Source: Smart Investors
Author: Ina

The Black Jack Club, a 21-point club led by Professor Rosa of the Massachusetts Institute of Technology, has brought in the brightest students in the university. Every weekend, they go to Las Vegas one after another to gamble at 21 points, winning all over the casino with their excellent mental calculation and memory.

This is a scene from the Hollywood movie “Decisive Blackjack,” and it is also the daily life of investment guru Edward Thorp (Edward Thorp) in Las Vegas after becoming an MIT math teacher.

Blackjack is the game with the closest win rate for both parties in gambling. Winning this kind of game means Thorpe has to deduce strategies corresponding to millions of cards.

This mathematical genius, known as the “originator of quantification,” is highly respected in mathematics and investment circles, but his name is not well known to the public.

Jack Schwager, who has interviewed many hedge fund bosses such as Dario and Drucken Miller, once said that Thorpe is one of the smartest fund managers he has interviewed.

He was the first modern mathematician to successfully use quantitative models to analyze risk, and the first mathematician to achieve great success in personal wealth as a result.

Since then, a group of “quantitative experts” have been born, such as those gifted teenagers in the Department of Applied Mathematics at the State University of New York at Stony Brook — Thorpe is their “dean.” Simmons, who is only 30 years old, was the head of the mathematics department.

After returning from Las Vegas, Thorpe used his mathematical research to write a novel called “Defeating the Casino”, which was very popular, and Thorpe was warned by Las Vegas casinos because of this.

Later, fearing that his life would be in danger, he decided to move his math game from Las Vegas to the Wall Street stock market to continue playing.

For him, the stock market is a new form of gambling:

“Understanding gambling games like blackjack is one of the best ways to train to enter the world of investing. You need to learn how to manage money, calculate win rates, and think about how to act when you have an advantage.

Gambling is a simplified way to invest. Both can be analyzed using mathematics, statistics, and computers. They all require money management and choosing the right balance between risk and reward.

Even if everyone's bet is good for you, gambling too much can have devastating consequences.”

Bill Miller is also so obsessed with digital games that he even studies gamblers.

When Thorpe first decided to help others manage their money, one of his funders happened to invest in Buffett's partnership fund, so this investor arranged a dinner with Thorpe and Buffett, so Buffett was able to inspect Thorpe.

Thorpe was of course approved by Buffett.

He mentioned two of Buffett's most important influences on his career: first, he helped start his own hedge fund path, and then he made Thorpe a sizable business—investing in Berkshire.

If I had to sum up Thorpe's story, it was that the genius was addicted to games, repeatedly sought an advantage, survived, won, and left to enjoy life.

01 A genius who is addicted to math games

Born in 1932, Thorpe has had an extraordinary talent for mathematics since childhood.

When he was in high school, he won first place in the California Physics Contest, and was shortlisted for the Westinghouse Science Genius Award (a nationally respected scientific award) of 40 people, and was interviewed by US President Truman at the time.

Entered the University of California, Berkeley at age 17, and became a doctoral student in physics at Columbia University at age 21.

Thorpe and Buffett, who came from a mathematician family, invested quite differently.

Using his own research, he created a tool to evaluate option prices, carried out low-risk option arbitrage, and applied the statistical arbitrage model to more financial instruments through the use of computers.

Thorpe initially wanted to establish a “market-neutral” investment strategy, that is, regardless of the stock market, the investment will have a good return.

His partnership operations formed what we know today as hedge funds that seek absolute returns.

In 1969, Thorpe and Regan founded the first market-neutral hedge fund, Princeton Newport Partners (PNP for short).

02 The 1987 stock market crashed and bottomed out successfully

Thorpe will use a computer to calculate the price of various warrants. When he sees which warrants are overvalued, he buys the corresponding shares as a hedge. This is the predecessor of the convertible bond arbitrage strategy.

No one has actually used a computer to calculate this strategy before; it is entirely based on personal experience.

In the 10 years from 1969 to 1979, the S&P 500 had an annualized return of 4.6%, including a dividend rate, while Thorpe's hedge fund had an annualized return of 17.7%, and the volatility was much lower.

Moreover, when the Black Swan arrived, Thorpe's fund was still able to carry it.

On “Black Monday” in 1987, the value of US listed companies sometimes evaporated by a quarter in a day, becoming a nightmare for countless traders, but it was Thorpe's highlight moment.

Seeing that capturing the unprecedented spread between futures and indices has huge profit potential, Thorpe first shorted stocks and bought index futures to capture the excess spread. Later, as the price plummeted, Thorpe reduced its short positions by nearly half, and achieved almost the best hedging.

Due to a market-neutral strategy, Thorpe's hedge fund achieved a positive return of 9% over the five-month period from August to December 1987, while S&P fell by almost 22% during the same period.

His book “Beating the Market” shares his investment methods and is considered one of the most influential investment guides of all time.

The book also inspired Ken Griffin, founder of hedge fund giant Castle Investments, and Bill Gross, the famous king of bonds.

Thorpe is also Castle Investments' first limited partner.

03 Inner compass - life risk control

Thorpe has always had a strong inner compass at work and in his life, which is risk control.

He once teased that he missed the investment in a long-term capital management company (Long-Term Capital Management L.P) in 1994 and was unable to become rich for a short time, but in 1998 he made a profit by buying stocks whose prices were severely reduced due to its collapse.

Nicolas Taleb, the author of “The Black Swan,” once mentioned all the wisdom he learned from Thorpe.

He mentioned how Thorpe minimizes clutter in operating businesses:

“Many successful speculators have invested in large-scale businesses since their first breakthrough, running between many offices, morning meetings, cafes, and trade secrets. When they are busy accumulating wealth, they often lose control of their lives.

But that's not the case with Edward. When his company stopped operating and parted ways with his partner, he didn't go on to start a large fund company.

Instead, he has limited the amount of asset management he can do (most people choose to reintegrate into other companies and use their fame to raise huge amounts of external capital to charge high fees).”

Taleb also mentioned how Thorpe dedicated his talents to health and longevity, just as he tried to beat casinos and markets.

In April of this year, Bloomberg Businessweek published an interview with Thorpe. The focus of this interview is not about how to invest, but how to keep your body energized.

At 91 years old this year, he can also do 2 pull-ups and 15 push-ups. He weighs only 2 pounds more than when he was 17.

Thorpe said that he also applied the concept of managing financial risk to managing risk in life.

He carefully studied the literature and refined his wellness plan. Although I no longer run marathons or do high-intensity strength training, I still jog regularly and work out at the gym.

Thorpe's attitude towards sports, health, life, and treatment is particularly evident in his intelligence and prudence. In this regard, he also mentioned some of his working principles:

(1) There is no need to increase risk;

(2) Assess and manage risks yourself (be your own doctor);

(3) Stay away from everything that makes you addicted.

There are two interesting examples from the interview. One is that the reporter asked him if blood transfusions would be considered for the exam. Thorpe said he was in very good condition and there was no need to be a mouse (no risk increase).

Another one is that in the 80s of the last century, when Thorpe was looking for a fund manager for his FOF, he originally wanted to meet Renaissance Simmons. As soon as he heard that the other person was used to smoking during meetings, he dismissed this idea, simply because he didn't want to smoke second-hand smoke.

“In the early 80s, it didn't matter because he was losing money back then. I didn't go looking for him again until around 1989. He's a very smart guy, but I'm surprised he would succumb to such an addiction.

By the way, this is one of the most dangerous things I try to avoid: all types of addiction.”

The book “The Man Who Overcomes All Markets” reveals how Thorpe, who is meticulous, and methodical, uses his own unique method to pursue the safety of life, knowledge, and assets, especially the joy of work and life.

In the preface to this book, Taleb gave Thorpe a particularly high evaluation:

“Thorpe is famous for his generosity, his witty words, and his desire to share his findings (through text but also face-to-face) with strangers — an excellent quality you hope to discover in other scientists but often don't.

But at the same time, he's humble — arguably the only humble businessman on the planet — so unless readers can decipher the meaning between the lines, they won't notice that Thorpe's contribution is far more important than he described.

Why is that?

Because the theory he revealed was simple, pure simplicity.”

Smart investors have taken 45 golden sentences from Edward Thorpe from this book. From there, we can get a glimpse of this investment guru's thoughts on risk prevention and control, probabilistic thinking, and life and happiness, and share them with everyone.

05 Digital games from Las Vegas to Wall Street

1. When I moved from beating gambling games to analyzing the stock market, I naively thought that I would step out of a world full of fraud and frequent problems and enter a world where regulation and laws are bound and investment competition is more fair. But the truth I've seen is that bigger bets only attract more devious liars.

2. Life is a combination of opportunities and choices. Think of opportunity as a card in your hand, and choices are how you play. I chose to delve deeper into the theory behind Blackjack, and as a result, opportunity presented me with a series of new and unexpected opportunities.

3. Those who are easily deceived are lured to gamble on a game that is mathematically bound to lose in a glittering playground. However, only a few winners will be promoted like poster stars, attracting more gamblers to frequently make heavy bets, lose money, or even go bankrupt.

4. Understanding and properly handling the balance between risk and reward is the most basic challenge for all gamblers and investors, yet people have a poor understanding of it.

5. If it can be proven in the end that there is no optimal calling system, then your best strategy is to let your opponent reveal their calling strategy according to regulations, and then choose a targeted strategy to deal with it.

6. Scholars usually use a probability distribution to describe stock price fluctuations, and give this distribution an esoteric name: log-normal distribution. This distribution theory fits well with small and relatively large historical price changes, but it greatly underestimates the probability of large fluctuations in stock prices.

7. The more people trade, the more they lose to computers. This is one reason why buying and holding is better than buying and selling (unless the difference between a single trade is large).

8. The stock market is also a game of incomplete information, and it is very similar to bridge because each has methods of deception. Just like in bridge, you can make money if you can get information faster and apply it to the market, so it's no surprise that the greatest investor in history, Buffett, is addicted to bridge.

9. I always think the surest way to get rich is to bet only on things that have a big chance of winning — whether in a casino or in the field of investment. I've never heard of anyone beating a casino, so gambling in Las Vegas was never a priority for my vacation.

10. Buffett had two critical influences on my career: first, he helped me get on the path of starting my own hedge fund; then, he made a very impressive business—investing in the difficult small textile company he managed: Berkshire Hathaway.

06 Probabilistic thinking is the most important part of investing

11. Splitting all the gambling games I've played in my life into several units or changing the time and place of gambling did not affect my probability advantage or long-term mathematical expectations. This principle applies not only to gambling, but also to investing.

12. Unless you have sufficient evidence to back it up, never assume what investors call “inertia” — a trend where prices continue to rise or fall, will continue.

13. Although my initial analysis of the economic situation was correct, I was unable to accurately measure the risk of high leverage. I spent several thousand dollars to buy this lesson and realized that risk management will be one of the main topics in my career for the next 50 years.

14. Gambling is a simplified version of investing; the two are strikingly similar. Just as some gambling games can be beaten, we can sometimes earn more than the average return on the market. Both can be analyzed using mathematics, probability, and computers, and require asset management, and a careful balance between risk and benefit. Even if you can get the most out of every bet, betting too many can lead to big trouble.

15. Hedging strategies allow us to avoid losses, but we can also lose some potential profits in a bull market. Changes in return on investment are mainly driven by fluctuations in the quantity and quality of hedging strategies rather than changes in the market.

16. The downside of using only Value at Risk (Value at Risk) is that it does not consider the worst 5% of situations, but these worst situations often have disastrous results, and extreme situations that actually occur may be more extreme than those predicted by commonly used Gauss (normal) statistical models.

17. Among the many index scores we have analyzed in our systematic analysis, several showed strong correlation with the historical price of stocks, such as yield (annual income divided by stock price), dividend rate, book value divided by stock price, momentum, emptying volume (number of shares currently vacated), unexpected surpluses (the actual amount of profit in the company's profit announcement was significantly higher or lower than analysts' predictions), the trading volume of the company's management, directors, and major shareholders, and the ratio between the company's sales revenue and market price.

18. We never ask “whether the market is effective”, but “to what extent and in what ways the market is not effective” or “how should we use this”.

19. Judging from historical data, buying the last 1/10 stocks with the worst trend and shorting the top 1/10 stocks with the best trend can achieve an annual yield of 20%. We call this system the MUD system, taken from stocks that “rose the most, fell the most” (most-up, most-down).

20. Outperforming the market is not equal to winning the market. The former is often just a matter of luck, while the latter finds a statistically significant advantage and profits from it.

07 Advice for investors

21. Being able to connect with different strangers in a few simple steps explains to a large extent the speed and breadth of rumors spreading. If you have a good investment idea, then you consciously keep it private.

22. I only recommend stocks to family and friends who understand that stock investment is an asset that has been held for a long time and there is uncertainty about the future. I wouldn't recommend stocks to people who don't understand the principles behind trading and who are afraid of big fluctuations in stock prices; sometimes their reactions are really disappointing.

23. Ralph Gerard provided me with Buffett's letter to his partner and copies of materials proving his partnership with him — just two simple pages.

From then on, I realized that the ideal plan would be like Warren's: put my own and others' funds in the same limited partnership investment project.

24. If you are proficient in a certain field of expertise, then you should look for funds that can assist in the evaluation with your expertise.

25. From the collapse of long-term capital management companies, we should learn the lesson of excessive leverage, and this has been overlooked. You need to ask yourself if you can bear the consequences if the worst happens.

26. The return on active investment can be viewed as the sum of these parts: passive investment performance, positive or negative performance returns like throwing coins in a casino, and a 2% “coin toss fee” per year.

27. Taxable active investors are more miserable, because the asset turnover ratio is too high, which means that the return is short-term capital gain, and they bear a higher tax rate than investments that have been held for more than 1 year.

28. If you invest in index funds, then you should choose a fund with an annual expenditure of less than 0.2%, and refuse to choose funds with high management fees, sales fees or other expenses.

29. Investors can profit by buying funds that are clearly discounted compared to historical prices or similar funds.

30. It is also possible to short sell fund shares with high premiums. Depending on their different structures, funds of different periods in the portfolio may be hedged to some extent, and futures and options may also reduce risk additionally. The return of this strategy is fairly stable, but during a longer “trial” period, discounts and premiums tend to disappear, leading to a decline in return.

31. In order to win the market, you should focus your investment efforts on areas within your field of knowledge and ability to evaluate, that is, your “circle of competence”. Ensure that the information is valid, accurate, and generally complete. People who know the information early will “eat” those who know it later.

32. Don't invest unless you can use logic to prove it. If you have a history to follow, you gain an advantage.

08 About life and love

33. I am always easily irritated by narrow-minded and stubborn mediocre talents, and the experience that followed made me gradually understand that it is unwise to confront these people head-on. I've slowly learned to avoid them as much as possible, and even if I can't, I avoid direct conflict with them.

34. I enjoy fame, applause, and glory. All of these things inspire my passion for life, but none of them are the ultimate goals I pursue. I've always felt that what really matters is what you do and how you get it done, whether your time is worth it, and the people who share it with you.

35. What really attracts me is the joy of doing what others think is impossible, and simply solving problems brings.

36. In order to attract and retain excellent employees, I offered wages and bonuses far above the market level. This actually saves money because employees work much more efficiently than the market average. High pay reduced the employee turnover rate, and also reduced the time and money for me to re-teach original investment methods.

37. I often don't accept the conclusions others tell me, and I don't believe it until I personally verify it. This also causes me a lot of trouble at times. When I was 3 years old, my mother warned me not to touch hot stoves; I personally test widely accepted opinions such as “you can't beat the bookmaker.”

38. Strive to maintain consistent rationality. I not only practice this principle in a specific field of science, but also practice it when doing everything in this world. In addition to that, I also realized the value of not drawing conclusions easily without evidence.

39. If I could ask myself before doing something: What are you trying to make happen by doing this? What do you think will happen again? If I wasn't satisfied with any of the answers, I wouldn't do it.

These two questions guided me in my future life.

40. After Princeton Newport went out of business, I secretly reflected and understood that what really matters in life is how to allocate time. More than wealth, time with family is an irreplaceable treasure.

41. Every hour spent on fitness will reduce my day at the hospital in the future.

42. To determine whether your time is worth it, you can carefully consider how much wealth you have gained through hard work and work. Once you figure out your hourly rate, you'll be able to figure out when saving time is worth it. (ps: Naval also proposed a similar idea)

43. On Wall Street, success means making the most money; but for us, success means having the best life.

44. After Vivienne (wife) passed away due to cancer in 2011, we held a memorial service to commemorate her life. When I think back to our life together, I remember her brother saying, “Memories are a person's eternal treasure.”

45. Life is like reading a novel or running a marathon. Reaching the end is often less important, and the journey itself and the experiences along the way are more precious. As Benjamin Franklin once said, “Time is everything in life.”

Editor/Somer