The Riveting Story of Edward Thorp
After learning how to beat casinos at their own games, Edward Thorp turned his attention to Wall Street. Image source: iStock/Thinkstock.
It's tempting to think of Edward Thorp, the author ofA Man for All Markets, as the Forest Gump of finance. Intellectually, the two have nothing in common -- Thorp is a genius. But during a lifetime spent in academia and the markets, Thorp had a knack for being at the epicenter of many of the most significant trends and events in finance over the past half century.
The creation of a contrarian
The way Thorp explains it, both in his book and in a recent telephone conversation, is that he began life as a curious and independent child. He was born in the depths of the Great Depression to a father who worked long hours to support their family and a mother consumed with caring for a younger brother who had developed pneumonia as a baby and nearly died. "This left me much more on my own and I responded by exploring endless worlds, both real and imagined, to be found in the books my father game me," he wrote.
It was Thorp's curiosity and drive to learn things on his own, combined with a powerful intellect, that would later serve as the foundation of his incredible success in both Las Vegas and on Wall Street. "I formed a habit of thinking for myself," he said. "If somebody made a statement, I would check it out, test to see for myself if it was true or false."
This led to a childhood consumed with experiments. He tried to fly at an early age using large balloons -- he called the experiment off after one of his test balloons was shot out of the sky by a passing airplane. He made his own explosives, including the "big one" nitroglycerine, burning one of his hands to a crisp in the process. And he became one of the youngest people in the country at the time to pass a challenging proficiency exam on radio theory and Morse code.
Thorp's love of science convinced him to study mathematics and physics in college, funding his education in part with a scholarship he received after earning the top score in the state of California on a prominent physics exam for high school students.
But even though Thorp went on to get a doctorate in math and a masters in physics, it was gambling that captured his attention and first catapulted him into the spotlight. "I happened to go to Las Vegas [in 1958] to see if I could build a computer that would beat the game of roulette, which people told me was impossible," he explained. While there, he also tried his hand at blackjack, or 21, using a strategy he had come across that increased the odds of winning against the casino to almost even.
Beating the dealer
"I realized that the people playing blackjack and running the game didn't understand it," said Thorp. This inspired him upon returning to his teaching post at UCLA to read the math paper underlying the strategy. "As I began to read the paper, I realized almost immediately that you could get an edge against the casino and how to do it," he explained.
Thorp expanded and refined the strategy over the next few years with the help of an IBM mainframe computer -- this was years before a young Bill Gates' access to similar technology allowed himto acquire an insurmountable lead in the software industry. In doing so, Thorp developed a system to count cards, much to the consternation of casino owners who learned about it after he detailed the strategy in his 1962 best-selling bookBeat the Dealer.
The stories Thorp tells in his latest book about the ensuing game of cat and mouse that he played with the casinos are especially riveting. He wore disguises, employed compatriots to combat the casinos' efforts to cheat, and frequently jumped from casino to casino. Though it was an experience he had in 1963, after he developed what may be the world's first wearable computer to beat roulette, and as he was profiting from a method he devised for beating the casinos at baccarat, that captured the true nature of Vegas in those days:
Thorp was sure to clarify that he wasn't accusing the casinos of trying to kill him. "All I can say is what my experience was," he told me. "You can draw whatever conclusions you want." Either way, it wasn't long after the trip that he turned his attention from gambling to investing.
The greatest casino on earth
Two things prompted Thorp to redirect his focus from Las Vegas to Wall Street, "the greatest gambling arena on earth." The first was that he had begun investing his gambling winnings and book royalties into stocks. The second was that he realized he wasn't very good at it. This led him to wonder whether his methods for beating games of chance would give him a similar edge in the stock market.
Gambling and investing share a number of key traits, said Thorp. To do both successfully, you need to measure the probabilities of outcomes and then vary the size of your bets depending on those probabilities. If you bet too much when the probabilities are against you, then you'll exhaust your money. But if you bet too little when the probabilities are in your favor, then you'll leave money on the table. It's the same way he beat blackjack, betting heavy when the remaining cards in the deck favored him over the dealer, but light when it was the other way around.
After reading "scores of books and periodicals" on investing, Thorp developed a quantitatively based strategy for hedging stock warrants after discovering that they were routinely mispriced. The method was profitable and, in the course of managing money for himself and a handful of friends, it evolved into a formula that estimated derivative prices more precisely.
"I began using it for my own account and for my investors in 1967," he wrote. Two years later, Fischer Black and Myron Scholes, motivated in part by Thorp's book Beat the Market, proved the identical formula, publishing it in 1972 and 1973. That formula, known today as the Black-Scholes model, though Nassim Taleb refers to it as the Bachelier-Thorp model, went on to win Scholes the Nobel Prize for Economics in 1997 -- Black had passed away by then and thus wasn't eligible to join him on the winner's podium.
It was around this time that Thorp had a chance encounter with Warren Buffett, who had just disbanded his original investment partnership after stocks soared into the stratosphere in the late 1960s. A colleague of Thorp's at the University of California was one of Buffett's original investors as well as a relative of Benjamin Graham. The colleague wanted a place to invest his cashed-out proceeds from the Buffett partnership and arranged a meeting between Buffett and Thorp. "He wanted Buffett to have a look at me, though that didn't occur to me at the time," recounted Thorp.
It probably goes without saying, but Thorp was right about Buffett. It's probably equally obvious that Buffett was right about Thorp.
Thorp's hedge fund, Princeton Newport Partners, went on to earn a 19.1% average annual rate of return for two decades. It was also the very first quantitative hedge fund, making Thorp the first so-called "quant". Funds like these are a dime a dozen nowadays and have spawned many of the richest people in the world, including James Simmons of Renaissance Technologies, Stephen Cohen of SAC Capital Advisors, David Shaw of D.E. Shaw & Co., and Kenneth Griffin of Citadel Investment Group.
It was from Buffett that Thorp got the idea of how to structure his fund, pooling his own capital with that of his investors into a single limited partnership. Thorp also went on to invest in Berkshire Hathaway, making his first purchase in 1983 at $982.50 a share and continuing to accumulate stock thereafter. Those shares have since gone on to be worth $246,340 a piece.
Fast forward through two decades of phenomenal returns, and Thorp's time as an institutional money manager came to an end in 1988, when agents from the FBI raided his fund's offices -- Thorp was based in California, while his traders were on the East Coast. Thorp had done nothing wrong, but the partner in charge of his East Coast operations, along with a handful of others in the same office, was suspected, though later cleared, of aiding Michael Milken, the famed financier from the 1980s who came up with the idea of junk bonds.
The incident gave Thorp a unique perspective on the now-infamous insider trading scandal that led to Milken's downfall. It emerged from a confluence of two factors, explained Thorp. First, the U.S. Attorney pursuing the case, Rudy Giuliani, had his sights set on a political future along the lines of Thomas Dewey, who came within a hair's breadth of the White House decades earlier after gaining notoriety from prosecuting bootleggers during Prohibition. Second, the development of junk bonds enabled savvy financiers to disrupt the established order by financing the buyout boom of the 1980s, which frequently resulted in the former standard-bearers of the corporate world being kicked to the curb.
It's a compelling argument. It's also yet another example of Thorp's uncanny presence at the center of some of the most important events in the last half century of finance. For anyone who's even remotely interested in finance or investing, or just enjoys reading about fascinating people, I can't recommend Thorp's book enough. It's a riveting read and one you won't soon forget.
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John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.