wake of their collapse. LTCM’s loss was our gain in Ridgeline Partners.

Other institutions had pretty easy access to LTCM’s positions as they were unwinding it, allowing them to take advantage of the fire sale. This didn’t feel in the best interests of the economy, but made lots of other hedge funds and banks rich. /When Genius Failed/ goes into this quite well.

When Commodity Futures Trading Commission chairperson (1996–99) Brooksley Born wanted to regulate the derivatives that would later be a major cause of disaster, the PBS program Frontline detailed how she was blocked in 1998 by the triumvirate of Federal Reserve chairman Alan Greenspan, US Treasury Secretary Robert Rubin, and Deputy US Treasury Secretary Lawrence Summers, all of whom would later advise government on the 2008–09 bailout.

This was a really good—and frustrating—Frontline. Recommended.

As Keynes said, the market can remain irrational longer than you can remain solvent.

Gift wish list: t-shirt with this quotation.

Our corporate executives speculate with their shareholders’ assets because they get big personal rewards when they win—and even if they lose, they are often bailed out with public funds by obedient politicians. We privatize profit and socialize risk.

Exactly. Hard to emerge from this world though, isn’t it, without total catastrophe being the proof that the government has removed the moral hazard. Meanwhile, economy is destroyed for generations?

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. They are the ones who buy politicians, using campaign contributions, career opportunities, investment profits, and more. As owners of wealth who also control power, they run the country and will continue to do so. We saw how they used the government to bail them out of the financial crisis of 2008

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.

But the politically connected rich typically point to the higher rates paid by their nonconnected rich fellows as a cover to demand still more tax breaks for themselves.

Here’s my solution. Let the state tax for individuals simply be a fraction of the federal tax, to be set by the legislature, and chosen to raise the same total revenue as the current tax. The return would fit on a postcard, saving hours for each taxpayer and freeing several thousand unproductive state employees for useful work in the private sector. Eliminating three thousand state of California employees at a cost of $100,000 each, including salaries, benefits, and overhead, would save the hard-pressed state $300 million a year, not to mention all the time and money saved by citizens.

Please say you’re running for office at the end of this chapter ;) except, who would fund this platform? No one pays for fairness.

Tax rates are high because the loophole-riddled regulations allow many to pay less or even nothing. 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,

You can still have a progressive marginal tax schedule if you get rid of loopholes. It’s not the tax brackets that are the problem.

Again, we could have an enormous benefit to society. Hundreds of thousands of government employees, tax lawyers, accountants, and tax preparers would be freed to make (hopefully) a productive contribution to society.

Wait, but you mean kill jobs (bureaucrats and IRS employees, plus the multi-billion dollar tax prep industry)? Oh wait, you’re right, they don’t help society at all—well except they do a lot of lobbying, that’s good for America, right Trump? Or is your strategy to hire all of the lobbyists as regulators do they can’t lobby? But they seem to spring up as fast as anyone could possibly do away with (or hire) them...

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.

And dismantling of great public school and university systems, likely not to be improved upon by for-profit educational institutions—ahem, de Vos.

One of the most ominous and underappreciated threats to our future is in education and technology. My own state of California is a leader in the race to the bottom. The anti-tax movement has starved the state of revenue, especially the educational system. The ten campuses of the University of California, once among the finest public systems of higher education in the world, raised tuition to $12,000 a year by 2015. When I was a student in 1949 it was $70, which is like $700 today, adjusting for inflation.

Amen

Meanwhile gifted foreign students, many of them Chinese, receive advanced degrees in the United States and return home, rather than struggle for postdoctoral funding and permission to become residents. Talented American-born scientists and engineers are joining them in a reverse brain drain.

Takes a long time for this effect to play out but it’s happening and it’ll be devastating. Thanks Gingrich, Bush, Cheney et al. for the anti-science, anti-intellectual movement. Ugh.

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 starve education is to eat our seed corn. No tax today, no technology tomorrow.

Finkelstein, Mark and Thorp, Edward, “Nontransitive Dice with Equal Means, in Optimal Play: Mathematical Studies of Games and Gambling,