Investing lessons from Edward Thorp

Edward O. Thorp pioneered the use of quantitative investment techniques in the financial markets. He is the author of “Beat the Dealer,” which was the first book to prove mathematically that blackjack could be beaten by card counting, and “Beat the Market,” which showed how warrant option markets could be priced and beaten.

Set out below are lessons I have learned from Thorp:

1. “Try to figure out what your skill set is and apply that to the markets. If you are really good at accounting, you might be good as a value investor. If you are strong in computers and math, you might do best with a quantitative approach.” “If you aren’t going to be a professional investor, just index.”

Thorp likes to stay within his circle of competence. This is a hallmark of people who are rational. In that sense, Thorp reminds me of Warren Buffett. But unlike Buffett, Thorp didn’t make his fortune in the market by analyzing businesses and instead found his special competency in statistical arbitrage, which he more or less invented. Thorp was able to successfully take his considerable mathematical and intellectual gifts and apply them in an area where he has a significant advantage.

2. “The way I sized up the Ben Graham approach was that it would be a total lifetime of effort. It was all I would be doing. Warren demonstrated that. He’s the champion of champions. But if I could go back and trade places with Warren, would I do it? No. I didn’t find visiting companies something I wanted to do. I never even thought about finance until I was 32.”

Thorp decided early in life to get in the side car of other people who have a different competitive advantage. He invested in Berkshire when the stock was trading at $982 and still hold those shares today. When Buffett was winding up his partnership, he was asked to do some due diligence on Thorp as an investor by a mutual friend. That chain of events resulted in Thorp and his wife playing bridge with Buffett in 1968. Thorp described the meeting: “The Gerards invited my wife Vivian and I to dinner with Warren and his charming blonde wife Susie. Impressed by Warren’s mind and his methods, as well as how far he’d already come, I told Vivian that he would eventually become the richest man in America. A mutual friend talked recently with Warren, who spoke warmly of our meetings, of “Beat the Dealer” and “Beat the Market,” and of non-transitive dice.”

It is a good thing to remember that you are not Ed Thorp, Warren Buffett or Charlie Munger and neither am I. If you have similar mathematical gifts as Ed Thorp or Buffett, good for you. I do not have them. Even if you have those mathematical gifts, are you are rational as Thorp? Do you have control of your ego sufficiently to stay within your circle of competence?

3. “The first group of investors are those who do not want to do a lot of work who should invest in indexes. Index investors do better than maybe 90% of all other investors who are busy paying fees to advisers.” “The second group are those who would like to learn more about securities. They are entertained by following and analyzing securities. I think they can learn about special, unusual things although there is a price for that education. [They are] interested in the market, and it’s kind of fun for them. Those people if they want to learn more should go out and have their go at trying to make some money, but they shouldn’t use the bulk of their resources to do this. If they find something that really works then they can start putting more money into it. They’ll find that most of the time they haven’t really found anything that really works.” “The third group, which are the professional people some of whom actually get an edge. Most of whom don’t, but some of whom do. Those people get a start somehow in the market just like I got a start with an option’s formula, so I have an edge. I get in. I build an organization, which is small, and it gradually grows. It gets more and more skills. It gets into more and more kinds of investing. You, basically, get over the hurdle and get yourself established. If you can do that as a professional then you’re kind of on your way to collecting what people call Alpha, excess return. Then there’s the fourth group, which I don’t have much interest in, and those are the ones who are simply asset gatherers. They’re in there to collect fees and get rich, but there’s nothing really very interesting in what they do.”

In which category do you fit? Do you enjoy learning a lot about businesses? Are you willing to devote many hours a day to researching businesses? Have you tried picking stocks with a small portion of your assets and carefully tracked results to see if you are any good at it?

4.“The first thing people who have control do is tilt the playing field. Maybe the majority of wealth is accumulated because of tilted playing fields. Not because of merit.” “In standard gambling games in casinos you can generally calculate what the casino’s edge is, or if you figure out how to count cards you can calculate what your edge over the casino is. It’s a fact, a mathematical fact, that if you play a game like this and the casino has the edge, it will eventually collect all your money if you play long enough. On the other hand, if you have an edge your bankroll will grow and grow and grow.”

If you look carefully at what Thorp has accomplished with his funds, he was not gambling if you define it as a “negative net present value” activity (which you should). Thorp only invested when he had a statically generated advantage or as he calls it “an edge.”

5. “The overlap of interest between gambling and the stock market is very high. There are so many similarities and so much one can teach you about the other. Actually, gambling can teach you more about the stock market than the other way around. Gambling provides an analytically simpler world, and you can see principles and test theories.” “I was lucky in that I came at investments through blackjack tables. And the blackjack tables are an amazingly good training ground for learning how to invest, how to think about investments, how to manage them. And the reason is that they teach you, on the one hand, to use probability and statistics to evaluate things. And on the other, they teach you discipline.”

Again, the comparison to the methods of Charlie Munger is easy. Munger has said: “Life in part is like a poker game, wherein you have to learn to quit sometimes when holding a much loved hand….Playing poker in the Army and as a young lawyer honed my business skills … What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often.”

6. “Most stock-picking stories, advice and recommendations are completely worthless.” “Sell down to the sleeping point. As far as asset classes go, it is hard to know when you are in a bubble, and if you are in one, when it will pop.” “I read a good book recently, “Superforecasting” by Dan Gardner and Philip Tetlock. They wanted to see whether people can forecast better than chance. What they found is that experts often do not have much to tell us things of value. Experts receive a lot of media attention because they make strong, definite claims. But definitive claims are usually not accurate predictions.

The most effective way to learn this lesson is the same way you learn not to touch a hot stove as a child. But the better way is to watch someone else do it. “Just say no” to stock tips. Bernard Baruch described why stock tops are so appealing to some people in this way.

Source: Bloomberg

Junior Trader Stefan  Panteleev

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