Ed Thorp, The Man Who Beat The Dealer and The Market

you may know the name Ed Thorpe. I described him as really the first quantitatively driven hedge fund manager UH that of of any import. He was Jim Simons of Renaissance Technologies while Jim Simons was still a undergraduate math professor. He is the author initially of the book Beat the Dealer, where he figured out how to actually beat the house in blackjack. His analysis, his mathematical analysis of of blackjack led Las Vegas and casinos everywhere to completely change how

they deal blackjack. They now use half a dozen UH decks instead of a single deck their random reshuffles. They utterly have changed the rules in response to Ed Thorpe. He then figures out the physics behind beating wait for it, Roulette and working with information theorist Claude Shannon at m I T. The two of them come up with a wearable computer. Eventually they get thrown out of old casinos. The casinos don't really like losing money to M I T.

Math professors. He relocates to Irvine, you see, in California, and starts thinking about, well, what else is math heavy and filled with inefficiencies that has the potential when statists sical theory is applied properly to generate large amounts of money and finds his way onto Wall Street and and His second book is called Beat the Market and explains how when you can find two related equity issuances that

are miss priced, there's an arbitrage opportunity. Believe it or not, Before that, no one was really doing that sort of statistical arbitrage between a stock and a warrant or eventually a stock in an option. Uh. He's had an absolutely fascinating career in a fascinating life. His autobiography is called A Man for All Markets, and it's really quite intriguing. UH. Footnote to this entire conversation. After we finished the interview, my assumption is that, hey, he's got to be tired

of hearing my voice. But he invites us to dinner, and and three of us went and had a lovely meal there in Newport Beach. And and he's just an absolutely fascinating UM person and really a character who is beyond influential in the worlds of um, quantz and algorithms and hedge funds and you name it. His impact on

finance can't be understated, So can't be overstated. So, with no further ado my conversation with ed Thorpe, I have an extra special guest this week, and I am privileged to be sitting in his offices in glorious Newport Beach, California. Edward oh Thorpe is a legend in finance. He is an American mathematics professor, author, hedge fund manager. He is the person who essentially figured out how to beat Las Vegas.

I credit him with more or less inventing card counting. Eventually, Vegas banned him from a ton of a ton of casinos because he was beating the house. And his his first uh first book was Beat the Dealer. And after he did that, he figured out ways of beating baccarat and came up within a wearable computer and figured out

how to beat Rolette Roulette. And by that point Las Vegas and Reno wanted nothing to do with him, and he turned his attentions towards the next challenge similar to gambling, and it turned out that was investing in finance in Wall Street, and the book after that became Beat the Market because Edward figured out how to do things in a way that created substantial, substantial returns. I could talk about his curriculum Vita forever. Let me just add PhD in mathematics, taught it m I T in New Mexico

and University California, Irvine. Edward Thorpe, Welcome to Bloomberg and thank you for hosting us in your office. Thanks very, It's a pleasure to meet you and be here. I'm thrilled to be here. I'm gonna start with some quotes of yours and just have you respond them. And some of these are from Beat the Dealer. Chance can be thought of as the cards you are dealt in life. Choice is how you play them. That's a pretty deep

philosophical perspective. Tell us how you came to that well, if you look back at your own life, you probably have a number of circumstances where you could make an important choice one way or another, and the way you made that choice had a big effect. The woman you're married, if if you infected, get married, the children that you brought up, and how you brought them up, the career you chose in life. 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 where you started. You start twenty yards behind the start line, or twenty yards ahead of it or right on it. People start in different places.

Those are cards that are dealt. So along those themes you talk about managing risk as an investor and managing money as a gambler, you wrote, I also believe, then, as I do now have to more than fifty years as a money manager, the surest way to get rich is to play only those gambling games where I have an edge. Let's talk about the edge a little bit, Okay.

In the standard dambling games in casinos, you can generally calculate what the casino's edges, or if you figure out how to count cards, you can calculate what your edge over the casino is. So it's a fact, a mathematical fact, that if you play a game like this and the casino has the edge, it will eventually collect all your money if you play long enough. On the other hand, if you have an edge, your bank roll will grow

and grow and grow. So basically what happens is you your bankroll either grows or shrinks depending on what your edges or what your disadvantages, and there's luck that pushes it up and down around that growth curve. So that's that's the way things look in the gambling world. So so even when you have an edge, you have to be prepared for Hey, sometimes snake eyes comes up on the dice. To to mix metaphors a little bit. That was one of the early things that I learned, fortunately,

which was how much to bet on good situations. If you've got too much, you're likely to be wiped out. If you've got too little, it takes forever to make any money. So there's a happy medium in there, and that was one of the things that I came across quite early. Is there a mathematical solution to what's the right amount and what's too much in too little? Well, I was put onto this by a famous mathematician named Claude Shannon, who I knew at M. I T and I have to add in a man for all markets.

You just casually mentioned throughout the book. You casually mentioned these legends in science and physics and mathematics. And oh so I went to Claude Channon with this problem, and the two you spent weekends tell us a little bit about that. Well, let's see it. Um. I got interested in the idea of beating Roulette when I was a high school student, but my ideas weren't very well formed,

so I put it aside. And then when I went to u c. L A And gotta a bachelor's and masters in physics, I had about seven more years of physics behind me, and I happened to be talking to people at a study break in my student coopera I lived about Las Vegas. Some people have just come back and said, you can't beat those guys. I said, well, I think you can, and here's how I would go about it. So I described predicting Roulette using physics and they are good back and forth, and half the people

believe me in half of them didn't. But I convinced myself from the argument and all the new physics that I had learned in the interim from high school, that yes, this is very likely to work. So I set out to do that, and you created a wearable computer working with Channon and other people. Is that right? What happened was I went to Las Vegas with my wife over Christmas vacation. By this time I had a PhD in math at U c l A. And I was going

there just for a cheap, cheap vacation over Christmas. But I wanted to see Roulette wheels because I was busy working on beating Roulette, and I wanted to verify by close up observation of their wheels that what I was doing was likely to work. And on the way, I heard about a blackjack paper that some statisticians had read. So I thought, well, I'll get a little casino experience. I'm gonna need it if I'm going to be playing Roulette.

So I sat down at the blackjack table and played for about forty minutes, and I learned enough during that forty minutes to realize I could probably beat blackjack, and I went back and set to work doing that. And black jack is one of those situations. Back then, there was one deck. They didn't shuffle it. They played pretty much through to the fifty two cards. That was astonishing that nobody had sat back and said, oh, we should be able to track the math of this and figure

out how to beat the dealer. Well, there have been some savvy gamblers who had figured out that if you kept track of the cards and near the end there are lots of aces and tens, then there'll be more black shacks being dealt. And black jacks then and sometimes still now pay three to two if the player gets one, and just even money if the dealer gets one. He

basically a collect your bet. So the more black when the decks rich and aces in tens, the higher frequency of black shacks shifts the edge in favor of the players. So they would sit there and wait and wait and wait until there were lots of aces and tens near the end of the deck. Then they bet a whole lot of money, raised the bets and and hope the

statistics just play out over time. Yes, and that worked, but it took a long time, and it meant huge swings in the amounts they beat, and the casino was kind of caught onto that and got rid of these guys. They don't like people who were betting legitimately and winning. They seem to have a problem with that. Well, after I wrote a book about Card County beat the Dealer and it came out, they had a crisis in Las Vegas.

Who were tens of thousands of players coming out and a few hundred of which learned how to count cards properly. And these players were upsetting them very much. So on April Fool's Day of they announced a rules changed. The Las Vegas Resort Hotel Association had a big meeting and decided what to do. They had a lot of uh suggestions like break his knees, right, nice guys, But they changed the rules and they went from one deck to six or eight. Is that that was a sort of

a separate, parallel evolution. What they did was they restricted what players could do. They couldn't split as many pairs they could and double down as much that sort of thing. And I predicted that the players would not like this, and they leave the tables in droves, which is what happened. So they quietly went back to the old rules, and

then they did what you mentioned. They began to introduce what they called professor stoppers, which were four or six or eight decks, and they began to deal them out of shoes, because it's pretty hard to hold for to eight decks in your hand and try to deal professor stoppers.

That that's hilarious. So let's talk a little bit about information theory, because there's a line that you have about the great physics professor Richard Feynman, and you went to him with your concept about physical prediction of Roulette, and Vineman said, no, I really don't think anybody can beat Roulette. And you were thrilled with that answer. Yes very much, though,

explain why, because I love the thought process here. Well, Fieman had had to graduate students that had figured out a way to be defective Roulette, someones which weren't properly maintained or machined, and they had made several thousand dollars

doing this back in the early fifties. So he knew about He knew that fact about Roulette, and he also understood the edge that casino has had and how the mathematical ledge would grind down players who knew that mathematics had shown you couldn't beat roulette in the normal fashion of varying your bets up and down. In other words, it's a game of chance. It's a random outcome, and ultimately the house wins if you play long enough. Exactly.

So he knew those two things, and he himself had been in Las Vegas and he saw he saw a guy wandering around betting on red and black and roulette wheels. So he said of the guy, look, I'll bank roll it for you. The guy was betting five dollars a hand. He said, just bet with me. The guy would go over and you say red and the wheel would spend, and if he won, five would pay him five dollars, and if he lost, he paid fiveman five dollars. This went on for a while until Fine one was down

eighty dollars or so, at which point Biman quit. So, uh, that's pretty random that he's just banning one way or another. And what Fireman didn't realize was that psychologically his bank roll was eighty dollars and that wasn't big enough to be a casino. It makes a lot of sense. So so when Fynman said I don't think this could be done, that encouraged you, and I figured, here's here's one of the best physicists on earth. He knows about Roulette, he knows about a lot of math, and yet he thinks

it's not possible. But I think it's possible. So if he thinks it's not possible, probably everybody else does too. So that means I've got this all to myself. That that's ah, that's a fascinating way. That's like the little Kid and the pony, the old the old joke. Hey, if Fynman doesn't think it, then there's got to be a pony in here nowhere. Um. Another quote from the book, most market participants have no demonstrable advantage for them, just as the cards in black Jacks or the numbers that

Roulette seem to appear at random. The market appears to be completely af But you disagree with that assessment. Well, when people talk about efficient markets, I think it's a property of the market, but I think that's not the way to look at it. It's the market is a process that goes on and we have, depending on who we are, different degrees of knowledge about different parts of that process. I'll give you an example. Suppose I take a coin here where we're sitting, and I flip it

up and let you call it heads your tails. You'll probably think that the outcome is random, and assuming it's a true coin, sure, yes so, and people can argue about whether coins are true or not, but the distinctions are very minor. Essentially, it's fifty, so you can say, well, you know it's random. I I'm willing to call you the heads their tails. Not. Suppose that I, like Claude Shannon, take a sandbox and a little level with a cup on it and move the level down a measured amount

and let it flip the coin. Well, what Shannon found out was that the coin would flip a number of turns that he could calculate depending on how far down he pulled a lever before he released it, so he could have it spend three and a half times, for example, So if heads were up and he spent a three and a half times, it would land tails. A simple problem of force, angular momentum, and an amount of distance it travels exactly. So given the extra information, that coin

becomes fairly predictable. So it's the same with markets, depending it depends on any information you have, And of course people who do inside or trading do a pretty good job of predicting a market that seems random to most people. So a few quotes of yours that I find fascinating gambling is investing simplified. I think that's really interesting that

investing has become more complex than gambling. Why is that. Well, with most gambling aims, you can calculate probabilities, and so you know what the odds are in any given situation, and you can figure out pretty accurately how much to that. With a security it's more difficult. You only have rough estimates.

For example, there's something called the long normal probability distribution that is a rough model for how stock prices change, but it's not an exact model, and it has parameters and like volatility, and if you make a supposition as that what the volatility is going to be in the near future, you can get an idea of the distribution of prices of a particular stock in the future, but you might be off in what you think the volatility is going to be, and so your distribution will be off.

So anyhow, it's it's a matter of estimating things that you can't get exactly, you can't know. So so how natural was that progression from the casinos to Wall Street other than they're both big, interesting mathematical riddles to be solved. Well, I learned a lot of things in the casino, I would say, just as an aside um, using a winning gambling system of the casino is per training for the investment world. And the reason is that you learn how

to manage money, You learn how much to bet. When you know what your edge is, you get a certain discipline in conducting a strategy that you think is right. For example, let's suppose that you're an index fund investor. If you understand what the probability distribution has been for an index fund in the past, then you have an idea of what kind of ups and downs you're going

to be writing in the future. And when something bad happens like two thousand and two tho nine, you don't run out like a scared rabbit at the bottom and miss the whole climb back up to new highs. And yet that seems to be what many people. Many people do, they do, but if they had been car counters a black tack like the professionals I see the blackjack ball once a year if they had been, if they had

that experience, they wouldn't flinch at all. So in the book, you describe sort of your first tentative ventures into markets after um the Vegas experience. Tell us how you you began investing well after I had made money both from book royalties and from card counting at blackjack and baccarat in Las Vegas. After I've done that, I had money to invest for the first time in my life. Academics weren't paid a whole lot then and they're not paid a whole lot now, So I find my problem was

to figure out how to invest the money. So, knowing nothing, I made my collection of mistakes. I paid a mr Market is rather expensive tuition to learn a bunch of basic things that I'm described in the book, things that behavioral finance people understand now as foolish mistakes. And then I sat down for a whole summer and read everything I could on finance in a big bookstore in Beverly Hills. You described two summers of of of learning in the library and in the books. How many books did you

play through? What were you reading. Well, my first go round and the first summer was to read whatever they had in a big Martindale's bookstore on Beverly Hills. So it was newspapers, investment books, charting fundamentals, all kinds of advice, which which leads me to ask a question. And again it's a quote of yours. Most stockpicking stories, advice recommendations are completely worthless. Was that was that your takeaway back

then or is that something you learned over the years. Well, it wasn't my instant takeaway, but it was something I came to fairly rapidly as I plowed through all these things. What what is it that led you to the conclusion, which I completely agree with, that a lot of what's out there is just either conflicted or self interested, or noisy or not well informed commentary. Well, I had a science background, and I tend to draw conclusions based on

nation facts evidence. That's so old school. We don't do that anymore. It's it's it's now, it's all about the fake facts, fake news. I'm basically immune to all that stuff. It's like water running off a dock or whatever. So anyhow, you brought a fairly critical eye to whatever was being passed off his market advice? Is that a fair statement just because people said something wasn't good enough. I had that set from the time I was a child. I wanted to check it for myself and verify for myself.

And you blew up a number of chemistry kits and other such things which you describe in the book UM. So let's talk a little bit about return. So one of the things you discovered are pricing inefficiencies, pricing anomalies that say, hey, here are two related UM stocks. You can either have a stock and a warrants or later on a stock and an option, and they should trade parallel, but they don't. Sometimes one or the other gets cheap and the other gets overvalued. Was anybody else doing those

sort of paired or hedged trades at the time. No, Actually, what happened when I I was sent my set. I spent my second summer trying to learn about finance, and I got lucky. The first week or so, I got a little pamp in the mail from something called r h M warrant survey guy named Sydney Freed. I believe that his son still runs this survey, and so it told tales buying warrants for pennies and cashing him out

for dollars in the future. So as I read through it, I learned what I warrant was, and I said, hey, wait a minute. This simplifies the investing problem tremendously because the price of a warrant and the price of this underlying stock are related. So I don't have to worry about all these fundamental things. I don't have to go out and talk to CEOs and read balance and income

statements and compare companies one to another. If these things moved together, then if they get out of whack, I had to be able to set up some kind of investment short one along the other that will make money for me. So I began to think then about how how to price it warrant, how to know when I was at a proper price or overpriced or underpriced? And you were using some pretty early computer technology at the time. Yes,

I had actually got into using computers with Blackjack. I had done that back at M I T and sixty. They had an IBM seven oh four that was available then. So I taught myself for tran and the programmed to figure out the equations solve the equations that I needed to decide which cards were good to have in the deck in blackjack and which cards were good to have out of the deck. So anyhow, I had the experience

with the computers, which was fortunate. So then when I got to think about warrants, I had the computer background. Two actually mathematic size and draw graphs and do that sort of thing. Made it much more easy for me. And so you would find when these two related securities were out of out of sync, and basically made the bet that was did any of them ever go against you in an unanticipated way? Or did everything perform as expected.

The first things we found were overpriced warrants, and I happened to run into a professor at U see I the first day that you See I opened for classes back in we're both new faculty members, and he had written a thesis about warrants name Machine Kasuf. And so we got together and met every every day for about a year or two to develop the theory further, and then we wrote a book Beat the Market about it

and the warrants that we found that were overpriced. We were short and we would buy common stock, long hedge, and every one of those was a winner m hm. And every one of them historically had been winner, so we knew that these overpriced warrants somehow eluded the market. There were warrants with two years or less ago, and investors seemed to think that two years was forever, so they proaced the warrants way high, and then the warrants when they would wake up as the clock ran on

the two years, the warrants would collapse in price. So you could short the warrant about the stock. And it was just one annualized event after another and compounded. How did this investment end up running? What did you end up putting up his returns? Well, we made about a year gross and we had investors, faculty members at you see I that sort of thing that rode along with us. So after our our fee, which was the profits and

no more, uh, they needed twenty percent a year. And we did this for several years and then um I went into business for myself and she went off and went into business for himself, and you you launched a couple of hedge funds we're going to talk about in a little bit. I want to ask you about one other quote of yours that I really enjoyed. That's related to this. Every stock market system with an edge is necessarily limited in the amount of money it can use

and still produce extra returns. In other words, every edge has a scale limit. It can only get so big. Yes, and and how did how did you come to that conclusion? What made you realize, hey, this can only go so far. Well, let me say, first of all, the scale limit could be huge. It could be tens of billions, or could be ten or twenty or fifty million. I have a friend who has a commodity hedge fund that's one of the best performing ones around, and it it's limit is

like seventy million dollars. Because trading costs get too high. What happens is if you find a pair of securities that out of line, if one's overpriced and one's underpriced. If you start selling short the overpriced one, you'll drive its priced down so it'll be less overpriced. If you start buying the enterpriced one, you'll lift its price so

it will become less underpriced. So your action in trading misprice securities tends to drive them towards the correct price, which, by the way, is a service to the other people in the market because then they see securities that are more fairly priced that they would be otherwise. So not quite shouting those cat you you actually are affecting this by training it as opposed to a bigger liquid equity where a few million dollars and gonna move the price

very much. And by the way, that's one of the huge things between that is a difference between finance and physics. In physics, you can do the same experiment over and over and you doesn't affect the natural world. But in finance, what you do affects the human world. You're you're a You're an observer and a participant and affect the outcome of everybody else's opportunities. Let's talk about some of the interesting things you've done and people you've met over over

your career. You played bridge with Warren Buffett. Uh tell us how that came about. Well, when I was at U c Irvine, after I had figured out how to value warrants, I started trading for my own account and then the word spread and I signed up people at the university who wanted me to trade for their accounts.

And one of the people was the dean of the graduate division, A fellow named Ralph Waldo Gerard, National Academy of Science member, among other things, and so he wanted to get to know me and find out more about this trading. So I was introduced to a friend of his who was going to I didn't know this, but the friend was going to kind of check me out.

And the friend was the young Warren Buffett. So we had a dinner at the Gerard house with our wives and then we end up playing bridge, and I went down to Emerald Bay where Warren had one house and later two houses. That's not too far from here. Lodona or Emerald Bay is about four or five miles right down the coast. It's at the north end of Laguna Beach. Lovely part of the world. And you actually said something to your wife, I think that Warren Buffett guy is

going to be the wealthiest person in America. Exactly How did that thought process come about? Well, he was cashing out his partnership, which had about a hundred million dollars in it then it was. It was the biggest hedge fund around and also the only really successful one at that point. The runner up is Michael Stronhardt's fund, which was up slightly during a pretty bad period in UM seventy and Buffet's partnership was still doing well, but he

said things are so overpriced. I'm cashing out, which is why Ralph Gerard was looking at me. He wanted someplace to put his money that was coming out of Buffett Partners and Buffett was vetting you to see if you were okay to take their money, which is not a bad person to be vetted by. So we got along just fine and talked about a lot of different things, and the way we thought about things was similar, that is,

you know, rational, evidence based and so forth. His method of investing, though it was a lot more hands on that I wanted to be. I wasn't an invest I wasn't interested in spending my total percent energy and life just investing. I just thought it was an interesting thing to be involved in because I had some money to invest at the time. So the nine letter from Buffett to his partner's explains he's winding down and eventually he takes Berkshire Hathaway and relaunches it. Um not too not

too far off from the distance. You were one of the first investors in in Berkshire Hathway Is that a fair statement, No, not so early. What happened was Buffett didn't tell his limited partners that what he was going to do next. What he was going to do next was turned Berkshire Hathaway into his own private mutual fund. So he had stock to distribute, and he could either distribute stock to the investors or give them money, and he preferred, I think, to keep the stock and give

them money. So mostly the investors were cashing out. Some of them took some Burkshire stock and not not a whole lot happened with Berkshire for the next decade, and I was unaware that he was turning it into his own mutual fund. But I was sitting around doing something

or other with the hedge fund. I was then and running Princeton Newport Partners, and heard some news item about Berkshire Hathaway and Warren Buffett, so I focused on it, and I realized right away what had happened in the intervening fourteen or fifteen years, that Buffett had turned this uh sick textile company into his own private investment tool.

So had I had I known that? I had I been able to invest in Berkshire Hathaway in to I might have invested somewhere in the twelve or fifty dollar range. But but now, but now, the stock with two dollars so most people was a g It's already had a huge multiple. You don't want to buy it now? I said, yes, I want to buy it now. So I began buying in and And how long did you hold on to

Berkshire hath You still have it to this day. So I'm compelled to ask, a hundred dollars invested in Berkshire hath Away when you put that in in eighty two, what would a hundred dollar be worth today? Well, it's easier for me to think in hers with a thousand, because that was stocker slutly less. So it's worth roughly two. That's a pretty good return. Well, how does what does that average out compounded that mid twenties? Something like that two D and fifty four thirty five years, two D

and fifty thirty five years. I'm guessing mid twenties, but I'm sure I could just punch it into the computer and get the actual answer. But by any stretch of the imagination, it's a fabulous return. And the consistency over such a long time. There is nothing comparable to that, is there that? That's amazing? How did you never get tempted to sell? Let's see if I can figure it out. Okay, I want to take the route of two and fifty so um, so it's about to the five point six

over thirty five. So I would say, I'm just this is rough. I could be off a few maybe analyzed, Oh that's no big deal. He's you know, he should have given up for a very long time. That's astonishing. You know. One of the things, and we just talked

about it earlier, is eventually everything reaches a capacity. You can't just find an edge and scale it forever unless you're Warren Buffett, whose edges a tremendous amount of um not only intellectual capacity, but discipline and the ability to say I don't care about this, I don't care about that, I don't care about technology. This is what I do well, and I'm going to stick to my knitting. A lot

of smart people don't have that ability. Well. Warren Buffett um agrees with the point we made earlier that as you get bigger and bigger, you tend to have capacity problems, and so you can see that in the performance of Burshire Hathway. There's a table in my book which shows how the decade by decade how the return has dropped compared with the SMP. So it's converged too fairly close to the SMP five hundred in this last time period. So at this point you're gonna say he's as big

as he can get and continue to outperform. Yes, but Burrshire still has some advantages when you can. Let's suppose that does exactly the same as an index fun going forward, which may not be a bad rough estimate. It doesn't pay dividends, so you don't pay any taxes until you sell your stock. When you sell your stock, if you hold it more than a year, you'll be paying long term capital gain, which is less than you'd pay if you were a trader and generating short term gains or um.

And as far as the dividends go, the company that well, I'm not sure where the tax taxation is going to be on dividends now or by the time this broadcasts. Who even knows what I want? But what what is long term capital gains fifteen versus or or higher? I don't know. I've I've lost track. Yeah, but it's considerably lower long term than than short term. I don't plan to pay me for a while, so I'm not paying attention.

Were you ever tempted to sell? Did you ever look at this and saying or do you just not pay attention to it? I don't pay a whole lot of attention to me. It's a buy and whole situation. And if I do sell, I'm gonna have to pay all these taxes because I have a low basis, a very low basis, so I get I get punished for selling. Well, that's reason to hold on to it. I'm sure. I'm

sure Warrant appreciates that sort of loyalty amongst its stockholders. UM. On a related note, you were at at Citadel Ken Griffins. You were his first limited partner. What what did you see in Ken Griffin that made you say this guy is onto something interesting. He's he's clearly of a mathematical bends. I'm willing to give him money and see what he

can do with it. Well, the guy who discovered Ken Griffin is a fellow named Frank Meyer, who was a friend of mine and who I got acquainted with in the early days of Prince and Newport Partners because he was he was representing some investors who wanted to get in to Prince and Newport Partners. So anyhow, when Prince and new Park Partners closed down in nine, Frank had just discovered this um Harvard student who was trading out

of his dorm. And what Ken Griffin was doing was trading derivatives, convertibles, lawrants, options and so on, pretty much in the style that I've been trading them. And so Frank decided to set him up in business. So he was his mentor guru, um business organizer. Ken was a young guy then, so smart but still new to all this.

And since I was shutting down Prince and Newport, it was natural for me to talk with Frank and Ken and explain to them what I did and how I did it, and basically give them my business road map. And they initially followed that, and of course it evolved into its own great thing, and the Citadel is phenomenal success. Are you still an investor in sid Adel? So you are really a buy and hold investor. You look at things over the long haul. That's fascinating. Let's talk about

start with a quote of yours. Any edge in the market is limited, small, temporary, and quickly captured by the smartest or best informed investors. Still true today, I'd modify that a little bit. I think that that's true of most of the edges. Some of the small edges have fairly large scope to them. I'll give you one simple example. There's something called a tax loss harvesting, and that's a

politically created edge. You could, for instance, set up a thing like an index fund, a thing that tracks an index fund, and at the end of the year, sell your losers and take the tax loss and use the money to buy new stocks. That would keep your collection of stocks tracking the index fairly well, and just keep doing that. You could sell one SMP index and buy a different SMP next. Well, you know that's you can't do that, because be a wash has to be something

slightly different. Different. You could take let's say, of the stocks in the SMP index and buy them on day one. You can let it run for a year minus a day, look at the losers, sell them, take the tax loss, use the money to replace those losers with some of the stocks you didn't already hold. So you have four d stocks you haven't bought, you have a hundred that you did have, so you move into some of the four and then you let it run for another year, and you do it again and again, so you keep

taking losses and collecting money from the government. And that's an edge that's persists. It's a politically created edge. Got it because of the tax code, Yes, because of the tax code. So nineteen sixty nine was a famously tough year for hedge funds. Carol Loomis wrote a big article about it in in Fortune and and she ultimately ended up being um a really interesting and important journalists. But in in nineteen sixty nine, your hedge fund was just

launching or about to launch. We launched in November of nineteen sixty nine, the year that's so terrible. Yes, and there was there were There were articles in Fortune and maybe Forbes, I don't remember which now, which listed twenty some odd of the largest hedge funds and they're all losing going out of business, except for Buffet Partners Limited, which is going out of business for lack of opportunity.

And uh, I think that Steinhardt hung in there. He was up maybe five percent, but it was a disaster. So we we started in the middle of a blood bath, and how did you do? How was that first year in business as a hedge fund, Well, we were wondering what was going to happen. So the first two months the market was down four or five and we were up four percent, So that was a That was a good start. And I made as much money then as I was making at the university just in the first

two months, so that's a good sign. Then the next year we were up again and the market was down, and so we opened up a big gap on the market fairly early, and that continued. Seventy three the SMP falls, you're up seven. In the SMP five hundred falls, seven, you're up nine percent. At what point do people start knocking on your door saying, Hey, I have some money for you to manage. For us, we had a steady waiting list and we started out with I think a

fifty dollar minimum, and it rapidly rose. Um eventually was ten million, and then finally we just couldn't take any more investors. So it grew over the years from initial one point four million to about two hundred and seventy million under management. And you understood all the math behind this. You understood the probabilistic edge you had, but were you ever surprised by, Hey, this is really working out better

than we imagined. Uh, that's an interesting question. When I sat down with my then principal partner fellow named J. Reagan back in sixty nine, I estimated what was going to happen, and I said, I think that by five, with the way we're going to grow and the fees we're going to have, will each be worth a million dollars. And you actually hit that number right on time. That's

pretty much. Yeah. So in five I sent him a copy of what I've written what I already sent him nine sixty nine, just as a little reminder and at at at what point did it sort of did or I should ask the question, did it ever scale to a point where you said, Gee, this has really gone far beyond what I was expecting. I don't think so. Um. One of the things I learned at the casino table

was that scaling is a very interesting psychological thing. When I first started playing blackjack, on my first big trip, I went with a couple of multimillionaires who wanted to bank or on me for a hundred thousand dollars I said, no, I don't know how to handle money. I'm gonna be and if anything goes wrong, you're not gonna like this. You're not gonna like it in spades. So let's only

go with ten thousand. And the first eight hours I sat down there betting one dollar when it wasn't favorable and ten dollars when it was favorable, and they just about went out of their skulls with this penny andy betting. But then I got used to it after eight hours, and then I went to two dollars small bets, twenty dollars big bets, and that lasted a couple of hours, and then I got used to that, and then I went to five to fifty and the top bet they

would allow at that point. So what I found was you could scale up, and when you get used to scaling, you do the same things, same kind of thinking that you did at the small scale on bigger and bigger scales, So that that stayed with me all the way up. It's just the process getting used to the larger numbers. But that's a physical and a psychological adjustment where when you start out at one and ten five dollars sounds like a lot of money, but you have to stare,

step your way up until you're comfortable. Was it was it the same with the hedge fund, starting out relatively small and at a certain point and the biggest you've got in terms of assets under management was we had about a billion long and about a billion short, but we had about two d seventy million behind that. I will I will say this to Bill Gross who used to be here in next door pimp go literally, I'm looking out the window at the Pimco tower right next

to yours. So he got his start playing blackjack too, as you got in the book. And so he took two hundred dollars like the book beat the dealer said he would, went out, slaved away for four months, turned into ten thousand like it said he would. And then when he went to Pimco, he was really used to scaling up. And there came a point when PIMCO had

just under two trillion under management. So that's a lot of scaling up from from literally a very small division that was wanting was a Pacific life for they were running the money of a local insurance company and decided

to set it out as a as a separate entity. Well, the way all this happened was after reading Beat the Dealer bill read Beat the Market, and so he decided to write his thesis in the convertible bonds at U C l A. And then it was one he was looking for a job and his mom said, oh, they're looking for people over at a Pacific Mutual Life. So he went over and they at oh, we don't need any bond guys here. He said, well, I wrote my thesis in convertible bonds. I said, oh, we don't have

one of those. So that's how he got high. And literally literally Pacific Life is not that far from here either. It's right up the right up the road. That thing I call the mushroom building. Oh that's it. That's that's so funny. So a couple of really fascinating things that took place with with you and and the hedge funds. First, not only did you never have a losing year, you never had a losing quarter. That's a remarkable run. How

is that consistency possible? Well, I was a child of the Depression, so I'm highly risk averse, Okay, So I decided that I wasn't going to lose money, and that's what I liked about hedging, and and by its nature you try and put positions on that even if it goes against you. The downside is is limited due to the hedge. Yes, and I put a lot of positions on uh, so I was diversified over hedges. I kept track of how the hedges did for one period in

the earlier mid seventies. I kept track of two of them, and about a hundred eighty of them were winners, about ten of them were pretty close to pushes, and then about ten or more losers, and the winners were bigger than the losers on average. So that that's how stable and solid these hedges were. So with a diversified portfolio of hedges, it was almost inevitable would come out ahead every month. We only had three down months and those are less than one percent, so we could call those

a push. Let's let's let's talk about black shoals. So both with the warrants and with the training options against the common stock, you created your own pricing model to figure out when the either the warren or the option was overpriced and priced relative to the underlying security, which essentially was the black shoals option pricing. You invented black shoals option pricing before black shoals. How does that come about?

The way that happened was, Uh, there was a great book, one of the first quantitative finance books, called The Random Character of Stock Market Prices came out kind of came out of m I T. Paul Kotner, revised, updated, and I happened to read that book. And they had some warrant models in the book, and the warrant models had two parameters that nobody knew what to do with. Nobel Prizewinner Future Nobel Prizewinner Paul Samson didn't know what to

do with these parameters, nor did anybody else. And the two parameters were the unknown rate of growth of the stock and the proper discount rate for the uncertain hay off from the warrant or option. And so I understood that model. I had actually worked it out myself, and then I saw that it was already in the book. So I did something everybody already knew. And I thought about for a while, and then I said, you know, I'm doing hedges that are essentially risk neutral. And so

is there a world in which those parameters could be chosen? Yes, if the world's risk neutral, then I choose the risks rate for those parameters. So I stuck the risks right THEW and lo and behold, magic, wonderful formula. Tried the formula out all kinds of different ways logically to see if it did what it was supposed to, and it did so. Now I had a formula for value and options,

which was the future Black Sholes formula. This Black, by the way, told me later on when we had conversations, that they had figured this thing out in sixty nine, but they were rejected for publication a number of times, and only when they got some help, I think from Samuels then that they were able to get their article in print. They got the first one in print in

nineteen seventy two. Now you've been using this model for four or five years at that point, and what what was your Well, I was 'mentilally unaware of the world of academic finance because I was just doing all this stuff on my own myself, like I was used to doing when I was a kid, learning science by myself. And then the cbo EA Chicago Board Options Exchange decided to create list of options, which revolutionized the whole h

over the counter options in the warrant market. So in other words, ZSER trading on an exchange, you don't have to go through a specific so that made the cost much more more reasonable, and it also allowed you to trade a much broader set of vehicles. That that was the plan there was supposed to happen in I think

April of Vree. So I had been operating my hedge fund for already almost four years, and I had been training options and weren't using the Black Sholes formula among other things, and also value well, you were really training using the ed Thorpe formula because black Sholes didn't exist, and I didn't as far as I knew, that were

no such people as black controls. So then I was sitting there about a month before it opened, and I get a brown envelope with a mimeographed article in it and a letter from a FELLO named Fisher Black, who I said, I as I said, I'd never heard of, and he was saying, I'm an admirer of your work. And we took the idea from beat the Market the hedging idea and use dynamic dging, and we've derived this formula.

And so I started reading the paper, and I said, gee, this looks a lot like my formula, and so I programmed it on my little helipacker computer which drew graphs, and I drew the curves and they were saying, curves, I've been drawn. So I said, oh, it is the same formula. Let's let's look at it algebraically. So I saw that the algebra translated in the formula. They were the same thing. And I realized more. I actually had

a triple of formulas, and not just one. And the triple took care of two cases that were then important in the market, your short warrants and long stock and you can't get the short sale proceeds used that broker pockets it and use it to pay his own debit balances down. And the other formula, uh, that was a second formula. The third formula was the reverse your short stock and long warrants and deprived of the short sale proceeds.

Black controls assumed the main formula that you got the use of the short sale proceeds, which you did, or you would when you traded on the exchange. But before the cbo E people did not get the benefit of using the short sale proceeds. So you needed three formulas, and so I had them all and there there's was the middle of the three. And there was something else about the formula I had, which was it used a method that was different. H used something from basically what's

now high school calculus, just integration. And that means that my formula could be applied to probability distributions that were different than the long normal distribution, which was the one that underlied the Black Rolls formula. So it was a more general attack on problems. So you get the package from from Black. You see that your secret sauce is now out in the public, even though it's not quite

as comprehensive or robust as your version of it. Do you say to yourself, Oh, cats out of the bag and this is no longer going to be a money maker for I figured I don't have the competitive edge that I thought I had. But it turns out that the act American finance world was fairly slow moving, as was the collection of market makers. So when the CBO

CBO we opened on day one. We were down there with our traders and our formulas and our charts, and it was it was wonderful there was no competition really. Now you wanted to bring down um small calculators and handheld devices, and they really gave you a lot of grief about that. Well, it was what we wanted to do was bring down hand held calculators so we could just punch out the formula values right on the floor.

But they wouldn't let us do it because it was unfair to the old guard that the old Guard didn't have this advantage. And we asked if we could use walkie talkies and they said no, we couldn't do that either. So what we resorted to doing was printing enormous tables that had all the possibilities in them. And these tables were on z fold paper eleven by seventeen. They were probably oh three inches thick because they covered lots of cases and prices and options and that had to be

updated daily correct. We ran. We ran printers four or five hours every night, and air freighted our tables to our traders, uh initially on the cbo E and then on the m X the Pacific and Philadelphia exchanges, so it's a day or so behind, but close enough that it was an advantage to them. Well, we covered a wide enough range of prices so that we caught most of the moves for a week or so, and so the tables were usually good for a week, and that

gave you guys a statistical edge. And in the actual tables had all our traders had to do was take the tables down to the post flip and decide what trades they wanted to make. And they what What did the CBO we have to say about that? They they they let us do that. They didn't recognize the advantage it was giving you. I think they did. The Wall Street Journal had an article about it in nineteen seventy four front page article. And what was the net result

after the article? Did the any more pushback or I think it encouraged people to try to come up to speed. So so even after black Sholes is out, even after all of the mathematical advantages that you had identified were well known, you're still running a big advantage over everybody else. And the fund continues to perform very well for the next how many years, Well, we ran from late nine through the end of eight, and we did fine through

the whole period. In fact, we got higher rates of return in the later period that we did in the lower So what made you decide to finally shut that fun fun down? Fellow named Rudy Giuliani made me decide to set up So, so let's talk about that. Because Giuliani and others open and invested an investigation. You, I'm going to cut to the end. You did nothing wrong. You're completely exonerated. However, this is a giant pain in

the neck, isn't it. Well, what happened was really Julianni, in my opinion, decided that his career would be advanced greatly if while he was um ahead of the Southern District in New York U S Attorney's of Attorney's Office, that if he prosecuted inside or trading, it would be a great benefit to his future, which it was, And

so he found various targets. One of them was Michael Milken, who was everybody's target because Michael Milken was on horsing the old guard by funding drunk bond people who were taking over companies and kicking the old guys out. So his his head had to roll. And fortunately for the people who wanted to kick him out, they were able to find some things to get them with. And Robert Freeman of Goldman. Sachs was another guy that they were after.

I don't recall what the reason was. It turned out my partner, Jay Regan, was his roommate at Dartmouth and they were pals. And also we did a fair amount of trading with Michael Milken and his company, so there was a big grade of our offices. The idea was to get Jay Reagan to say something that would help

convict a freeman and Milican. Well, what happened was they never got anything from Jay Regan or any of the other people in Princeton, but they're able to make enough of the case so that it dragged through the courts for like two and a half years. Meanwhile, Giuliani split and went on to other things. And there was an initial trial which and conviction which was thrown out of five people in the Princeton office, and then the government elected not to retry. And when all it's more cleared, Uh,

nobody paid any money. Nobody did at any time, but they spent ten or fifty million dollars on legal fees. So is it fair to say that you're not a big fan of Rudy Julian and you should you should know that most New Yorkers share your opinion. And I'm not being political when I say that people forget. I'm gonna let me digress. People forget. Right before September eleven, he was cheating on his wife. It was about an

ugly divorce. His political career had, you know, had plummeted nine eleven, resurrected his career if it wasn't for that, And you know, the President wasn't very visible then and Rudy stepped into the void, and that basically really gave him a whole second, a second run on a political career. But a lot of New Yorkers, you you asking year, well, you know, they got the bombs off, the the squeegee guys were gone, and there's no begging in the subway.

But that second term, he just whatever credibility and goodwill he had accumulated, he completely frittered away. So that leads to an interesting quote of yours um about money and so cess. And I thought this was fascinating quote. Success on Wall Street was getting the most money. Success for us was having the best life. That is a fairly philosophical perspective that is often missing, at least on the East Coast. Or in New York. Tell us a little

bit about that philosophy. Well, what I learned over the decades was that it's it's how you live your life that matters, and the people that you spend your time with that matters, and the stuff you pile up doesn't really matter very much. Having money helps, It makes living easier pleasanter. You have more fun, better medical care and so forth. And your kids and your grandkids, you can help take care of them and make sure things are fine. But I don't need to own an island in Hawaii.

I don't need to have villas all over I don't need to have private jets. And you know, a lot of other people feel the same way. I mean, they'll take Warren Buffett for instance. He doesn't spend that much money when you consider he is one of the two or three richest guys in the world for the longest time. Well, what makes him happy is doing his job. He tap dances to work, and not a lot of people get

to do that. And he realizes the same thing as he said, it's it's kind of the people you love and the people who love you that matter the most, to say the least. By the way. Have you seen the HBO documentary on Buffett. It's quite charming. He's he's he's. I know a lot of people think his stick is, oh, he's just being that down home, but he comes across is very genuine and he seems like a real person. If you get a chance, it's I think it's about

an hour, it's it's for it. Although you you know him personally, so maybe you'll you'll see it differently, But I should say I knew him personally. I haven't seen it for a long time. But so, um, let's let's keep talking about Princeton Newport Partners. That's a better name than Convertible Hedge Associates m but that's why, that's why we changed it. So so that was simply, oh, this is a little uh one partners in Princeton, the other partners in Port Beach, and and that's a fair enough name.

So when you first started it, who were some of the early investors. Let's see, there was Bob Evans, who later became head of Paramount Studios, was married to McGraw and and put out a number of really seminal movies. If if memories says um anybody else of note that goes Charles Langman of the RITZ. I don't remember much about him. Most of these partners were pretty quiet. We just kept making money. So then to bother us that that those are the best types of partners, especially if

you keep making them money. Um, So you eventually decide to close UM Princeton Newport partners down after the Giuliani It was too it was too hard to operate in that atmosphere, and it was too difficult to keep reassuring them into partners that first of all, he threatened partnership with Rico, so they had the fear that through some quirk or other, their assets might get confiscated for unknown lengths of time. And we knew that there was no

risk of them losing. But also it was just too harrowing. And I said to myself, I don't need more money anyhow. So there's a famous quote, and I know I'm mangling this, but it's there. There are a few things more dangerous than an over zealous prosecutor and run amuck. And I think that describes the circumstances with Rudy. Way back when you didn't need the money, but at a certain point you decided to start PNP. What motivated you to get

back into hedge fund games? It was let's see Richline Partners that I started, and what happened was I took a break from and then one of my UM previous partners, who was now working for UH, a very large pension profit sharing plan, said, you know statistical arbitrage, which we've been running, and which I might say, as far as I know, we were the first discoverers of back statistical arbitrage. You're doing really well. We'd like you to get back

in this game. So I said, well, I'll take a look, and I said, oh, it is doing it quite well. Sure we'll we'll run some money for you. And it was easy to do. I could do it with about three full time equivalence as opposed to a staff of eighty which I was using for Princeton Newport Partners. And I didn't get the sense you're a big fan of

managing a large staff. That's a lot of work. It turns out what I learned was if you manage five people, then you're spending maybe a third or half your time managing, and then you've got to find somebody. If you have five more people, you've gotta have somebody to help manage them, and it sort of grows exponentially. You get this big pyramid and you keep getting farther and farther to remove from what's really happening. Right, So, so PNP you're doing

statistical arbitrage? Actually can rich line Partners were doing rich

Line Partners? And and and what was the performance numbers like for rich Line We did about twenty percent a year with a little more variability than P m P. I don't We didn't make money every month, but we made money nearly every month, and it was somewhat event driven because the arbitrage opportunities would come along through M and A or through what what was the underlying The biggest The biggest event that we experienced was in with

the long term capital management. It turned out that lots of people who were competitors now began to bail out, and so that caused four or five day dip. We had the first loss that we had of any significance. It was just three or four and that was a shocker. But those those days passed and then we had the greatest run we've ever had. We think we made like

scent in six months. Not to share be and then the another hedge fund pnp UM In the twelve months ending August, the limited Partners, I guess this is Netta. Fees were up over seventy from a market neutral portfolio that used less than two to one leverage. That's that's Origin Line Partners. Oh so why do I keep calling this pnp PPM in so it might be Uh so that's the old one. And then Ridgeline took over. So back to Ridgeline in you're up se from market neutral,

very little leverage. How did this come about? And why would you ever want to shut that down? Well, the reason we had that glorious run was because our competitors went away, and as they bailed out, they created opportunity. Okay, they disrupt the market places they exit, and that creates arbitrage opportunities. And they also don't control the excursions from favalue as much, so the excursions got bigger and so

more more profits to be had. How much longer did you keep Ridge Line open after we went from actually nineteen two two thousand and two, and then I shut down not because we're doing badly, but because we're doing just so so, making maybe ten percent a year so and the opportunities had had just gone away. Is that is that basically I think that there was more competition and so the deviations from fair value that we're exploiting word is big. And at that point I said to myself,

you know, why am I doing this? I'd rather just manage my own money in a more passive way and enjoy life. So let's talk a little bit about that. Passive investing has caught on a great deal. UH. It's a long time coming. It's finally, um, finally made its way to a number of people. Black Rock is one of the big underwriters of ETFs in passive investing, not exclusively,

but they're up to five trillion. Vanguard is probably best known as the inventor of the passive index, or at least the first company that was created to roll out a passive index that people can invest in. They're now up to four trillion. Have have mom and pop investors finally figured out that for them, a passive investment is better than stock picking or market timing, some of them have.

So you make a convincing argument that if you cannot demonstrate your edge, your advantage over a passive uh index, then then you shouldn't be doing anything but a passive index too. It seems perfectly logical and rational to me. Do you get pushed back from people about that? No, what I did is probably a lack of alertness discussing it, So I have to that's gonna. That leads me to a question I didn't ask before, but I have to. You seem incredibly grounded and a regular, low key sort

of guy. You took the California Test of of um Mental Maturity. It's an i Q test as a kid. You had the highest score they had ever seen. How do you manage to keep high school at your at your high school, but in the world, not in the world. Okay, so that makes it I'm gonna that makes the question easy. How do you keep your ego in check? But still you all joking aside? You invent card counting, you invent

statistical arbitrage, you invent um paired training. Go down the list of things that you did that are really unique in the world of finance as an investor, how do you manage to keep your ego in check? What you have to do is look all the other things that people do. There's so many great things that people are

doing all the time. And if you meet any individual, the person sitting next to you on a bus or a plane or whatever, that person will be able to do things or no things that you can't know or can't do. Maybe they can sing better, maybe they know a language you don't know. Maybe they know how to um fix a car. Just you know, one thing after another, identify the car has been been rigged against you. And you think that's basically helps you keep your ego in check,

helps anybody keep their ego and check. I find it hard to understand why so many people have such big egos. Okay, that's that's a fair enough thing there, especially those people who haven't created a body of accomplishments. I kind of think that maybe the big ego is a substitute for feeling like they're falling short here and there, a little over compensation. So that's fair enough. Um. In in the book, chapter you say, beat most investors by indexing, and chapters one,

can you beat the market? Should you try? Um? When should somebody try to beat the market? Well, my simplified views go something like this bit roughly, the three kinds of investors. There are guys who don't want to really do any work. They just want to have their money grow. Those people should be thinking about indexing makes perfect sense. Then there are people who really 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 and try to make some money. But they shouldn't use the bulk of their resources to do this. They should just a fun account, yeah, exactly, And then 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,

a little fooled by randomness, exactly. And then there's a third group, which are the professional people, some of whom actually get on edge, most of whom don't, but some of whom do. And those people get a start somehow in the market. Just like I gotta start with an options formula, and 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. So 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 access return. Then there's a fourth group, which I don't have much interest in, and those are the ones who are simply asset gathers and they're they're in there to collect feest and get rich, but there's nothing really very interesting what they do. That's a You've described a huge part of what takes place

in finance. Most of it people who are trying and not getting anywhere. People have just given up and said I'm going to go passive. And people who are are don't have an a special advantage, but they're just a commulating assets and manage them, managing them in some better or worse way. Referring to indexes in past of investing, people are now describing, oh, this has gotten too large, it's a bubble, that it's distorting price discovery. Passive indexes

are going to cause the next crash. What what do you make of that? Well, suppose that half of all the list of equities in the United States we're in index funds. Then the other half would not be. The half has not be that would not be is a lot bigger than the market was ten or twenty years ago. So I don't see that putting half of the UM stocks into the next funds is going to cause any problem, except there's one thing. There's the question of the float

in different companies. Some companies are more closely held than others. So you might have a company in which sevent is closely held, it never trades and only up for trading. So I believe that the index funds, the SMP Vanguard anyhow, has changed so that they use a proportion of the float rather than a proportion of the total market cap.

And they've compared how that tracks with UH if they had been able to use the proportion of total market cap rather than proportion of the float, and the tracks has been extremely closed so far, So so far, no problem. I think it was Andrew Lowe and might Taste said you could get down to passive ten percent active. That's enough for price discovery as long as it's sufficient liquidity. So there could theoretically be a ways to go if

he's right sure on the case. There is supposed that you had in an exponse not forgetting about the float issue, which which might cause some divergence. Well, ten percent of the current market is probably a good deal larger than the market was fifty years ago. Sure, so you still have price discovery even even if that. Here's another quote of yours that I really like. Whether or not you try to beat the market, you can do better by

properly managing your wealth. Explain that where was that quote, let's take I don't know it was here on my page. I think it's from this book, and it's it's in the context of of why more people it's either twenty five or chapter twenty six about why more people should be doing passive. Whether or not you beat the market, you could still do better, you know what. Let's see if I can find that, I'll tell you what I

think it is. I think it has to do with the fact that there are what Buffett calls fee collectors or toll takers. And the upshot is that when you think about fees collected by advisors or managers, and also the losses due to active trading, both market impact and commissions, it adds up to roughly a couple of percent a

year drain on assets. So if you could make let's say ten percent a year in a stock index one long term, anything can happen in the short term, then maybe you're making eight percent a year before taxes if you're paying all these fees and tolls. So just shifting to passive investing, get your extra two percent for basically no work, and compound that over forty years, and that really adds up. Using the UM rule seventy two for instance,

roughly thirty six years. Actually thirty five closer, because the rule varies from seventy two depending what the interest rate is. Using the rule of seventy two, in a little less than thirty six years, you have twice as much money if you invest this way then if you pay the two percent toll, So it makes a big difference. We

have been speaking to Edward Thorpe, professional investor, trader, gambler, mathematician. UH. If you want to find out more about the works of ed Thorpe, you can read his most recent book, I'm and for All Markets Beat The Dealer Beat the Markets are both classic books. You may have to hunt around to find find them. UM. If anybody wants to find anything else you've written, these are really the main places to look. Is there to what? What is the website?

It's uh Edward Ohthorpe dot com, Edward oh Thorpe dot com. It also has another second website links to it, a Man for All Markets dot com. If you enjoy this conversation, be sure and check out our podcast AFTRAS, where we keep the tape rolling and continue to discuss all things investing. Check out my daily column on Bloomberg at Bloomberg View dot com. You can follow me on Twitter at rid Alts. We love your comments, feedback and suggestions right to us

at m IB podcast at Bloomberg dot net. I'm very Ridholts. You're listening to Masters in Business on Bloomberg Radio. If you're having a business dispute, the process can be slow and drawn out, especially if you rely on litigation in the courts. You can wait for years before your case is resolved, and the longer your case proceeds, the more your case can cost. Not with the American Arbitration Association. Arbitration or mediation with the American Arbitration Association is faster.

In fact, nearly fifty of our cases settled prior to hearings. A d R dot org resolve faster. Welcome to the podcast. Thank you and for doing this. I'm really enjoying this conversation and I appreciate you being so generous with your time. Uh, you've led a fascinating life. You've also led a well lived life. Which are some of the things you talked about in the book. It's not about money, it's not about accumulating toys, it's not about just piling up junk.

It's spending time in a way that matters. As you know. I totally agree. I read the book. I know. So, so let's let's talk a little bit about some of um my favorite questions. I ask these of all my guests, and we often find some interesting things. What do you think is the most interesting or important thing that people don't know about your background? I would say that I'm consistently rational over a rare wide range of things. And you meet a lot of people who are I recall

locally rational. That is, they do things very sensibly and logically in some areas, and then there's a total breakdown in some other areas where they act very strange and don't use good sense. So, in other words, the logical part of their brain only limited to certain subjects. Um. Well, I hope we all endeavor to be logical across logical growth everything. But I think a lot of people, um don't behave that way. Let's let's talk about some of

your early mentors. Who are the people who really influenced you and helped you along your career. Well, I was obviously deprived in that way, so I don't have much in that category. My father help me a lot from ages three to five. Okay, that was enough to really get me started. How about colleagues you worked with? Who? Who? Who did you really enjoy working with at at various schools.

I think the most fun I had was working with Claude Shannon at M I T. Because he was a very creative thinker, and we could just sit there and talk about the widest range of topics, and we kind of played off each other, and we we thought alike about so many things, but we also had different experiences in background, so it made a really good team. And

you ended up creating was it the Wearable Computer? With him? Well, it turned out, yes, we're trying to beat Roulette, and so we built a computer to wear on the body that was hidden and this computer head switches to input information about the Roulette wheel, ball and rotor as they were moving, and then it would make an immediate prediction

as to what was going to happen. So, so you know the arrangement of numbers and colors on roulette wheel, you're you have a certain spin in one direction of the ball and the rotors in the other direction, and you basically were able to calculate as long as I could get a timing fairly accurate when the ball is moving this way, we can have a pretty comfortable guess

as to the cluster of outcomes. Yeah, basically we were able to time the ball and the rotor, so we know what speed they were both going at, and the computer would know where they were at any time, and then it could forecast roughly where the ball was going to fall. And there are a lot of uncertainties in the wheel that are delivered. The ball will bounce off little veins on the side, it will spatter over the

viders between pockets. But it turned out the prediction, the predicting was so strong that we got a forty percent edge, which is hute. Yes, so gigantic, you can't believe it. So you mentioned Warren Buffett, any other investors influence the way you approached investing or was it pretty much all based on your own research and math? It was pretty much thinking for myself, which was both good and bad. It was good because I thought of things that I wouldn't have thought of if I had been taught the

formal academic way. It was bad because I had to rediscover some things that I would have known easily had I taken, you know, formal training. So let's talk about books. This is one of the favorite questions of of listeners. What are some of your favorite books, be they finance or nonfinance, fiction or nonfiction? What do you what do you enjoy reading? What have you enjoyed reading. Well, that's a very broadcuestion. I probably have currently in my libraries,

both here and at home, ten thousand books. And I haven't read every page of every book, but I've read some pages in every book, and I've read some books in their entirety. And human knowledge is so vast that I can't just pick out a few books and say these are the great books from all those thousands and thousands of books. And by the way, besides the ten thousand, there are others that I've read that aren't in my library,

many others. And then so I would say that I look at things kind of like Charlie Monker, And it's multiple mental models in which you focused on certain ideas in certain areas, Like here's one from psychology. There's something called the Meyer Briggs personality index, and so, uh, there are four four dimensions they type people on the first one is easy extrovert, introvert. And so if there are four dimensions and there are two choices, then you have

sixteen pure types of people. None people aren't typically that's simple. They don't fall into those categories. But you can get a surprising amount of information by estimating what type of person is um But there's they're sensing. Sensing versus feeling is another dimension, and so a sensing person is very aware of everything that's going on around him, and a

feeling person is a highly emotional person and so forth. Anyhow, it's an easy way to have a first cut thought about people, and it teaches you that people are very different, but there's no good or no bad in the various types. They're just different and helps you understand so that that's a simple mental model. Or there's anchoring in the stock markets, something I learned to my pain very early. I bought a stock at forty it went down to twenty I didn't want to let go till I came back to

forty a little. Just let me get break even exactly, the losing cries of losing investors everywhere. Four years later, I get break even, I get out, but of course there's inflations, so I haven't really gotten out even, and I've deprived myself of investing the money somewhere else where it might have been done a lot better, and so forth. So the price I bought at forty is a price particular only to meet. There's no relation to anything going on in the outside world, and so to be anchored

at that prices uh idiocy. And and yet people do it all the time because they're they're subjective perspective takes over from a more global perspective. So you have ten thousand books. I'm looking at a handful of books over here. Nothing really leaps out, as these aren't necessarily these are the five seminal books you have to read. But what books did you find interesting? Or or let me make it more recent, what's the last book you read that

you really enjoyed? There are five six struggling Okay, well, one of them I enjoyed quite a bit. Was a well known one Philip Tatlock's super Forecasters, so by the way previous guests on the show, and absolutely a delightful human being. Yes. In fact, I was at a conference a few years ago that he and I both spoke at, so I kind of got to know a little bit more about his thoughts and ideas there. But yeah, very

interesting piece of work, well worth knowing. Another one was The Accidental Accidental Superpower by guy named Peter's Eye Hand, and he's a Stratford type. By the way, I might say that if I read a book and I find it interesting, it doesn't mean that I'm endorsing that book kind of percent. It's just that I'm finding things that are worth thinking about in that book. And I may may come out with a different conclusion, but he's provoking a thought process and make you think about an issue. Hey,

I hadn't really considered this quite in this context. That's fascinating. Yes, So I'd rather read a book that doesn't just reinforce opinions I already hold. I want a book that's going to add something that I don't know that's information, if it's new, if it's the same stuff over and over, that I've already thought about. That's not information, so more confirmation biases and how you select books. All right, So that's to give us one more and we'll let you

off the hook with this. Okay. There's a one by Paul Wilmock. It's called The Money Formula, and it's it's just it's just out and it's about how quants have help screw things up in the financial world. Screw things up. Well they I don't know if that's the right phrase. They they've certainly helped mix things up and change things. But I would argue for the better, and I think

you are going to be an agreement with that. Well, perhaps I put that too simplistically, but um, what I think part of his thrust is that the cell side on Wall Street has taken quant product us to use to market to people, and they haven't been discriminating about the products that they've marketed, a collateralized mortgage obligations being a case in point. Well, any tool could be used for good or evil, to say the least, but you know, it's it's anything is only a sausage is only as

good as the meat that goes in. Well, you know, take coals, both good and evil. It pollutes, but it also keeps us warm and supplies this energy. It got us to the point where we can now start looking at less polluting energy options. And you know, when we look at that transition that's taking place not just with cold and natural gas, but quantitative is replacing the old qualitative for a reason because it's demonstrably superior in so

many ways. I think that's a fair statement. I agree. Um, So you you started in this industry, in the finance industry forty plus years ago. Um, what it? What do you think is the most significant change that's taken place over that time? There's more than one. One of the big ones has been the computerization and the quantification of investing. That's really two big ones, right, So technology is everywhere and applying it mathematically seems to be the dominant thing.

What else? The second has been the aggregation of money management into huge firms that are offering what seemed to be choices but are largely just playing vanilla in different packages. Is that is that still going on? Or is that now getting bigger and bigger? I think that the big firms are getting relatively bigger. Uh. The thing I read about hedge funds. Recently on a psyche bi got very riskful.

I think I've heard of him was the number of new hedge funds is smaller than the number of Hatche funds that are disappearing, but that the total assets under management for hedge funds is increasing over three trillion dollars. So you know, Jim, I'm fond of repeating Jim Chanos's quote. He said when he started in hedge funds thirty years ago, there were a couple of hundred hedge funds. They all created alpha. Now there's almost ten thousand hedge funds and

those same thirty hedge funds of the alpha generators. And there is some truth to that. There is. It is not a true Gaussing distribution. That's very much a fat head in a long tail um and not not everybody who's running a hedge fund is capable of putting up the sort of numbers that you put up. Well. In the nineties, I could find hetche funds when I didn't feel like managing money of my own. I could find hedge funds that we're making annualized. And then in the

two thousands they kept dying. The numbers drop for Cliff and I want to say it's Simon Lacks book The hedge fund He said in the book, the losses hedge funds suffered in O eight oh nine had wiped out all of their previous profits in total. It didn't wipe out manager's fees, but it wiped out all the all the profits and other than those top let's call it five hedge funds, it's certainly not thirty these days. The balance really don't seem to be generating any sort of alpha.

So you have a skewed when you look at the returns. They're so skewed not by the big hedge funds, but by all the rest that are under performing. Well. I think it's probably a first apement to say that all the money that have ever been put into hedge funds and then put it into X funds. The investors who did that would be far better off than they actually were. Renaissance technologies accepting in a handful of others. But that you could you could very well be right. Um, let's

let's go to the next question. Tell us about a time you failed. And I know you wrote a few times in the book about things he failed and what you learned from the experience. Well back when I was in high school, I heard about a chemistry contest. It was the Southern California Chemistry Teachers Contest, and I happened to love chemistry, and I was at a school where

basically there weren't any academics. But I decided that I would study for this test because if I were able to win it, I could choose a scholarship to a place I could not otherwise afford to go, like calchech or UC Berkeley or whatever. So I trained up for this test really hard, and the typical winning score was about Basically there was a couple of hundred of the best high school chemistry students from southern California would compete each year, and I competed as a fifteen year old

as a junior. People who were basically seniors who were seventeen and eighteen years old, and I thought I was going to get the test were higher. So the best score by far they had ever seen. And I took old tests that my chemistry teacher had assembled over the years, and I was scoring that way on the old tests one after another. I went into the test and I

just rolled through the exam. I got just about everything right, and then I came to the last part, which was a lot of calculating, and they allowed slide rules that year, and they didn't say they were necessary, only that you could bring one if you wanted to. Turned out the tests were designed so that only with a good slide rule could you complete that part of the test. I had a tense cent slide rule I brought along was worthless. It was so inaccurate that there was no chance of

even bothering. So I did what I could by hand, and I completed I think eight hundred and seventy three points on the test. I got eight hundred sixty right, and but um, I was just crushed by the fact that I didn't have a good slide rule, but I hadn't prepared and covered that base properly. So that that taught me that one of the things you wanted to do is look at things redundantly when you can and try to cover all the downside possibilities that might occur

and eliminate them. So that worked in very well later when I played in the casinos and when I ran hedge fund. Did you end up taking the test again when you were a senior Um, that's a good interesting question. I asked him if I could, and they said, no,

you can only take it once. So I thought about that, and I found that there was a physics physics test that was also given by It was analogous to the chemistry test who was given by the physics teachers, and another couple of hundred of the best students southern California took that. So I crammed for that test. I only heard about a short time before, and I wasn't able to finish all the studying that I wanted to do,

but I was able to win that one. Really, so and you that, Um, so, that's like a tuition scholarship. And you I had a choice of cal Techer Berkeley. I found out I wanted to go to cal Tech, but I couldn't because I didn't have the money to live in your passage, you know. So you went to Berkeley? And how did that work out? Well? It worked out

just fine. I got a full scholarship, and after a year at Berkeley, I changed the U c l A because I had more friends down there, and I went through the UC system and everything went was fine for me. You're physically fit, you seem to be in pretty good shape. Tell us what you do to stay physically fit and what do you do to keep mentally fit? Well physically. I've been a long distance I had had been a

long distance runner for about twenty five years. I used to run marathons and have sent ten ks in five ks. I'd run about forty miles a week, and then I hurt my back weightlifting, so now I just walk. When when did you stop running around? What you How old were you? I stopped running when I was sixty eight, ran my last marathon in New York in and so that's twenty years ago. But you're not eighty eight. No, I'm doing the math. You sixty eight? Well, seventeen years ago? Seven? Okay?

And you do you say you do you still lift weights or yes? I go to the gym with a trainer twice a week. I walk about ten to fifteen miles a week, and then I do some hiking in the hills. What do you do to to keep mentally active? What? What do you enjoy? What? What keeps your focus these days? I'd like I still like problems in finance, so I take time after work on some of them. I also black math problems and chest problems and so forth, play word games, um, travel, read a lot, talked to really

interesting people. Okay, I have a very smart family and so they're very stimulating. That sounds like I have a I have grandchildren who are all very talented. Three of them are triplets, and they're all out of I t Oh, really, so you're you're busy all the time. There's there's no depth of things to keep you occupying. The last time I was born, I think was when I was eleven.

That's a fair fair statement. So if the triplets and M I T or any other millennials or recent graduates were to come up to you and say, uh, Ed Thorpe, I'm thinking about a career in finance or investing, what sort of advice would you give them? I'd say, play to your strengths and your skills, do what you like to do. And if you do what you like to do, then you're gonna do better than if you do something that you think you should do but don't want to do.

And try to plan your life so that you're spending your time with good people. That sounds like that sounds like good advice. And and my final question what do you know today about investing that you wish you knew fifty years ago when you were getting started. I would like to have known that I could have bought Berkshire Hathaway at twelve instead of it instead. So so that's the key thing is precience about the success of Warren Buffett. I will tell you a lot of people would have

liked to buy Berkeshire Hathaway under a thousand. So even twelve is even even when you got in, is better than when most people got in. Um. Ed Thorpe, thank you so much for being so this is this has been an absolute delight we have been speaking with Ed Thorpe. I I will pound the table on a couple of his books. A Man for All Markets is his most

recent book. It's really it's more than than a biograph fee It's a history of what's happened in finance over the past half century, including the rise of hedge funds, the rise of quants, the rise of all sorts of things, told from a unique perspective of somebody who not only beat the deal or and beat the markets, but as as Um, learned a lot of secrets about life that

that many of us should learn um. If you enjoy this conversation, be sure and look up and inch or down an inch on Apple iTunes, SoundCloud overcast, or Bloomberg dot com and you could see the other hundred and fifty or so such conversations we've had. We love your comments, feedback and suggestions right to us at m IB podcast at Bloomberg dot net. I would be remiss if I did not thank some of the people who helped to put this podcast together. Michael Batnick is my head of research.

Taylor Riggs is our producer. Booker Medina Partwada is our audio engineer who helps make these things sound as good as they actually do. I'm Barry Ridhults. You've been listening to Masters in Business on Bloomberg Radio. Masters in Business is brought to you by the American Arbitration Association. Business disputes are inevitable, resolve faster with the American Arbitration Association, the global leader in alternative dispute resolution for over ninety years. Learn more at a d R dot org.