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

by Edward O. Thorp

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 believe the cause was a new financial product called portfolio insurance. Had I paid closer attention earlier to the vast expansion in its use, I might have foreseen the disaster. This investment technique was largely created and marketed by the quant firm of Leland, O’Brien and Rubinstein. Suppose a company pension and profit-sharing plan with a broad portfolio of equities wants to protect itself against a sharp drop in the market. It sets up a program, either in-house or by a portfolio insurance specialist, to switch from equities into US Treasury bills as the market falls. This is done in stages: For each drop of, say, a couple of percent, part of the stock portfolio is sold and the proceeds used to buy T-bills. If the market later rises, the process is reversed until, once again, the portfolio is fully invested in equities.