Preston Pysh  04:58

But that’s the one that they built the whole movie around where they were counting cards.

Jack Schwager  05:03

Yeah, so actually, it goes, it’s even more credible than that. I’m just gonna give you a few of the things here. Here’s a guy, starts out, comes from a very poor background, grew up in a depression. He teaches himself physics in high school, gets accepted I think after which California one of them, you know, one of the top universities in California. Well, he doesn’t have his Ph.D. in physics. He was writing his thesis with his physics degree. Besides, he doesn’t know enough math. He goes and starts taking graduate math courses, gets his Ph.D. in math, never goes back, and writes his thesis. So he doesn’t technically have a Ph.D. in physics. Then gets the idea that they’d like to beat casinos. It sounds completely preposterous. How can you beat casinos not by cheating, by the way?

And so the first game he comes up with is roulette. Now, when I first heard the concept that hey, somebody says that could beat roulette. I said it’s impossible because we’re thinking probability. But you don’t think in terms of Newtonian physics, that what he got known about was, well, if you could time it well enough, you could get by the physics. If he got this velocity to the ball between two different points and you knew his momentum and everything else, you can predict a probability of which octet of the wheel was more likely.

This is back in the 60s. So we didn’t have like, no back in the 60s. I remember the 60s, even the late 60s, I remember using an IBM 360 which took up a better part of the room, and you had to use punch cards to do progressions or something like that. So he in the 60s developed this miniature computer way ahead of his time.

06:45

And so this thing work they played for like minimal amounts of money, they just want to prove the concept. They have like a 40% edge in roulette. Then he came up with and he read a paper by some math guys and I forget where they were saying, “Win a blackjack from a mathematical standpoint.” But when he came in with the insight was, “Hey, it’s not a matter of how you just bet, because that’s what these guys were trying to do. So if you bet all the right ways, if you hold on 16, you know, take the call, you know, the typical standard rules. If you did all the right bets, that turns out to slow and at the edge and you come very close.”

But he thought he got the affiliate inside, “Wait a minute. Who says you have to bet the same thing every time?”So he figured out that if you change the size of the bet, like when the more cards out, then you know, you bet more and more picture cards out you bet less more. That could totally change your probabilities.

And he was doing this and realized it would take years and years to what he has many decades to do. So you have to find shortcuts, but he figured it all out and came up with this a couple of methods and then simplified. And he put a story in the book where there was an attempt on his life, just like out of the movies like his car was fixed, the brakes would not work. Go down a hill. In any case, so he did that, put out the book. That was a book that changed the casinos. You know, the multiple decks all of that? That’s because of him.

Preston Pysh  08:09

Oh yes. So Jack, would you say that the thing that you took away from Edward Thorp was just his pure intellect? Was he like a voracious reader that got him there or is he just?

Jack Schwager  08:16

That was the thing that impressed me was just the intellect but just the raw intellect. He was a nice guy too, I gotta tell you. I’ve met a lot of brilliant people, but Thorp was probably the smartest guy I’ve ever spoken to. And I know people that made me feel stupid, but when I say made me feel stupid, I don’t mean that he made me feel stupid. It’s just in comparison to his intellect.

It is just raw intellect. I just think he’s got that talent and that’s how we beat the markets. He started to apply this intellect, this pure quant intellect to the markets and then you go on. The first guy to have thought of a *market neutral fund, all these strategies, he’s the first guy that does it and figures out how to do it and gets the edge. So not only brilliant but innovative thinking outside the box. He was the first guy to think of it. So he’s an amazing guy and people don’t know him to the extent they know some of the other big names. They know him for “Beat the Dealer” but because it changed casinos and all that but they don’t know his hedge fund.

Stig Brodersen  09:23

Yeah, and correct me if I’m wrong, Jack, I think he came up with a pricing model for warrants long before Black-Scholes as you know, get all the fame for the options theory.

Jack Schwager  09:33

Thank you for reminding me. Yeah, maybe the biggest thing is, everybody knows the Black-Scholes model. Nobel Prize was given for the Black-Scholes model. The amazing thing is Thorp’s trading is a mathematical equivalent of the Black-Scholes model five years before that article was ever published. He could have been the Nobel Prize winner, right? But that’s what he said. He was like the only guy in the world who could go to price options and he’s just printing money. So he was for that until that article came out, he was just… He had like a printing press of money because he just, he just couldn’t lose. He won the price options and nobody else did.

Preston Pysh  10:08

He’s like, I’ve already been doing that I’ve been making millions of dollars doing that.

Jack Schwager  10:11

Yeah, that’s part of the record, that part of his record is because he came up with all these things, but ahead of everybody else, that’s how you get a record of something like I think was about 277. I forget the exact number of months. Three losing months out of 277. And all three of those were less than 1%. And that’s why I say, you know, that’s why the probability works out to be less than the *inaudible, less than picking one atom randomly out of the mass of the Earth.

Stig Brodersen  10:41

You know, I’m so happy that you mentioned Thorp. I haven’t told this story on the podcast, and this will be for another time, but he’s the reason why I’m standing here today. So I’m so happy that you mentioned him.

Jack Schwager  10:53

Go on. I mean, I’ll talk enough on this, but I’m curious to know how that happened.

Stig Brodersen  10:58

Yeah, I mean, it’s just very briefly. I read some of his material early on and was just very fascinated about his way of looking at everything as a game. I think perhaps that’s his true gift. And perhaps that was also why he didn’t necessarily win the Nobel Prize. I mean, that was not the game he was playing, and how he was looking at casinos. And then afterward he was looking at stocks and how he was pricing options. And I think I started reading that around the age of, I want to say 20 or something? And that that was what made me make a decision to go into all this, what we’re doing now, you know? It’s just a long time ago. So I feel I owe him a lot. And it’s just rare that we have a chance to talk about him and how influential he’s been on so many people and in so many different ways. For me, he’s one of the most underrated out there in his own field, which is just really, sad, perhaps because he didn’t want the fame. Who knows?

Jack Schwager  11:55

Yeah, he’s not… He tends to be quiet. He does not seek publicity for sure. You know, on the contrary…

Stig Brodersen  12:04

We were completely shifting gears here, Jack. So one thing that I know that we completely agree upon is how important it is to have independence in your strategy, whether it is investing or trading. And you have this quote from the famous trader Michael Marcus saying, “You have to follow your own light.” So, still, we can get swayed by other people that we consider smart, even if these people might follow another strategy. So I would like to ask you, could you please tell your personal story about not shorting the yen back when you were director of Futures Market?

Jack Schwager  12:36

This was airtight on the first book. And I’m not going to mention a name here, deliberately, but one of the traders I interviewed would call me from time to time and he would call me and ask my technical opinion on the markets. I never knew why because he was like a million times penetrated and I was why would want my opinion, I don’t know. But he would do that and I would talk.

So one day he calls and we’re going to the market and it had to put this in context, this was a year I started off. I made money. I was ahead then dribbling of money, I was losing, losing, losing. Now you’re giving them back most of the money I made, I was still ahead, but not by very much. I decided to cut back. I had like one position ladder of any consequence, maybe had something else but just one. And it gets to that market, the Japanese yen, not a picture this, what the chart looks like. It had a very sharp decline, like a falling off the cliff, and then went into a very, very tiny consolidation. Really, thick. And he gets to the end, I said, “Well, you know, when I’ve seen a pattern like this, where the market is down extremely steeply, then goes into a tiny consolidation, most of the time, it’ll go down again.”

And he says, “Well, I don’t know, Jack.” Gives me 58 reasons why. I said, “Hey, you know, you’re probably right. It’s just an opinion, you know?” So, anyway, so  I hang up the phone, and I knew, as I said, I knew I should not listen to other people. I knew that and I normally would… I think I wouldn’t have However, this is where fate intercedes. That afternoon, I had to travel for a few days to go to Washington DC. I knew I had a lot of meetings, I’d be busy at work. This was pre-iPhone and pre-smartphones and all that. And I did not even have a computer of any sort to look at anything.

So I said to myself, well, you know, I haven’t done so well lately. I got this one trade for a good profit. You know, here’s one of the smartest guys, one of the best traders I know, who’s on the opposite side of this trade. Do I want to fade in on the trade, as I go over to the overnight desk and I get out of a position? Okay, I come back a couple of days later. I don’t know where the market is *inaudible. Come back a couple of days later.

14:47

You and your listeners probably know the next thing. Sure the yen is down a few hundred points, right. Okay. So that’s no surprise. We know that’s gonna happen. Now, here’s where the surprise is and this is I tell people honestly, I’m not making this up. I couldn’t make this up. That day he calls again, I was gonna be so cautious to bring up the yen, you know? And it’s like, “Hey, everybody could be wrong. I’m not gonna say anything.” But he brings it up. I say, “Hey, hey, are you still long?” And he exclaims to me, “Long? Because I’m short.”

Now, but I didn’t tell you. What I didn’t tell you is for me, I traded positions quickly at the time for like months at a time. You know, he offered him a long term trade was like two days. When he was speaking to me, he was bullish, because he was looking for a bounce. The market probably didn’t bounce. He probably decided wasn’t acting right or maybe went down a little bit, got out, went the other way. So he made money and I was right all along and I end up not making anything. So it’s like a perfect sample. You can’t listen to anybody. it is gonna mess you up.

And going back to Marcus you have that great quote, “You have to follow your own light.” The rest of that quote, paraphrasing, is you could take the best traders of the world, two of the best traders in the world and put them together, and then get the worst of each. And, incidentally, he was speaking about, I know whom he was speaking about. Michael Marcus hired Bruce Kovner, who then went on to form Caxton, one of the great legends of trading and investing. He had hired Kovner for a time they traded from the same office. So they talk whatever. So he says that he’s talking about himself and Kovner. So two of the world’s best traders. And he’s still saying that if they don’t stay true to their own approach, they will still get messed up. They try to trade as the other guy does.

Preston Pysh  16:37

I’ve got a follow-up question that hits at the point you’re getting at and that’s matching your style or your personality with your investing approach. And it has to do with Joel Greenblatt. So I know that you are close with Joe, I know he’s endorsed some of your books. You’ve interviewed him a couple of times. And Joe has some books out there that take Warren Buffett’s approach and make it a lot simpler and he calls it his magic formula. And after interviewing him, do you think that people out there could simply pick up his two books and implement this magic formula and get the fantastic results that he’s had? And please tell our audience Joel Greenblatt’s results, because he has high returns. And what personality do you see that gets attracted to the Joel Greenblatt approach?

Jack Schwager  17:24

I heard of Greenblatt and then I dug up a track record and then did it like.. I did the book in 2012. His track record ended. I think it ended in 1995. That’s a while ago, that was a very interesting track record. It’s was about 10 years long. It had over the years, of course, the worst year, he had was like a profit of about 28%. That was his low year. And that was like, you know, remember in that period, you had 87 crash you had 94, which is a bear market. And his worst year was a positive 28-29% So and then with the NAV at an all-time high, the fund disappears. My first question to Greenblatt was why did you close the close? Who closes the fund with 10 years were the worst years plus 28%? He said that you had just gotten too big that he couldn’t do the trades managing other people’s money because he was doing a lot of value-oriented trades, which might have been involved some smaller cap stocks. They couldn’t do that.

Preston Pysh  18:30

Like he was doing net-nets on small-cap, is it?

Jack Schwager  18:32

Yeah, some stuff like that. He was doing a lot of different strategies. But it’s the Buffett philosophy of buying a value orientation. And so that is at its heart. That’s in his bones. And in fact, I’ll go to your question. I’ll get to your question in a moment about whether people can use the formula but let me just give you as an aside, as part of what I do for the interview.

I try to do different things to get to know people in the interview process. It’s not just I think I sit down with them for one hour or whatever. But in Greenblatt’s case, I met him a couple of times. But also when he was teaching a course at Columbia, he was teaching a course in the markets on the graduate school level in Columbia. And so I sat in on one of the courses for this particular session. He said, “Okay, today, I’m going to be Buffett then you guys ask me questions and I’ll answer them.”

And so the class was asking questions and he was answering them, and they were getting completely confused. They say, “Well, wait a minute. are you answering this as Buffett?” Yes, and they were like “But, Professor Greenblatt?” They couldn’t tell. I couldn’t either. It’s going back and forth between the two.

19:36

So basically, this whole question of letting me give you the other thing, which we’ll set up which will answer your question indirectly, but in a more interesting way, as other people can use a formula. So he did this study using this magic formula or more advanced form of it or whatever. And then had ranked the stocks going forward based upon a formula and it turns out that the top decile over a longer period of time… Top decile, you know, the best, the second decile, the second-best, the third decile, and the lowest decile was worst of loss and all their money.

So my first question, you know, being a kind *inaudible. The first question that pops into my mind, which is so obvious, is hey, why buy the top decile? Why don’t you buy the top decile and sell the lowest decile simultaneously? You’ll have a balanced portfolio, presumably much less risk, and more return because the lowest decile lost a little bit of money. So to me, it seemed like, hey, that’s such an obvious thing. How can you didn’t do that?

So he says, “Yeah, that’s a good question. That’s also a question a number of my students asked that. There’s only one reason that I didn’t do that. I would have gotten wiped out if I did that.” And the reason he explained was a good example late 1990s. Late 1990s, the stocks are going crazy. Everybody thinks well, *inaudible bull market, S&P is up 20-30% Assets go through the roof. Internet,  internet craze. Stocks go from 10 to 200. Okay, everybody knows all that stuff, right?

We forget the value stocks, a lot of value stocks aren’t only going up, they might have been losing money, right? So you’ve got an atmosphere here where the worst garbage is going on its way from 10 to 200, before it goes back to one or zero, right? But you’ve got that interim period where it’s gone to 200. So you get a period where the crummy stocks are going up tremendously and good stocks are losing. What does that mean? That means if you’ve got 100%, you’ve lost more than 100% of your money. And so he would have gotten wiped out doing that. So while in most years that strategy looks like much better return to risk, and that situation can get you killed.

Preston Pysh  21:47

So it’s interesting. We had a guest. Do you know Wesley Gray? He’s a hardcore quant guy. awesome. We gotta introduce you to Wes because he’s just a wealth of information. He runs around with Patrick O’Shaughnessy and James O’Shaughnessy in that group, but one of the things that he did was a lot of research on what you’re talking about exactly where when you get into a high market valuation periods, like where we’re at right now, growth picks do extremely well, and maybe not what you would necessarily think. But then they just fall off a knife’s edge. And whenever the value picks start doing well and the market starts having a major downturn. So it’s interesting that you got the same feedback and the same information from Joel Greenblatt when you were talking. I find that interesting. And we’ve talked about this on our show when we had Wes on. It’s an interesting discussion. I know Wesley Gray has a lot of published articles on it. Maybe we can throw some of those into the show notes to complement this discussion but awesome feedback. Thank you for that, Jack.

Jack Schwager  22:47

And also Greenblatt says that this was it’s cute but true. So he has three rules of value investing is the first rule is value investing works. The second rule is value investing doesn’t work all the time. And rule number three is rule number two is while rule number one works. If anything worked all the time, and not people would use it would stop working. And it’s because you get a 99 that value investing still works because it was just a matter of buying undervalued stocks. It’s would have been, everybody would do it, it would just you know? But would stop the edge and go away. But so anyway, that’s his explanation. So the answer the magic formula is it’ll work most years, but there’ll be times where it does not work, and it could be prolonged time.

Stig Brodersen  23:36

So Jack, one thing that’s interesting about Joe Greenblatt is that he’s thinking asset trade, but also as an investor. So many investors, they think in terms of buying a stock, hopefully, will be undervalued, and then the price will eventually go up. Now traders they also think in terms of leveraging their own position, not necessarily using debt, but if they have a strong opinion about where stock is going, they might be able to get a higher payoff. One of those ways to do that is by using an option. And I know that you have a very interesting story about your good friend Joel Greenblatt and how he used options to invest in Wells Fargo back in the early 1990s.

Jack Schwager  24:15

To set that up, I should say, because people are misconceptions of options being riskier and so forth. They can be riskier the way most people use them, they are probably riskier. But the idea here is the way some great investors have used them that I’ve spoken to and Greenblatt’s one of them. That’s one of the ways he got such great such a great track record. And somebody like in the hedge fund *inaudible who trades like that all the time.

The math of the options market is that assumes there’s always an equal chance of the market going up or stock going up or stock is going down. And these traders realize or investors realize that there are points in time where that’s not necessarily true. The natural pricing of an option to be symmetrical in terms of percentage gain and percentage loss is not going to be correct. So in this case with Wells Fargo, he realized… Wells Fargo has very, very solid stock. It was a very, very strong company, however, the time they had. Their book contained a lot of real estate in California, and California was having its real estate market problems. So there was concerned about the bank, but Greenblatt thought that they’d be fine.

25:22

But he said, basically, there are two possibilities. If this is gonna be a problem, they’re gonna go bust, then it’s gonna be a zero. And it’s like, I think it’s gonna be okay, then the stock is like tremendously on the price to shoot, triple, quadruple, whatever. So his plan was, and of course, he didn’t want to just buy the stock and leave. So take that back *inaudible goes to zero that they take a chance of that. What he did instead was buy out of money options because his thinking was out of the money option, you’re not going to get paid less the market goes up, or this case the stock goes up significantly.

However, it’s relatively cheap. You put up a small amount The money in this case, if the stock goes down goes sideways, or only goes up moderately, he loses that amount, but it’s a small percentage of the total cost of the stock. However, it gets to the strike price, and let alone if it goes well beyond the strike price, then you start getting multiples of your money. And so for him, it seemed like a good play because the market was saying, “Hey, here’s like a 50-50 shot of Wells Fargo going broke versus, you know, being okay.” In his mind, it was much better than a 50-50 shot, they’d be okay. And he played it in a way that if he was right, he get paid multiples of what he was risking. So that was the basic concept of the trade. You know, the story is, I don’t know it went up like four times.

Preston Pysh  26:41

400% return. So Jack, one of the things that I liked about your book is some of the people that you’ve interviewed through the years have just crazy or like, interesting approaches to making money and they’re successful at it. That’s the thing that’s just so mind-blowing for me like one example that comes to mind was the guy from your hedge fund book, the “Hedge Fund Market Wizards” book where he was breaking all the phones and just seemed like he had this wild and rapid personality. And then another one was the gentleman that your son worked for who was betting in the exact opposite direction of whatever the market was trending, and yet he was still able to make money. So I guess my question is this is what was one of the more interesting investing approaches that you’ve come across with all these different interviews? What would you say you took away from interviewing that person that maybe you could apply to your own approach?

Jack Schwager  27:36

So it’s a bifurcated question, because the latter part of that is like, what did I take away and what I learned that type of stuff and there are lots of answers to that. And that’s has a positive answer that then you began with a couple of people and the second one, you mentioned one of my sons works for Jimmy Balodimas. You go through the books, one of the things you note is or most people realize is all these guys are doing something different, you know, it’s like them. They’re just nothing like each other. It’s not like a bunch of guys doing the same thing. So you got people all over the map.

However, if your question would be, who was the most different trader, you know, or who used the most different approach versus everybody else? He would be Jimmy Balodimas because here’s a guy who’s using an approach that it just flies in the face of everybody. You know, it’s just counter to everybody’s advice. It’s counter what everybody does. It’s something like if you told me, somebody does what Balodimas does, I said, this guy’s gonna blow up in a year or two. And he’s been doing it for 20 years, whatever he’s been doing it for. First of all, what does he do?

So what Jimmy Balodimas does is he has this personality where he has to be the opposite. Everybody can’t stand the deed. He always has to be fighting everybody. He has to be on the opposite side of everybody. And the more people are crazy about something, the more he wants to be the opposite side of it. So you get markets where extreme markets like and he trades both stocks and commodities, but talk about some of the commodity examples because they’re the extreme ones.

29:08

If your audience might remember silver, four or five years, six years it was? But when silver was going straight up, and it went all the way up into the 40s, and eventually got the low 50s, and it’s going almost vertical. Who’s selling silver? Well, there’s Jimmy selling silver right into that uptrend at 45 or 46. You had a cotton market, the stock market that had since the Civil War, I’d never gone to $1. It goes to like, more than above $2 and it does the last part and just a very short period of time. Just like another clip like who’s selling cotton? It was like $2. That was Balodimas.

So he steps in front of free trades. And not only that, it’d be one thing if he did back then just held the position when the market has eventually crashed, but then when on the first good break, he takes his property it’s like insane. But *inaudible knows the fight so. So that’s the style he does and the reason why, you know and by the way, I say it in that book, the first line of that chapter is Jimmy Balodimas breaks all the rules. And the first line of my conclusion to that chapter is something along the lines of don’t try this at home. You know, nobody trades this way. I don’t want anybody to trade this way. How do I know he’s for real? Because like I say my son works for him. And so he was there. He arranged the interview and all that.

30:37

So my son worked for the firm, and everybody knew that Jimmy was like this guy who produces multi-million dollar results on the *inaudible here. The first day I go to interview him. Set the scene. This is like the end of the first quarter. I forget which year it was, but it was a year it was like 2011 I think, but it was one of those years where the stock market was going up almost every day. The first quarter had been up pretty steadily. And that March, that month I went to visit him, it was one of those days the market couldn’t go more than three or four days without making a new high. So if you were like short, I mean you just you couldn’t grasp. You can’t catch your breath. It was just like, down today up again, you know, it’s like and so at the end of the month,  last day of the month, I think it was the market is down 2% and so there was some story about Libya or something and there’s some excuse for the market to go down and sold off.

And so I go into his office and he’s got the monitors. My son’s there too and all the screens are like all red, everything’s like all red because that was the day the market was down right? And it turns *inaudible of course he’s been short everything, right? So but it’s one day the markets down and first of all, he’s put those like think of guys who could short markets going straight up, finally a day the markets down 2%  the whole screen are red and he’s short. The thing the guy be like I don’t know if you want to lose that day. At the end of the day, he was losing, but he would be the same way just like, you know, that’s what it was.

32:04

How does a guy short a market that goes up every day, going up almost every day of the month, gets one day that’s down and still ends up breaking even, how do you do that? So the thing is this is where he makes the money. This is where his skill is. And this is somebody who can’t teach. But he’s always taking profits, but he’s always taking money off the table. So you short a stock and it’s a terrible trade, the stocks that go for 50 to 100. But he’s short. So you go short, it’s short, it’s 50. The stock picks that open up 49 and a half. He sells some of it, goes up 51. You know, so he buys it back then goes up to 51. he will sell it again.

So he’s constantly taking these small profits along the way. And so even though he’s wrong in the trend, he’s making these profits on these because he’s just capturing money off the table continuously. He trade. He does about 500 trades a day, according to my son. So that’s how he was making us money, but he could have made a lot more money if he did the same thing with the trend, but he insisted on doing it against the trend.

Preston Pysh  33:05

So that it seems like he… that you would eventually blow up with using that approach. And you’re saying he’s still been doing it?

Jack Schwager  33:12

He’s doing it for a long time. And I don’t… I can’t tell you how… I would have talked to the first one to say the same thing, Preston, I would have been the first one. And I would have said it’s impossible. Nobody could trade this way. And maybe he won’t get away with it. But it’s been a long, long time, but he’s been doing it then. I don’t think anybody should…  I mean it doesn’t trade that. 9999 people out of 10,000 will go broke doing this and the last one out of thousand will lose 80% of their money.

Stig Brodersen  33:45

So this wraps up our first part interview with Jack Schwager. Stay tuned for the next episode, where we continue the discussion with Jack and learn more about fundamentals in trading and how to measure your performance in investing.

Outro  33:58

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