A Dozen Lessons in Investing – Edward Thorp

“Edward O Thorp 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. He also was the co-inventor of the first wearable computer along with Claude Shannon. Thorp also pioneered the use of quantitative investment techniques in the financial markets (Option Arbitrage, Warrant Modeling, Convertible Arbitrage, Index Arbitrage and Statistical Arbitrage).”

Thorp speaks clearly and from the heart. He reminds me of that other ultra rational decision maker Charlie Munger. Despite his prodigious intellectual gifts Thorp remains grounded and approachable. A few sentences reveals his gift for communication which reminds me of Michael Mauboussin:

My life has been an adventurous journey I thought readers would enjoy my stories of the people I met and the challenges I faced.” “Chance can be thought of as the cards you are dealt in life. Choice is how you play them.” “A lot of big choices that you make at some point or other, and then there are things that you can’t control like who your parents were, and what kind of economic circumstances you were brought up in, where you started. Did you start 20 yards behind the start line or 20 yards ahead of it, or right on it? People start in different places. Those are cards that are dealt.


Set out below are usual twelve lessons I have learned from Thorp:

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 did not 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.

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 also 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.”

Speaking of impressive mental calculation, Barry Ritholz recently interviewed Thorp and watched him calculate his return on his Berkshire shares in his head. Thorp is the sort of person who taught himself FORTRAN so he would create his card counting techniques for Blackjack on an IBM 704 mainframe. The number of things Thorp taught himself is astounding.

It is a good thing to remember that you are not Ed Thorp, Warren Buffett or Charlie Munger and neither and 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?

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?

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