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2024/05
The inspirational journey of Edward Thorp: From gambler to legendary investor
Edward Thorp is the renowned pioneer of market-neutral strategies in the United States and the first person to beat the casino through card counting.
He has authored several books, including ones on how to beat the casino and how to beat the market. Jack Schwager, who has interviewed numerous hedge fund moguls, also mentioned that Edward Thorp is the most innovative fund manager he has ever interviewed.
However, you should familiarize yourself with the name Edward Thorp. Today, let us introduce this financial genius to you.
Interest in Finance Began at the Casino
Born on August 14, 1932, in Chicago, Edward Thorp was passionate about gambling from a young age. At age 10, while helping his cousin at a gas station where they monitored gambling machines for the mob, he quickly figured out the tricks: by changing how the lever was pulled, one could increase their odds of winning.
While pursuing his graduate studies in physics, Thorp was still contemplating roulette gambling. He believed he could create a machine to predict the seemingly random movements of the roulette wheel statistically.
After graduation, Thorp first visited the casinos in Las Vegas. He played the blackjack game while studying and analyzing its rules and loopholes.
After extensive research, Thorp finally discovered the key: high cards like Aces are crucial for the player. In contrast, low cards are advantageous for the dealer, especially the “5,” which is incredibly beneficial.
So, for the average person, you don’t need to remember complex formulas and the different suits of cards. Even if you have a poor memory and can’t remember phone numbers, keeping track of the number of Aces and Fives that have appeared can significantly increase your chances of winning.
The Young Genius Who Beat the Casino
“Understanding gambling games like blackjack is one of the best ways to train for the investment world. You learn how to manage money, calculate odds, and decide how to act when you have an advantage. Gambling is a simplified form of investing. Both can be analyzed using math, statistics, and computers. They both require money management and the appropriate balance between risk and return. Even if every bet is in your favour, betting too much can still have devastating consequences.” – Edward Thorp
Edward Thorp spent two years using early IBM computers and the Kelly criterion of probability theory to discover the card-counting technique for blackjack.
He published the paper “Optimal Strategy in Blackjack,” which swiftly took Nevada’s casinos by storm, allowing him to win tens of thousands of dollars.
Transition to Wall Street's Stock Market
Because Thorp was unbeatable in casinos, he was eventually blocked as a “prohibited person.” Thus, he turned to the nascent stock warrant market on Wall Street, using mathematical formulas programmed into computers to find market mispricings.
He accurately calculated the fair value of warrants using quantitative models and quickly placed orders when prices deviated.
Thorp saw gambling as a simplified version of investing and began self-studying financial knowledge, such as Graham and Dodd’s “Security Analysis.”
However, Thorp’s first investment was similar to that of the average person. He bought 100 shares of Otis Elevator Company at $40 per share, only to watch the price fall to $20, and it took four years to break even.
Thorp discussed his first stock investment failure with his wife, Vivian, who pointed out that he had bought a stock he didn’t understand, akin to using dice to decide which stock to buy. Thorp had an epiphany and began exploring methods of investing based on mathematical logic in the stock market.
Soon, Thorp discovered a method of investing by hedging warrants and stocks, which is essentially the well-known hedge arbitrage, but in Thorp’s time, it was a novel investment approach.
Unlike other investment strategies, hedge arbitrage does not rely heavily on a one-sided market trend. Thorp wrote another book, “Beat the Market,” and used it to persuade 14 partners to establish a hedge fund.
Thorp’s hedging strategy showed a slight advantage during a bull market. However, during the bear market of 1969, the benefits of his strategy became apparent: while many funds saw their net values plummet, Thorp and his firm continued to grow, leading to the establishment of Princeton-Newport Partners in 1969, one of the earliest hedge funds. This fund continued to grow in the following years.
Conclusion
By 1973 and 1974, after two years of market crashes, Thorp finally became a millionaire, fundamentally changing his family’s life. Thorp gradually left academia to become a professional investor.
Throughout his investment career, Thorp fully implemented the approach of applying abstract thinking to real-life situations. Thorp’s life demonstrated that using mathematical knowledge in gambling and investing can lead to significant financial gains.
Thorp used his mathematical knowledge to simplify processes into mathematical models, forming corresponding strategies and answers, whether dealing with gambling or financial market investments.
This approach is akin to solving “word problems” in mathematics, though few have applied this method to practice as Thorp did.
