The last thing that I want to highlight is that he was the first person to invent the first wearable computer. Now this is on display up at MIT, which is where he was a professor. The computer was made because he had a theory that you could use Newtonian physics to predict where the ball might land on a game of Roulette. And it turns out he was right, you actually can predict where the ball is gonna land on Roulette, if you know the velocity, or where the speed is going. He created a wearable computer that he put in his shoe that told him in his ear, and remind you this is back in the 60s that he did this, where the ball was going to land. 

So these are some of the things that we’re gonna be talking about in today’s show, among many other things. These are all outlined in his new book that just came out this month. And the name of the book is “A Man for all Markets.” As a person who read this book, I can’t highly promote this enough to our audience because he goes into all the details on how he did these things, what he was thinking about when he created this. 

So, Dr. Thorp, fantastic book, let’s jump into the first question and get this interview going. So let’s talk about the blackjack. I’m really curious to know how you harvested this idea of how you could maybe beat the odds of blackjack when everyone in the world had the exact opposite opinion that it could never be done. How did you go about thinking about this?

Edward Thorp  6:29  

Well, we’re formulas. If you saw the formulas, exactly, or the equations exactly, then you could figure out the precise probabilities of winning or losing, given any collection of cards that the deal was coming from, whether it was a full deck, any partial deck, or any number of decks, or a number of partial decks. So what I did was I had the computer take out four aces. Then it told me what happened and shifted in favor of the casino, quite a lot, almost 3%. So I thought to myself, well, that’s good news because if I put an extra four aces in, it would probably shift the other way. I save almost the same amount. 

So soon as I saw that result, I knew that I had a winner. I went and elevated the twos, threes, fours and so on. The upshot was when all the smoke cleared, when the deck was rich in big cards, it shifted the edge in favor of a player. When it was rich in small cards, it shifted the edge in favor of the casino. 

So player one had small cards to come out of the deck rather than big cards. For the casino, it was better for them that big cards were used up. So I developed a card counting system, actually many card counting systems, then the real work started, which was actually doing it. So I spent about the next year first with hand calculations. I didn’t get very far, the problem was too big. Then I went to MIT for my appointment there and I found I could use high speed computers of MIT, an IBM 704. It was the earliest days, computers were scarce, but the good ones were starting to come online. This was a refrigerator sized machine that served 30 New England universities, and I was able to use the machine. So I spent almost a year teaching myself how to program and running subroutines that I would sew all together into an overall program that will enable me to evaluate all the cards that were missing *inaudible the game.

Preston Pysh  8:24  

So I’m curious, did you think that you would have been able to solve the math behind everything that you were trying to calculate back at the time point when this was occurring, if you didn’t have access to that computer in that computer lab?

Edward Thorp  8:39  

That’s an interesting question. At the time, I thought I need to do as exact calculation as I could. But as I learned more about the game, I realized that there were ways of approximating the problem that would have given me a pretty good solution. I probably could have gotten that pretty good by hand.

Preston Pysh  8:59  

All right, Dr. Thorp, one of the things that we constantly see as a theme on our show is the similarities that exists between gambling and investing with respect to probabilities. So Charlie Munger and Warren Buffett are super famous for talking about expected value. If they feel one decision is going to give them a 75% probability, another decision would give them a 25% probability. They’re going to take the resultant of those probabilities and make an informed decision. 

But where I think a lot of people miss, the other piece of that conversation, is how it relates back to position size. So we had a really intelligent member of our community on Facebook that proposed this question. His name is Patrick Buchanan and Patrick asked us to ask you, “How can one apply the Kelly criterion to the stock market, given the large array of potential outcomes and holding periods?” So if you could kind of give our audience a little bit idea of what the Kelly criterion is and how it relates to was expected and probable outcomes, it would be really beneficial for people.

Edward Thorp  10:05  

Okay, first a little about the Kelly criterion. The root idea is there’s a trade off between risk and return. This is well known to almost everybody in investing. But the question is, what is the trade off? How much should you bet when you have an edge? And how much should you cut back to allow for the risk that is associated with your bet? 

For a very simple situation, like tossing a *biased coin. Suppose the coin has a 60% chance of coming out heads and a 40% chance of coming out tails. You get the bet on heads or tails. Clearly, you’ll be betting heads, but how much should you bet? This is the basic problem that I faced in blackjack, it was very much like a coin toss only the edge might have been 52-48 or 51-49, 2% or 4% edge. How much should you bet? And the Kelly criterion is the solution for that problem. Also a much wider *collection, and then the simple coin toss in case, this is where you have an even money payoff. So in a 60-40 coin toss, you’ll bet 20% of your bankroll, that by the way, is fairly scary to people who actually do it, because the pretty wide swings. 

And so, if you only bet about half as much as what Kelly says, you end up growing at about three quarters, the rate you would have, if you’ve done the whole thing, and your risk is cut down to half, so you feel a lot better. So I generally recommend that people just bet half Kelly so they won’t get scared.

Preston Pysh  11:32  

So I’m curious if there’s a rule of thumb that you use when conducting that math that you just talked about?

Edward Thorp  11:37  

The math of the Kelly criterion, *it’s fairly involved, if you have real world situations with many possible payoffs, and also with uncertainties. So people have done a lot of work on that and they solved a lot of the problems explicitly the best compendium of information, but it’s very mathematical. There is a book called “The Kelly Capital Growth Investment Criteria,” and the publisher is World Scientists. And it came out in 2010, about 700 pages. There were three editors myself, Leonard C. MacLean, and William T. Ziemba. So I’d recommend that for math types want to dig into this further.

Preston Pysh  12:22  

So I’m really excited that you brought that up because I was not aware of this book. And the Kelly criterion is something that I’m very interested in learning more about specifically because in a book that we read, probably two years ago. It was by Tony Robbins, where he profiled a bunch of different high profile investors, and one of the people that he interviewed was David Swensen, who manages the Yale Endowment, which is a multi billion dollar endowment. 

The thing that I really remember about that interview with David Swensen was that he talked about this idea that you can’t time the market but what you can adjust is your position size to mitigate risk. I really remembered how much he emphasized the importance of position size and I think for a lot of people listening to the show, if you’re really wanting to understand mathematically, what the most optimal position sizes based on what expected values you expect to have, the Kelly criterion is what you really need to know and understand. So, knowing that you’ve written a comprehensive book about the Kelly criterion is really exciting to me. I’m sure many of our audience members will be just as excited to hear that.

Edward Thorp  13:35  

I’d like to say one more thing about the Kelly criterion, which is it has a world scale applicability. If we look back into the various bubbles and disasters that we faced over the last century, most of them come from too much leverage. And from the framework of the Kelly criterion, it means you’re betting too much and the Kelly criterion, when you work through this, it shows you that if you bet too much consistently, you will be ruined eventually. 

So these disasters that we’ve gone through, there was a crash of 1929, where people were buying stocks on 10% margin. There was the crash in 1987, where they were using portfolio insurance. And that tended to lever their portfolio in various curious ways. Then there was the long term capital management disaster in 1998, where they were levering at 30 to one, sometimes even 100 to one. And then our recent disaster in 2008-2009, banks are levered up, like 33 to one and the banks who got that privilege, two of them are gone. And three of them had to be bailed out by the taxpayers. So the Kelly criterion applies not only in the small for individual investors, but it applies in the large for nations.

Preston Pysh  14:53  

All right, so Dr. Thorp based on what you just said, I have to ask this question because I know everyone in our office audience that’s listening to this interview is thinking the same thing. And that is, how do you see the market today? When I say that, I emphasize a couple things. The first one is just  this morning I was reading a report or an article on Larry Fink, who’s the CEO of BlackRock. His company’s a multitrillion dollar kind of business handling securities. He says it’s not looking good, it’s actually looking pretty scary. And whenever I think about where we were in the 2008 crisis, we’re at the end of that credit cycle and where we are now at the top of the next credit cycle that we’re in, we have a lot more credit added to the system this time around. 

So whenever I look at, call it the stock market. I think about systematic risk, which is when credit contracts on a macro scale. How do you think through position sizes? And what’s your expectation from this point forward, considering that we may be at the top of a credit cycle? How do you think through that?

Edward Thorp  16:13  

I think it might have been JP Morgan, somebody asked this question. They said, I’m worried about how high things are, should I sell? So the advice he gave was sell down to the *sleeping point.

Preston Pysh  16:28  

I like that.

Edward Thorp  16:30  

So as far as asset classes now, it’s, it’s always hard to know when you’re in a bubble, and if you’re in a bubble, when it’s going to pop? It’s a lot like the chaos theory image of dripping sand onto a little pile that shaped like a cone on the beach, and the pile gets higher and higher. And then finally, suddenly, there’ll be a little avalanche, a pile of stuff will slide down. Or the same thing with real avalanches and snow piles up. You never know quite when it’s going to go. But you know that if it keeps piling up eventually something will trigger it, and you’ll have a disaster sometime. 

Right now, we have an attack on regulations that rein in banks from levering up. And also the rating of the derivatives industry slightly from taking too much risk, and the more of those regulations are removed, the more these guys get a chance to lever up. And the more chance we have of a rerun of 2008-2009. 

Now, they’re not particularly worried, though, because the taxpayers bailed them out last time, for the most part, not everybody, but most of them. And they can probably count on that happening  since basically control a wide swath of leaders in government that can make sure that’s going to happen. So it’s basically heads the risk takers wins, tails, the public loses.

Preston Pysh  17:49  

All right, so I have another question for you. So one of the narratives that we hear a lot of very smart people talking about, is the idea that the next financial event that occurs is going to be one induced by central bankers and a distrust of central banking. So one of the narratives that we heard from a guy, Jim Rickards, who’s a New York Times bestselling author, that relates to a lot of this kind of stuff is he said, “You know, back in the late 90s, we had the long term capital crisis, which potentially could have brought down the markets. The next credit cycle we had the banks that all needed bailed out. And the one that’s coming is going to be the central banks that need to be bailed out.” He talks about this escalation because of more derivatives, more credit that’s being added into the system each time we create another cycle. 

So my question is this. Do you see the next cycle being induced by central banks?

Edward Thorp  18:54  

I don’t know the answer to that.

Preston Pysh  18:59  

I love that response. And guess I, you know, this is a really profound moment for me to hear you so quickly default to a 50% probability on something that I guess I was expecting you to really talk about more. And that’s not something that we normally see and that’s not something that I normally do. That’s something that I can really learn a lot from, is just how quickly you are able to come up with such an intelligent response to something that most would probably pontificate on. And I know you just provided such a quick snapshot of time, but what I immediately think about based on the way you responded to that is something that we hear Warren Buffett talk a lot about, which is have a really strong understanding of what it is that you know versus what you don’t know. And I really liked the way that you just responded to that.

Edward Thorp  20:00  

Well, I read a good book recently that fits my mindset on these things quite well. It’s by a psychologist at, I think it’s University of Pennsylvania named Philip Tetlock. And he has a co-author, a journalist named Dan Gardner  And this book is called Superforecasting. So Tetlock has been working on the idea of whether people can forecast better than chance. And he found, as I have over a lifetime, that experts, so-called experts don’t really have much to tell us that’s of value. They basically get a lot of press a lot of media attention, because they make strong definite claims about one thing or another. But strong definite claims are usually not the stuff of accurate predicting. We can only see the future very fuzzily. So there are a lot of possibilities you have to kind of weigh them and think about them. We found out that the people who go at things that way, can make somewhat better predictions on average than chance, andalso better than the people who don’t think that way. 

So the whole book is about this kind of thing. So my view is that on most things, we can speculate about lots of possibilities. But it’s difficult to get enough of an edge to actually put money down, expect to make a profit. But it’s worth speculating anyhow, because you can be ready at least psychologically for the bizarre range of things that might unfold.

Preston Pysh  21:27  

So I might be reading into things too much. But, you know, looking at the way our facial expression, and the way that you responded to that question, and so quickly to say, I don’t know, I kind of caught a glimpse that you wouldn’t be surprised if that was the case that played out, but you just don’t necessarily have enough information in order to confirm or deny. So that’s why you’re at the 50%.

Edward Thorp  21:50  

That’s right. 

Stig Brodersen  21:52  

All right. I’d like to talk more about your investing career because even though we talked about blackjack and how you made a name for yourself in the blackjack space, you also have more than 30 years as an investor. And as Preston was saying at the beginning of the show, with an annual return of 20% over that time period. So could you tell us about the transition that you’re making from being an author, being academia and into something that might be even more complex, working with options, *inaudible, and other financial instruments? 

Edward Thorp  22:27  

Well, I’m not sure where to start there.. I got interested in investing, because I made some money gambling, and I made some money from book royalties. And that meant that I now had for the first time in my life, a certain amount of savings. So after having done badly in early investments, I said, I better put my mind to this thing. And by chance, I got a book in the mail that I sent away something called “Common Stock Just Once.” And those were basically options issued by… they were traded over the counter that as you… He was a telephone market. 

As soon as I read about them, I realized that I could get rid of most of the risk in investing and still capture some extra return if those *warrants were priced correctly, and there was every reason to think in a telephone market, that they would not be priced correctly quite often. So that summer, I came out toward the end of the summer to the new UC Irvine Campus. First day, I met an economist that was also a new professor there. He had written his thesis in 1962, under a very famous economist named Arthur Burns. His thesis was on common stock *purchase walls. So we hit it off right away with a big exchange of ideas, and we decided to meet every week to improve theory and improve his investment returns. Then we kind of went our separate ways investing for people. We each had our little collection of people that invested in hedges. We made about 20 or 25% a year…

The Dean of the Graduate division of UCI was a National Academy of Sciences member elegy, he had become one of investors. At that point in 1968, the markets were manic. Anyhow, he introduced me to both. And we talked, played bridge or we got together otherwise for dinner and so forth. He was actually evaluating me for Gerard. But apparently things went well, because Gerard moved his money over to me. So that was a high radar and I realized that he was very smart, very dedicated, long term compounder. His life was securities. This guy understands long term compounding, pretty smart. He’s going to be maybe the richest guy in the United States one day. Turned out there were times when he was. So I then realized from him that more efficient way to operate was to have a limited partnership. So I set up the first quantitative market neutral hedge fund.

Preston Pysh  24:54  

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Stig Brodersen  26:08  

This story about Warren Buffett really brings me to the next question. And it’s an idea that Buffett has been really famous for, and you also wrote about that in your book. And that is the idea that the vast majority of investors should actually stick to ETFs instead of buying, for instance, individual securities, which might surprise a lot of people because that is what Warren Buffett did, and why he is so financially successful. A lot of people in the value investing community are interested in hearing your thoughts on that too. Why do you think that the majority of investors should invest in ETFs?

Edward Thorp  26:46  

What I found over 40 or 50 years of doing this, at some level, *inaudible and I realize… What I have found is that you can find situations give you extra return, but it requires quite a bit of work to find them. And so, there are really simplistically three groups of investors. There are investors who don’t want to do a lot of work, just want as well as they can without doing a lot of work. So people like that should buy indexes. And the reason is that index investors do better than maybe 90% of all the other investors, all the other investors are busy paying these two investment advisors. 

Then the second group of investors are people who would like to learn more about securities, and they’re entertained by following them and trying to think about them and analyze them. And I say to those people, go ahead and do it. You may pay for your education, but you may have a good time in doing all this and you may learn something. Who knows you may find some special unusual things that are really pretty good. 

Then the last category are the guys who make the big money in the market. People who have usually a fairly large staff, large capital resources and *inaudible stop and charge other people fees for doing it. And the fee chargers end up making most of the money in my experience. So that in mind, don’t expect as a small investor to be able to grow and make a big killing.

Preston Pysh  28:14  

Alright, so Dr. Thorp, this is a question that I’m really excited to ask you because we always ask each one of our guests to come on the show to tell us what the most influential book and you can name more than one that has shaped your life or influenced you in a special way. If you could share that with our audience, we’d appreciate it.

Edward Thorp  28:32  

The first book that really influenced me in a quantitative way was a book from the MIT Press, edited by Paul Cootner. It came out in 1964, initially, and it’s called The Random Character of Stock Market Prices. It was a collection of quantitative type papers. Maybe the very first quantitative *tape has began appearing. And since I was thinking about the market in a quantitative way, that’s it, right in with my venture at the time has considerable influence on me. In fact, they had early one models in there, which weren’t a solution to the warrant and option problem. But they came close. And so that enabled me to actually figure out the option formula when I thought about what they’ve done.

Preston Pysh  29:19  

So Dr. Thorp, we can’t thank you enough for your time. This was just fantastic to just meet you. I can honestly say I’m honored Stig and I have been following you for a long time for years at this point. And we really admire your contributions, especially from a mathematical standpoint of how to think and how to think about probabilities, and just all those things. We can’t thank you enough for that. And most importantly, we can’t thank you for your precious time that you shared with us today and our audience. We are going to benefit from this tremendously. 

I do have one question I’ve got to ask you. When I was reading through your book, there’s a picture of you in the back. And whenever I looked at the book, I said, “Oh, well he’s younger than I thought because I know you’ve done all these things from back in the 1960s and such. “And I’m looking at this picture of a person who looks like they’re probably 55 years old. Well, when I read through the bio, you’re 84 years old?

Edward Thorp  30:13  

Well, that’s an interesting question. I actually had that question about a few times. And I did a poll a couple of years ago, I go up to strangers, like waitresses, and restaurants or librarians or whatever. And I’d say, I have a question for you. I’ll pay you $1. And so my question, and then it’s about me not about you, so don’t worry. If you get an answer that’s fairly close, I’ll pay you an extra $5. So the question was, how old am I? And if you come within five years, you get to $5. And no one’s ever collected. The average guess was between 55 and 60. The highest guess was from a very old lady, she guess I was 72 because everybody is 72 at least aren’t they?

Preston Pysh  30:58  

So what in the world is the Secret if you can give us one final tip for longevity, if you can give us one tip that look that good when we’re at the same age as yourself. So what is it? What is it that you do different?

Edward Thorp  31:12  

Well, let me just say first before answering that is that picture is almost three months old. So I thought about this problem. I like being alive and doing things and learning things and enjoying people traveling and so forth. So I want to be around as long as I can. So part of my thinking is exercise. So I ran marathons for 20 years or so and that was a great fitness builder. And now I do a lot of walking and working out with a trainer in the gym. 

A second thing is what I eat. I try to eat in limited quantities and eat really healthy food most of the time. I don’t eat healthy food all the time, but I do fairly good job of it. I never smoked. I never played football because I want to bang my head. Even as a little kid, I understood what concussions can do. Another thing is to get medical test regularly. So you find out something early, you can fix it.

Preston Pysh  32:07  

Well, there you have it, folks. There’s the really valuable information. So, Dr. Thorp, we can’t thank you enough. Thank you. Thank you. Thank you, sir, for coming on our show and talking with us today. I know everyone got a lot out of this and we really do appreciate it. So everyone who’s listening, the name of the book is “A Man for all Markets.” I have read it cover to cover and I can tell you it is a fantastic story. That will give you plenty of insights.

Stig Brodersen  32:33  

Alright guys, that was all that Preston and I had for this episode of The Investor’s Podcast. We will see each other again next week.