We Study Billionaires - The Investor’s Podcast Network - TIP128: Edward Thorp - Investing Legend, Math Genius (Business Podcast)

Starting point is 00:00:00 We study billionaires, and this is episode 128 of The Investors Podcast. Broadcasting from Bel Air, Maryland. This is the Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish, and Stig Broderson. Hey, how's everybody doing out there?

Starting point is 00:00:30 This is Preston Pish, and I'm your host. for The Investors podcast. And as usual, I'm accompanied by my co-host, Stig Broderson out in Seoul, South Korea. And folks, we have an incredible guest with us today. Absolute legend, to be honest with you. And his name is Edward Thorpe. And I want to start off by telling a quick story about Dr. Thorpe before we begin this episode. So about a year ago, we had a really famous author on our show.

Starting point is 00:00:57 His name is Jack Schwagger. and he's the author of the Market Wizard series books. And for anyone that's not familiar with these books, Jack Swagger goes around the world and interviews the smartest investors on the planet. Most of them are billionaires. And then he outlines the key aspects of their investing approach. So we had the honor of interviewing Jack Swagger on our show, like I said, about a year ago. And during that interview, one of the questions that I asked Jack was, you know,

Starting point is 00:01:25 you've interviewed all these famous investors, these people. like Ray Dalio, you name it, he's interviewed them. But I said, who is the person that you would say is the smartest person that you've ever talked to? And before I could even finish that sentence, Jack interrupted me and he says, oh, this one's easy. It's hands down Ed Thorpe. He said, the guy's on a completely different level than anyone else I've ever interviewed. And so, Dr. Thorpe, I wanted to start off this episode, embarrassing you a little bit with

Starting point is 00:01:58 that story, but also to be in all sincerity just to tell our audience the company that we're with today and to let you know that we are so honored to be talking to you on our show. Thank you very much. I didn't know that story. All right. So if you guys want to know just a couple of Dr. Thorpe's accomplishments, I'm going to run through three of them real fast. Before we start this conversation to give you some context of who we're dealing with here. So first, if you've ever heard somebody say, that person's counting cards when you're talking about the game of blackjack, that whole idea was invented by Dr. Thorpe.

Starting point is 00:02:38 He literally invented card counting. And so this all started whenever he wrote this world-renowned book. And the name of the book is, Beat the Dealer. The book was written back in 1962, and it's sold well over a million copies. and this book was pretty much the benchmark. And we're going to get into a little bit of this conversation with Dr. Thorpe during the show. But he figured out the mathematics of card counting and then wrote an entire book around it. In fact, there was a movie about Harvard students.

Starting point is 00:03:07 It was called 21, the Hollywood movie about Harvard students using the techniques that Dr. Thorpe wrote about. And they went to Las Vegas and beat the odds of the casino. know. The next thing that I want to highlight about Dr. Thorpe that people might not know is that he is literally the Warren Buffett of options and derivatives. So, chew on this fact. Dr. Thorpe had a positive return for 227 months out of 230 months trading options. So if we actually subscribe to the efficient market hypothesis, that means that there's a 50% odds of beating the market each month. This means that the chances of him being able to do that for 227 months out of 230 is nearly impossible. In fact, the odds are one out of 10 to the 63rd power. Or in another way,

Starting point is 00:03:58 you have a one and trillion times better chance of randomly selecting an atom on Earth than getting similar results. So that's the second thing that I want to highlight. And he went on to have an enormously successful trading career with returns in excess of 20% annually for 29 years, just to kind of give you a glimpse of how he performed in the market. The last thing I want to highlight about Dr. Thorpe here, and I see he's smiling and probably a little embarrassed because I keep talking about all of this. But I think it's really important that our audience knows this about you, Dr. Thorpe. The last thing that I want to highlight is that he was the first person to invent the first

Starting point is 00:04:39 wearable computer. And now this is on display up at MIT, which is where he was a professor. And the computer was made because he had a theory that you could use Newtonian physics to predict where the ball might land on a game of roulette. And it turns out he was right. You actually can predict where the ball is going to land on roulette if you know the velocity that the speed's going. And he created a wearable computer that he put in his shoe that then told him,

Starting point is 00:05:09 in his ear, and remind you, this is back in the 60s that he did this, where the ball was going to land. So these are some of the things that we're going to be talking about in today's show, among many other things. These are all outlined in his new book that just came out this month and the name of the book is a man for all markets. And as a person who read this book, I can't highly promote this enough to our audience because he goes into all the details on how he did these things, what he was thinking about whenever he created this. So Dr. Thorpe, fantastic book. Let's jump into the first question and get this interview going. So let's talk about the blackjack. I'm really curious to know how you harvested this idea of how you could maybe beat the odds of

Starting point is 00:05:57 blackjack when everyone in the world had the exact opposite opinion that it could never be done. How did you go about thinking about this? Well, we're formulas, and if you could solve the formulas exactly, or the equations exactly, then you could figure out the precise probabilities of winning or losing, given any collection of cards that the deal was coming from, whether it was a full deck, any partial deck, or any number of decks, or a number of partial decks. So what I did was I had the computer take out four aces from the full deck, And then I told me what happened, that the edge shifted in favor of the casino by quite a lot, almost 3%.

Starting point is 00:06:38 So I thought to myself, well, that's good news because if I put an extra four aces in, probably it'll shift the other way. My favor, almost the same amount. So as soon as I saw that result, I knew that I had a winner. Then I went with the value of the twos, threes, fours, and so on. The upshot was when all the smoke cleared, when the deck was rich in big cards, it shifted the edge in favor of the player. When it was rich in small cards, it shifted the edge in favor of the casino. So the player wanted small cards to come out of the deck rather than big cards. And for the casino, it was better for them of big cards that were used up.

Starting point is 00:07:14 So I developed a card-counting system, actually many card-counting systems. Then the real work started, which was actually doing it. And so I spent about the next year, first with hand calculations, didn't get very far, the problem was too big. And then I went to MIT for my appointment there and I found I could use a high-speed computer at MIT. I had an IBM 704. It was the early days.

Starting point is 00:07:37 Computers were scarce, but the good ones were starting to come online. This was a refrigerator-sized machine that served 30 New England universities and I was able to use the machine. So I spent almost a year teaching myself out of program and running subroutines that I would soon well together into an overall program that would enable me to evaluate. all the cards that were missing back to the game. So I'm curious, do you think that you would have been able

Starting point is 00:08:04 to solve the math behind everything that you were trying to calculate back at the time point when this was occurring if you didn't have access to that computer in that computer lab? That's an interesting question. At the time, I thought I needed

Starting point is 00:08:20 to do as exact a calculation as I could. But as I learned more about the game, I realized that there were ways of approximating the problem, that would have given me a pretty good solution and that I probably could have gotten that pretty good solution by hand. All right. So, Dr.

Starting point is 00:08:37 Thorpe, one of the things that we constantly see as a theme on our show is the similarities that exist between gambling and investing with respect to probabilities. So Charlie Munger, Warren Buffett are super famous for talking about expected value. If they feel one decision is going to give them a 75% probability. another decision would give them a 25% probability. They're going to take the resultant of those probabilities and make an informed decision. But where I think a lot of people miss the other piece of that conversation is how it relates back to position size. So we had a really intelligent member of our community on Facebook that proposed this question.

Starting point is 00:09:20 His name is Patrick Buchanan. And Patrick asked us to ask you, how can one apply the Kelly criteria into the stock market, given the large array of potential outcomes and holding periods. So if you could kind of give our audience a little bit idea of what the Kelly criterion is and how it relates to those expected and probable outcomes, it would be really beneficial for people. Okay, first a little about the Kelly criterion. The rude idea is there is a tradeoff between risk and return. This is well known to almost everybody in investing.

Starting point is 00:09:52 But the question is, what is the tradeoff? How much should you bet when you have an edge? and how much should you cut back to allow for the risk that is associated with your bet? And for a very simple situation, like tossing a biased coin, suppose the coin has a 60% chance of coming out heads and a 40% chance of coming out tails, and you get to bet on heads or tails. Clearly, you'll be betting heads. But how much should you bet? This is the basic problem that I faced in Blackjack.

Starting point is 00:10:23 It was very much like a coin toss only. The edge might have been 52, 40. or 5149 at 2% or 4% edge, how much do you bet? And the Kelly criterion is the solution to that problem and also a much wider collection. And in the simple coin tossing case, this is where you have an even money payoff. So in a 6040 coin toss, you'll bet 20% of your bank rule. That, by the way, is fairly scary to people who actually do it because pretty wide swings. And so if you only bet about half as much as what Kelly says, you end up growing.

Starting point is 00:10:57 throwing at about three quarters the rate you would have, if you've done the whole thing, and your risk has cut down to half, so you feel a lot better. So I generally recommend that people just bet half-kelly, so they won't get scared. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history.

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Starting point is 00:15:00 sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So I'm curious if there's a rule of thumb that you use when conducting that math that you just talked about. The math of the Kelly Criterion are fairly involved if you have real world situations with many possible payoffs and also with uncertainties.

Starting point is 00:15:37 So people have done a lot of work on that and they solved a lot of the problems, explicitly. The best compendium of information, but it's very mathematical, is a book called the Kelly Capital Growth Investment Criterion, and the publisher is World Scientific. And it came out in 2010, about 700 pages. There are three editors, myself, and Leonard McLean and William Ziamba. So I'd recommend that for math types who want to dig into this further. So I'm really excited that you brought that up because I was not aware of this book. And the Kelly Criterion is something that I'm very interested in learning more about, specifically because in a book that we read probably two years ago, it was by Tony Robbins where he profiled a bunch of different high profile investors. And one of the people that he interviewed was David Swinson, who manages the Yale endowment, which is a multi-billion dollar endowment.

Starting point is 00:16:38 And the thing that I really remember about that interview with David Swinson was that he talked about this idea that you can't time the market, but what you can adjust is your position size and to mitigate risk. And I really remembered how much he emphasized the importance of position size. And I think for a lot of people listening to the show, if you're really wanting to understand mathematically what the most optimal position size is based on what expected values you, expect to have. The Kelly criterion is what you really need to know and understand. And so knowing that you've written a comprehensive book about the Kelly criterion is really exciting to me, and I'm sure many of our audience members will be just as excited to hear that. I'd like to say one more thing about the Kelly Criterion, which is it has a world scale applicability. If we look back into the various bubbles and disasters that we face over the last

Starting point is 00:17:36 century. Most of them come from too much leverage and from the framework of the Kelly criteria, it means you're betting too much. And the Kelly criteria when you work through the theory shows you that if you bet too much consistently, you will be ruined eventually. So the disasters that we've gone through, there was a crash of 1929 where people were buying stocks on 10% margin. There was the crash in 1987 where they were using portfolio insurance and that tended to lever their portfolio in various curious ways. And then there was the long-term capital management disaster in 1998, where they were levering at 30 to 1, sometimes even 100 to 1.

Starting point is 00:18:20 And then our recent disaster in 2008-2009, banks were levered up like 33 to 1, and the banks who got that privilege, two of them are gone, and three of them had to be bailed out by the taxpayers. So the Kelly Criterion applies not only in the small, for individual investors, but it applies in the large for nations. All right. So, Dr. Thorpe, based on what you just said, I have to ask this question because I know everyone in our audience that's listening to this interview is thinking the same thing.

Starting point is 00:18:50 And that is, how do you see the market today? And when I say that, I emphasize a couple things. The first one is just this morning, I was reading a report or an article on Larry Fink, who's the CEO of BlackRock, his company's a multi-trillion dollar kind of business handling securities. And he says, you know, it's not looking good. It's actually looking pretty scary. And whenever I think about where we were in the 2008 crisis, at the end of that credit

Starting point is 00:19:25 cycle and where we are now at the top of the next credit cycle that we're in, we have a lot more credit added to the system this time. around. So whenever I look at, call it the stock market, and I think about systematic risk, which is, you know, when credit contracts on a macro scale, how do you think through position sizes and what's your expectation from this point forward, considering that we may be at the top of a credit cycle? How do you think through that? I think it might have been J.P. Morgan, and somebody asked this question. They said, I'm worried about how high things are.

Starting point is 00:20:08 Should I sell? So the advice he gave was sell down to the sleeping point. I like that. So as far as asset classes now, it's always hard to know when you're in a bubble. And if you are in a bubble, when it's going to pop. It's a lot like the chaos theory image of dripping sand onto a little pile that's shaped like a cone on the beach

Starting point is 00:20:34 and the pile gets higher and higher and then finally suddenly there'll be a little avalanche a pile of stuff will slide down or the same thing with real avalanches and snow. It piles up, you never know quite when it's going to go but you know that if it keeps piling up eventually something will trigger it and you'll have a disaster of some kind.

Starting point is 00:20:51 Right now we have an attack on regulations that rain in banks from hovering up and also that rain in the derivatives industry slightly from not taking too much risk. And the more of those regulations are removed, the more these guys get a chance to lever up. And the more we, a more chance we have of a rerun of 2008, 2009. Now, they're not particularly worried, though, because the taxpayers bailed them out last time for the most part, not everybody, but most of them. And they can probably count on that happening again since they actually control

Starting point is 00:21:23 a wide swath of levers in government. They can make sure this is going to happen. So it's basically heads the risk takers win, tails the public loses. All right, so I have another question for you. So one of the narratives that we hear a lot of very smart people talking about is the idea that the next financial event that occurs is going to be one induced by central bankers and a distrust of central banking. So one of the narratives that we heard from a guy, Jim Rickards, who's in New York, Times bestselling author that relates to a lot of this kind of stuff, is he said,

Starting point is 00:22:04 you know, back in the late 90s, we had the long-term capital crisis, which, you know, potentially could have brought down the markets. The next credit cycle, we had the banks that all needed bailed out. And he said, and the one that's coming is going to be the central banks that need bailed out. And he talks about this escalation because of more derivatives, more credit that's being added into the system each time we create another cycle. So my question is this. Do you see the next cycle being induced by central banks?

Starting point is 00:22:41 I don't know the answer to that. I love that response. And I guess I, you know, this is a really profound moment for me. To hear you so quickly default to a 50% probability on something that I guess I was expecting you to really talk about more. And that's not something that we normally see. And that's not something that I normally do. And that's something that I can really learn a lot from is just how quickly you are able to come up with such an intelligent response to something that most would probably pontificate on. And I know you just provided such a quick snapshot of time, but what I

Starting point is 00:23:28 immediately think about based on the way you responded to that is something that we hear Warren Buffett talk a lot about, which is have a really strong understanding of what it is that you know versus what you don't know. And I really like the way that you just responded to that. Well, I read a good book recently that fits my mindset on these things quite well. It's by psychologist at, I think it's University of Pennsylvania named Philip Tetlock. And he has a co-author, a journalist named Dan Gardner. And this book is called Super Forecasting. So Tedlock has been working on the idea of whether people can forecast better than chance.

Starting point is 00:24:14 And he found, as I have over a lifetime, that experts, so-called experts, don't really have much to tell us that's of value. they basically get a lot of press and a lot of media attention because they make strong definite claims about one thing or another but strong definite claims are usually not the stuff of accurate predicting we can only see the future very fuzzily so there are a lot of possibilities you have to kind of weigh them and think about them and you found out that the people who go at things that way can make somewhat better predictions on average than chance and also better than the people who don't think that way so the whole book is is about this kind of thing.

Starting point is 00:24:55 So my view is that on most things, we can speculate about lots of possibilities, but it's difficult to get enough of an edge to actually put money down on it, and expect to make a profit. But it's worth speculating anyhow because you can be ready, at least psychologically, for the bizarre range of things that might unfold.

Starting point is 00:25:15 So I might be reading into things too much, but looking at the way your facial expression and the way that you responded to that, question and so quickly to say, I don't know, I kind of caught a glimpse that you wouldn't be surprised if that was the case that played out, but you just don't necessarily have enough information in order to confirm or deny. So that's why you're at the 50%. That's right. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business.

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Starting point is 00:29:01 Back to the show. All right. I'd like to talk more about your investing career because even though we talked about blackjack and how you made a name for herself in the blackjack space, you also have more than 30 years as an investor. And as Preston was saying at the beginning on the show, with an annual return. of 20% over that time period. So could you tell us about the transition that you're making from being an author,

Starting point is 00:29:28 being in academia, and into something that might be even more complex, working with options, warrants, and all the financial instruments? Well, I'm not sure where to start there. I got interested in investing because I'd made some money gambling and I'd made some money from book royalties. and that meant that I now had for the first time of my life a certain amount of savings. So after having done badly in early investments, I said I'd better put my mind to this thing. And by chance, I got a little book in the mail that I sent away something called Common Stock Purchaseous Once.

Starting point is 00:30:04 And those were basically options issued by companies. And they were traded over the counter that as you face, it was a telephone market. And as soon as I read about them, I realized that I could get rid of most of the risk in investing and still capture. some extra return if those warrants weren't priced correctly. And there was every reason to think in a telephone market that they would not be priced correctly quite often. So that summer, I came out toward the end of the summer to the new UC Irvine campus. First day I met an economist that was also a new professor there. He had written his thesis in 1962 under a very famous economist named Arthur Burns. His thesis was on common stock purchase warrants. So we hit it off right

Starting point is 00:30:47 away with a big exchange of ideas and we decided to meet every week to improve the theory and improve his investment returns. And then we kind of went our separate ways investing for people. We each had our little collection of people that invested in hedges. We made about 20 or 25% a year. Finally, the dean of the graduate division of UCI, who was a National Academy of Sciences member in biology, he had become one of our investors. At that point, in 1968, the markets were manic.

Starting point is 00:31:20 Anyhow, he introduced me to Buffett, and we talked, played bridge, or we got together with our wives for dinner and so forth. Buffett was actually evaluating me for Gerard, but apparently things went well because Gerard moved his money over to me. So that's the Buffet on my radar, and I realized that he was very smart, very dedicated, a long-term compounder. His life was securities. This guy understands long-term.

Starting point is 00:31:46 term compounding, he's very smart, he's going to be maybe the richest guy in the United States one day. It turned out there were times when he was. So I then realized from him that more efficient way to operate was to have a limited partnership. So I set up the first quantitative market neutral hedge fund. This story about Warren Buffett really brings me to the next question. And it's an idea that Buffett has been really famous for.

Starting point is 00:32:12 And you also write about that in your book. And that is the idea that the vast majority of the investors should actually stick to ETFs instead of buying, for instance, individual securities, which might surprise a lot of people because that is what Warren Buffett did and why he is so financially successful. A lot of people in the value investing community are interested in hearing your thoughts on that too. Why do you think that the majority of investors should invest in ETFs? What I've found over 40 or 50 years of doing this, actually a little over 50 now I realize. What I have found is that you can find situations to give you extra return,

Starting point is 00:32:52 but it requires quite a bit of work to find them. And so they're really simplistically, three groups of investors. There are investors who don't want to do a lot of work, just want as well as they can without doing a lot of work. And so people like that should buy indexes. And the reason is that index investors do better than maybe 90% of all the other investors. All the other investors are busy paying fees to investment advisors. Then the second group of investors are people who would like to learn more about securities,

Starting point is 00:33:30 and they're entertained by following them and trying to think about them and analyze them. And I say to those people, go ahead and do it. You may pay for your education, but you may have a good time in doing all this, and you may learn something. and who knows you may find some special unusual things that are really pretty good. Then the last category are the guys who make the big money in the market, people who have usually a fairly large staff, large capital resources, and as often as not can charge other people fees for doing it. And the fee chargers end up making most of the money, in my experience.

Starting point is 00:34:04 So that in mind, don't expect as a small investor to be able to grow out and make a big killing. All right. So, Dr. Thorpe, this is a question that I'm really excited to ask you because we always ask each one of our guests to come on the show to tell us what the most influential book, and you can name more than one, that has shaped your life or influenced you in a special way. If you could share that with our audience, we'd appreciate it. The first book that really influenced me in a quantitative way was a book from the MIT press edited by Paul Kootenar came out in 1964 initially. and it's called the random character of stock prices. And it was a collection of

Starting point is 00:34:45 quantitative type papers, maybe the very first quantitative papers that began appearing. And since I was thinking about the market in a quantitative way, that fit right in with my bent at the time and had a considerable influence on me. In fact, they had early

Starting point is 00:35:01 warrant models in there, which weren't a solution to the warrant and option problem. But they came close. And so that enabled me to actually figure out the option formula when I thought about what they'd done. So, Dr. Thorpe, we can't thank you enough for your time. This was just fantastic to just meet you. I can honestly say I'm honored.

Starting point is 00:35:23 Stig and I have been following you for a long time for years at this point. And we really admire your contributions, especially from a mathematical standpoint of how to think and how to think about probabilities. and just all those things, we can't thank you enough for that. And most importantly, we can't thank you for your precious time that you shared with us today in our audience. We are going to benefit from this tremendously. I do have one question I've got to ask you. When I was reading through your book, there's a picture of you in the back. And whenever I looked at the book, I said, oh, well, he's younger than I thought,

Starting point is 00:35:56 because I know you've done all these things from back in the 1960s and such. And I'm looking at this picture of a person who looks like they're probably 55 years old. Well, when I read through the bio, you're 84 years old. Well, that's an interesting question. I actually had that question quite a few times. And I did a poll a couple of years ago. I'd go up to strangers like waitresses and restaurants or librarians or whatever. And I'd say, I have a question for you.

Starting point is 00:36:24 I'll pay you a dollar, answer my question. And then it's about me, not about you. So don't worry. And if you get an answer that's fairly close, I'll pay you an extra $5. So the question was, how old am I? And if you come within five years, you get to $5. And no one's ever collected. The average guess was about between 55 and 60.

Starting point is 00:36:47 The highest guess was from a very old lady. She guessed I was 72. Because everybody's 72 at least, aren't they? So what in the world is the secret? If you can give us one final tip for longevity, if you can give us one tip to look that good when we're at the same? same age as yourself. So what is it? What is it that you do different? Well, let me just say first by answering that, that picture is almost three months old.

Starting point is 00:37:12 So I would joke now. Now, I've thought about this problem. I like being alive and doing things and learning things and enjoying people and traveling and so forth. So I want to be around as long as I can. So part of my thinking is exercise. So I ran marathons for 20 years or so. And that was a great fitness builder. And now I do a lot of walking and working out with a trainer in the gym. The second thing is what I eat. I try to eat in limited quantities and eat fairly healthy food most of the time. I don't eat healthy food all the time, but I do a fairly good job of it.

Starting point is 00:37:49 I never smoked. I never played football because I didn't want to bang my head. Even as a little kid, I understood what concussions were. I got them. Another thing is to get medical testing regularly. so you find out something early and can fix it. Well, there you have it, folks. There's the really valuable information.

Starting point is 00:38:07 So, Dr. Thorpe, we can't thank you enough. Thank you. Thank you, sir, for coming on our show and talking with us today. I know everyone got a lot out of this, and we really do appreciate it. So everyone who's listening, the name of the book is a man for all markets. I have read it cover to cover, and I can tell you it is a fantastic story that will give you plenty of insights. All right, guys. That was all the press that I had for this episode of the Amherst's podcast. We'll see each other again next week.

We Study Billionaires - The Investor’s Podcast Network - TIP128: Edward Thorp - Investing Legend, Math Genius (Business Podcast)

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