Books on Investing: Discussions, Reports & Suggestions : Eggheads and Bookies

» Normxxx - Eggheads and Bookies

By James Pressley | 21 September 2005

Sept. 20 (Bloomberg)— Almost 50 years ago, two scientists at AT&T Corp.'s Bell Labs discovered a formula for beating the odds in Las Vegas and on Wall Street.

High rollers banked the strategy at blackjack tables. A hedge fund used it to reap returns almost worthy of Warren Buffett. Then U.S. Attorney Rudolph Giuliani, later to become mayor of New York, crashed the party in pursuit of junk-bond pioneer Michael Milken.

Facts can indeed be stranger than fiction, as William Poundstone shows in

Fortune's Formula : The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street
In 1961, MIT mathematics professor Ed Thorp made a small Vegas fortune by "counting cards"; his 1962 bestseller, Beat the Dealer, made the phrase a household word. With Claude Shannon, the father of information theory, Thorp next conquered the roulette tables. In this prosaic but fascinating cultural history, Poundstone tells not only what they did but how they did it. For roulette, Poundstone shows, Thorp and Shannon used a betting scheme invented by Shannon's Bell Labs colleague John Kelly, eventually applying Kelly's technique to investing, resulting in long-term records of extraordinary return with low risk. (Thorp revealed the secret in 1966's Beat the Market, but investors proved harder to persuade than blackjack players.) Many other characters figure into Poundstone's entertaining saga: a forgotten French mathematician, two Nobel Prize–winning economists who declared war on the Kelly criterion, Rudy Giuliani, assorted mobsters, and winners and losers in all types of investing and gambling games. The subtitle is not a tease: the book explains and analyzes Kelly's system for turning small advantages into great wealth. The system works, but requires unusual amounts of patience, discipline and courage. The book is good fun for the rest of us.

Poundstone, a two-time Pulitzer Prize nominee, takes us from chalkboard to stock market and back as he explains the ``Kelly formula' for gambling through the lives of those who developed and exploited the system. It is a rollicking tale about money, mathematics and greed.

The book meshes science with storytelling, evoking a cast of characters that stretches from J. Edgar Hoover and shady bookies to Nobel laureate economist Paul Samuelson, with cameo appearances by the likes of actor Paul Newman and composer John Cage. The potboiler treatment is highly readable, though at times distracting, as the book actually revolves around three brainy guys and a slew of equations.

Cycling Mathematician

The story begins with Claude Shannon, a mathematician sometimes called the father of our digital age. Shannon hit on the idea that computers should run on the binary digits 0 and 1. He rode unicycles down the halls at Bell Labs and spent much time inventing gizmos after becoming a professor at the Massachusetts Institute of Technology. His information theory has influenced everything from cell phones to DNA sequencing.

With him at Bell Labs was John L. Kelly Jr., a gun-toting physicist from Texas. Kelly used Shannon's theory to devise a gambling system that combined maximum profit with protection from ruin: The gambler scales each bet to his remaining bankroll. ``Since you bet only a prescribed fraction of what you've currently got, you can never run out of money,' Poundstone says.

Kelly apparently never used his formula to make money. It took Edward Thorp to put the system to work on Wall Street.

In 1959, Thorp was a mathematics instructor at MIT. Convinced he could beat blackjack, he spent summer nights doing calculations, swatting mosquitoes and feeding data into the university's mainframe computer, an IBM 704. When it came to cards, he found, fives are bad for players and good for the house. You can beat the odds by tracking fives.

Betting Formula

Thorp sought Shannon's help to publish a paper on his strategy and was inundated with offers of financial support for a cut of his winnings. Shannon suggested using Kelly's formula to decide how much to wager.

Thorp's system worked so well that casinos stopped taking his bets. Then Thorp turned his attention to markets, joining a stockbroker in setting up Princeton-Newport Partners, a hedge fund that racked up a compound return rate averaging 15.1 percent annually after fees in its 19-year run between 1969 and 1988. The S&P 500 Index averaged an 8.8 percent annual return in that period.

Poundstone handles this material deftly, intertwining biography and theory in fast-paced declarative sentences (often of 10 words or less) and vivid analogies. Messages moving through a traditional communication channel are likened to bowling balls in an orange crate.

Split Portfolio

His polymath penchants get the better of him at times, as he can't explain one thing without digressing into another. Shannon, for example, had a plan for making money from stock-price fluctuations: Create a portfolio that is half cash and half stock, then adjust it daily to retain the split.

Before you can ask how transaction costs would affect this plan, Poundstone has plunged into a discussion about physicist James Clerk Maxwell and quantum theory. Only later do we learn that Shannon never tried the 50-50 portfolio. ``The commissions would kill you,' Shannon said.

The book features some unlikely spoilers, including Giuliani. Federal agents raided Princeton-Newport in 1987 as part of his prosecution of an insider-trading case against Milken at Drexel Burnham Lambert.

Milken was Princeton-Newport's broker. Investors wanted out. ``While Thorp was not charged with anything, his hedge fund was mortally wounded,' Poundstone says.

Poundstone offers no moralizing conclusions. Yet his allegiances become clear near the end of the book. By now, it's August 1998, when Russia roiled global markets by devaluing the ruble and defaulting on debt. The crisis hammered John Meriwether's Long-Term Capital Management LP. The U.S. Federal Reserve pressured Wall Street's biggest banks into bailing out the hedge fund to keep it from collapsing under more than $4 billion in losses.

Investor Lessons

Thorp, meanwhile, was running a new fund, Ridgeline Partners. It returned 47 percent after fees in 1998. Had LTCM used Kelly's formula, the book implies, banks and investors might have been spared much pain.

None of this means that the formula will rain riches on anyone who uses it. The system demands deep reserves of patience and courage. Yet two simple lessons are clear:

Only gamble when you have an edge, and never bet the ranch on a single throw of the dice.

-- posted by Normxxx