Recently, I read the autobiography A Man for All Marketsby Edward Thorp, which recounts the author’s journey through the worlds of academia, gambling and Wall Street. He may not be a household name, but Thorp’s practical contributions to finance and applied probability cannot be understated. Amongst his various exploits, Thorp wrote the book on card counting in Blackjack (Beat the Dealer), invented the world’s first wearable computer to beat the game of roulette, developed the Black-Scholes option pricing formula several years before Fischer Black and Myron Scholes did, and was a pioneer of convertible and statistical arbitrage.
The book is two-thirds autobiography and one-third financial observations, and while it is more geared towards trading (Thorp ran one of the world’s first quant funds), the book still contains valuable lessons for all investors. Below are some of the key lessons for fundamental investors.
Conventional wisdom is usually wrong
From a young age, Thorp understood the importance of challenging conventional wisdom. During his PhD years, the conventional wisdom in Vegas was that you couldn’t beat the dealer in Blackjack. Instead of taking the advice for granted, Thorp applied some logic and plausible mathematical reasoning to devise a practical system that gave him a slight edge over the house which, over many hands, led to substantial winnings. He would later develop similar systems for gaining an edge in roulette and baccarat, and even started his hedge fund Princeton Newport Partners in part to disprove and then profit from the Efficient Market Hypothesis (EMH).
The philosophy of not following conventional wisdom is what underpins the contrarian approach to investing. As Howard Marks says, in order to outperform the average, you have to be both different and right. By following conventional wisdom when it comes to investing, you may be proven right (or wrong), but you won’t be different from the collective masses. One pertinent example of this that all investors should be familiar with is Apple. For as long as the market can remember (that is, not long), Apple’s path towards $1 trillion market capitalisation has been inevitable. Yet as recently as early 2016, critics and market pundits were predicting that Apple would roll over the same way as all the hardware companies that had preceded it, as the smartphone market commoditised and competing handsets became “good enough”. In fact, since 2012, Apple stock faced one drawdown of 44% and another of 32% on the way to $1 trillion. An investor who followed conventional wisdom would likely have experienced a frustrating ride, buying high and selling low along the way.
Never rely on others to do your homework
Related to the lesson above, Thorp also warns against relying on other people to do your homework. There are certain situations where the Wisdom of Crowds results in more accurate estimate than any individual participant, for example when guessing the number of jelly beans in a jar or the weight of a cow. However, when it comes to investing, the Wisdom of Crowds usually manifests itself as what Thorp calls the “Lunacy of Lemmings”.
Thorp tells the story of how he unearthed Bernard Madoff’s ponzi scheme…in 1991, almost 18 years before Madoff confessed to the fraud. Again, by not taking Madoff’s consistently stellar returns for granted and applying a dose of plausible mathematical reasoning, Thorp proved that Madoff’s returns were statistically impossible using the strategy he claims to have employed. Yet 13,000 investors, including very “sophisticated” institutional investors and asset allocators, ploughed as much as $65 billion into Madoff’s gigantic ponzi scheme over more than 40 years. What appears to have happened is that new investors, seeing so many existing investors make so much (paper) money, decided to forego their own due diligence whether due to misplaced faith or fear of missing out.
In a similar vein, Long Term Capital Management had eight central banks and some of the world’s largest pension and sovereign wealth funds on its client list when it blew up spectacularly in 1998. These institutional investors, especially the central banks, were supposed to be masters of statistical analysis and risk. But the comfort of seeing similar investors on the register, who have presumably done the analysis already, lulled them into a false sense of security.
The importance of thinking probabilistically
Probabilistic thinking, as opposed to deterministic thinking, is something we have written about previously, and Thorp’s exploits at the Blackjack table highlight this concept very well. As hands are dealt and cards are revealed, the edge shifts between the house and the player. When the remaining deck to be dealt is high in tens and face cards, the deck is said to be “rich” and the player’s edge is largest. Players typically use some variation of the Kelly criterion to size their bets. When player edge is small or negative, minimum sized bets are made; when player edge is large, bigger bets are made to exploit the favourable odds.
At Montaka, we think about the value of each business as a probability distribution of outcomes rather than fixed point estimates. We prefer owning or shorting stocks where the probable outcomes are asymmetric in our favour, as this provides us with the highest margin of safety. We also employ a formulaic approach to sizing positions in our portfolio, similar to how players use the Kelly criterion, so as to minimise behavioural and emotional influences on portfolio construction. This combination of probabilistic thinking and portfolio sizing allows us to construct a portfolio that appropriately weights each investment relative to how asymmetric their payoffs are, and our conviction in those payoffs.
Finally, and perhaps most importantly, Thorp’s experiences in the casinos and the financial markets remind us that investing is a lifelong journey of learning and education. There is no time to rest on one’s laurels. Casinos can change the rules on the card counters, arbitrage opportunities can be crowded out and luck can reverse. But investors who remain intellectually curious, ask the tough questions and are diligent with their research will ultimately retain their edge.