Speaker 1: Masters in Business is brought to you by the American
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Speaker 1: for over ninety years. Learn more at a d R
Speaker 1: dot org. This is Masters in Business with Barry Ridholtz
Speaker 1: on Boomberg Radio. This week on the podcast What a Delight,
Speaker 1: I got to sit down in the offices of Ed
Speaker 1: Thorpe and chat for two hours about pretty much everything
Speaker 1: you may know the name Ed Thorpe. I described him
Speaker 1: as really the first quantitatively driven hedge fund manager UH
Speaker 1: that of of any import. He was Jim Simons of
Speaker 1: Renaissance Technologies while Jim Simons was still a undergraduate math professor.
Speaker 1: He is the author initially of the book Beat the Dealer,
Speaker 1: where he figured out how to actually beat the house
Speaker 1: in blackjack. His analysis, his mathematical analysis of of blackjack
Speaker 1: led Las Vegas and casinos everywhere to completely change how
Speaker 1: they deal blackjack. They now use half a dozen UH
Speaker 1: decks instead of a single deck their random reshuffles. They
Speaker 1: utterly have changed the rules in response to Ed Thorpe.
Speaker 1: He then figures out the physics behind beating wait for it,
Speaker 1: Roulette and working with information theorist Claude Shannon at m
Speaker 1: I T. The two of them come up with a
Speaker 1: wearable computer. Eventually they get thrown out of old casinos.
Speaker 1: The casinos don't really like losing money to M I T.
Speaker 1: Math professors. He relocates to Irvine, you see, in California,
Speaker 1: and starts thinking about, well, what else is math heavy
Speaker 1: and filled with inefficiencies that has the potential when statists
Speaker 1: sical theory is applied properly to generate large amounts of
Speaker 1: money and finds his way onto Wall Street and and
Speaker 1: His second book is called Beat the Market and explains
Speaker 1: how when you can find two related equity issuances that
Speaker 1: are miss priced, there's an arbitrage opportunity. Believe it or not,
Speaker 1: Before that, no one was really doing that sort of
Speaker 1: statistical arbitrage between a stock and a warrant or eventually
Speaker 1: a stock in an option. Uh. He's had an absolutely
Speaker 1: fascinating career in a fascinating life. His autobiography is called
Speaker 1: A Man for All Markets, and it's really quite intriguing. UH.
Speaker 1: Footnote to this entire conversation. After we finished the interview,
Speaker 1: my assumption is that, hey, he's got to be tired
Speaker 1: of hearing my voice. But he invites us to dinner,
Speaker 1: and and three of us went and had a lovely
Speaker 1: meal there in Newport Beach. And and he's just an
Speaker 1: absolutely fascinating UM person and really a character who is
Speaker 1: beyond influential in the worlds of um, quantz and algorithms
Speaker 1: and hedge funds and you name it. His impact on
Speaker 1: finance can't be understated, So can't be overstated. So, with
Speaker 1: no further ado my conversation with ed Thorpe, I have
Speaker 1: an extra special guest this week, and I am privileged
Speaker 1: to be sitting in his offices in glorious Newport Beach, California.
Speaker 1: Edward oh Thorpe is a legend in finance. He is
Speaker 1: an American mathematics professor, author, hedge fund manager. He is
Speaker 1: the person who essentially figured out how to beat Las Vegas.
Speaker 1: I credit him with more or less inventing card counting. Eventually,
Speaker 1: Vegas banned him from a ton of a ton of
Speaker 1: casinos because he was beating the house. And his his
Speaker 1: first uh first book was Beat the Dealer. And after
Speaker 1: he did that, he figured out ways of beating baccarat
Speaker 1: and came up within a wearable computer and figured out
Speaker 1: how to beat Rolette Roulette. And by that point Las
Speaker 1: Vegas and Reno wanted nothing to do with him, and
Speaker 1: he turned his attentions towards the next challenge similar to gambling,
Speaker 1: and it turned out that was investing in finance in
Speaker 1: Wall Street, and the book after that became Beat the
Speaker 1: Market because Edward figured out how to do things in
Speaker 1: a way that created substantial, substantial returns. I could talk
Speaker 1: about his curriculum Vita forever. Let me just add PhD
Speaker 1: in mathematics, taught it m I T in New Mexico
Speaker 1: and University California, Irvine. Edward Thorpe, Welcome to Bloomberg and
Speaker 1: thank you for hosting us in your office. Thanks very,
Speaker 1: It's a pleasure to meet you and be here. I'm
Speaker 1: thrilled to be here. I'm gonna start with some quotes
Speaker 1: of yours and just have you respond them. And some
Speaker 1: of these are from Beat the Dealer. Chance can be
Speaker 1: thought of as the cards you are dealt in life.
Speaker 1: Choice is how you play them. That's a pretty deep
Speaker 1: philosophical perspective. Tell us how you came to that well,
Speaker 1: if you look back at your own life, you probably
Speaker 1: have a number of circumstances where you could make an
Speaker 1: important choice one way or another, and the way you
Speaker 1: made that choice had a big effect. The woman you're married,
Speaker 1: if if you infected, get married, the children that you
Speaker 1: brought up, and how you brought them up, the career
Speaker 1: you chose in life. A lot of big choices that
Speaker 1: you make at some point or other. And then there
Speaker 1: are things that you can't control, like who your parents
Speaker 1: were and what kind of economic circumstances you were brought
Speaker 1: up in. Where you where you started. You start twenty
Speaker 1: yards behind the start line, or twenty yards ahead of
Speaker 1: it or right on it. People start in different places.
Speaker 1: Those are cards that are dealt. So along those themes
Speaker 1: you talk about managing risk as an investor and managing
Speaker 1: money as a gambler, you wrote, I also believe, then,
Speaker 1: as I do now have to more than fifty years
Speaker 1: as a money manager, the surest way to get rich
Speaker 1: is to play only those gambling games where I have
Speaker 1: an edge. Let's talk about the edge a little bit, Okay.
Speaker 1: In the standard dambling games in casinos, you can generally
Speaker 1: calculate what the casino's edges, or if you figure out
Speaker 1: how to count cards, you can calculate what your edge
Speaker 1: over the casino is. So it's a fact, a mathematical fact,
Speaker 1: that if you play a game like this and the
Speaker 1: casino has the edge, it will eventually collect all your
Speaker 1: money if you play long enough. On the other hand,
Speaker 1: if you have an edge, your bank roll will grow
Speaker 1: and grow and grow. So basically what happens is you
Speaker 1: your bankroll either grows or shrinks depending on what your
Speaker 1: edges or what your disadvantages, and there's luck that pushes
Speaker 1: it up and down around that growth curve. So that's
Speaker 1: that's the way things look in the gambling world. So
Speaker 1: so even when you have an edge, you have to
Speaker 1: be prepared for Hey, sometimes snake eyes comes up on
Speaker 1: the dice. To to mix metaphors a little bit. That
Speaker 1: was one of the early things that I learned, fortunately,
Speaker 1: which was how much to bet on good situations. If
Speaker 1: you've got too much, you're likely to be wiped out.
Speaker 1: If you've got too little, it takes forever to make
Speaker 1: any money. So there's a happy medium in there, and
Speaker 1: that was one of the things that I came across
Speaker 1: quite early. Is there a mathematical solution to what's the
Speaker 1: right amount and what's too much in too little? Well,
Speaker 1: I was put onto this by a famous mathematician named
Speaker 1: Claude Shannon, who I knew at M. I T and
Speaker 1: I have to add in a man for all markets.
Speaker 1: You just casually mentioned throughout the book. You casually mentioned
Speaker 1: these legends in science and physics and mathematics. And oh
Speaker 1: so I went to Claude Channon with this problem, and
Speaker 1: the two you spent weekends tell us a little bit
Speaker 1: about that. Well, let's see it. Um. I got interested
Speaker 1: in the idea of beating Roulette when I was a
Speaker 1: high school student, but my ideas weren't very well formed,
Speaker 1: so I put it aside. And then when I went
Speaker 1: to u c. L A And gotta a bachelor's and
Speaker 1: masters in physics, I had about seven more years of
Speaker 1: physics behind me, and I happened to be talking to
Speaker 1: people at a study break in my student coopera I
Speaker 1: lived about Las Vegas. Some people have just come back
Speaker 1: and said, you can't beat those guys. I said, well,
Speaker 1: I think you can, and here's how I would go
Speaker 1: about it. So I described predicting Roulette using physics and
Speaker 1: they are good back and forth, and half the people
Speaker 1: believe me in half of them didn't. But I convinced
Speaker 1: myself from the argument and all the new physics that
Speaker 1: I had learned in the interim from high school, that yes,
Speaker 1: this is very likely to work. So I set out
Speaker 1: to do that, and you created a wearable computer working
Speaker 1: with Channon and other people. Is that right? What happened
Speaker 1: was I went to Las Vegas with my wife over
Speaker 1: Christmas vacation. By this time I had a PhD in
Speaker 1: math at U c l A. And I was going
Speaker 1: there just for a cheap, cheap vacation over Christmas. But
Speaker 1: I wanted to see Roulette wheels because I was busy
Speaker 1: working on beating Roulette, and I wanted to verify by
Speaker 1: close up observation of their wheels that what I was
Speaker 1: doing was likely to work. And on the way, I
Speaker 1: heard about a blackjack paper that some statisticians had read.
Speaker 1: So I thought, well, I'll get a little casino experience.
Speaker 1: I'm gonna need it if I'm going to be playing Roulette.
Speaker 1: So I sat down at the blackjack table and played
Speaker 1: for about forty minutes, and I learned enough during that
Speaker 1: forty minutes to realize I could probably beat blackjack, and
Speaker 1: I went back and set to work doing that. And
Speaker 1: black jack is one of those situations. Back then, there
Speaker 1: was one deck. They didn't shuffle it. They played pretty
Speaker 1: much through to the fifty two cards. That was astonishing
Speaker 1: that nobody had sat back and said, oh, we should
Speaker 1: be able to track the math of this and figure
Speaker 1: out how to beat the dealer. Well, there have been
Speaker 1: some savvy gamblers who had figured out that if you
Speaker 1: kept track of the cards and near the end there
Speaker 1: are lots of aces and tens, then there'll be more
Speaker 1: black shacks being dealt. And black jacks then and sometimes
Speaker 1: still now pay three to two if the player gets one,
Speaker 1: and just even money if the dealer gets one. He
Speaker 1: basically a collect your bet. So the more black when
Speaker 1: the decks rich and aces in tens, the higher frequency
Speaker 1: of black shacks shifts the edge in favor of the players.
Speaker 1: So they would sit there and wait and wait and
Speaker 1: wait until there were lots of aces and tens near
Speaker 1: the end of the deck. Then they bet a whole
Speaker 1: lot of money, raised the bets and and hope the
Speaker 1: statistics just play out over time. Yes, and that worked,
Speaker 1: but it took a long time, and it meant huge
Speaker 1: swings in the amounts they beat, and the casino was
Speaker 1: kind of caught onto that and got rid of these guys.
Speaker 1: They don't like people who were betting legitimately and winning.
Speaker 1: They seem to have a problem with that. Well, after
Speaker 1: I wrote a book about Card County beat the Dealer
Speaker 1: and it came out, they had a crisis in Las Vegas.
Speaker 1: Who were tens of thousands of players coming out and
Speaker 1: a few hundred of which learned how to count cards properly.
Speaker 1: And these players were upsetting them very much. So on
Speaker 1: April Fool's Day of they announced a rules changed. The
Speaker 1: Las Vegas Resort Hotel Association had a big meeting and
Speaker 1: decided what to do. They had a lot of uh
Speaker 1: suggestions like break his knees, right, nice guys, But they
Speaker 1: changed the rules and they went from one deck to
Speaker 1: six or eight. Is that that was a sort of
Speaker 1: a separate, parallel evolution. What they did was they restricted
Speaker 1: what players could do. They couldn't split as many pairs
Speaker 1: they could and double down as much that sort of thing.
Speaker 1: And I predicted that the players would not like this,
Speaker 1: and they leave the tables in droves, which is what happened.
Speaker 1: So they quietly went back to the old rules, and
Speaker 1: then they did what you mentioned. They began to introduce
Speaker 1: what they called professor stoppers, which were four or six
Speaker 1: or eight decks, and they began to deal them out
Speaker 1: of shoes, because it's pretty hard to hold for to
Speaker 1: eight decks in your hand and try to deal professor stoppers.
Speaker 1: That that's hilarious. So let's talk a little bit about
Speaker 1: information theory, because there's a line that you have about
Speaker 1: the great physics professor Richard Feynman, and you went to
Speaker 1: him with your concept about physical prediction of Roulette, and
Speaker 1: Vineman said, no, I really don't think anybody can beat Roulette.
Speaker 1: And you were thrilled with that answer. Yes very much, though,
Speaker 1: explain why, because I love the thought process here. Well,
Speaker 1: Fieman had had to graduate students that had figured out
Speaker 1: a way to be defective Roulette, someones which weren't properly
Speaker 1: maintained or machined, and they had made several thousand dollars
Speaker 1: doing this back in the early fifties. So he knew
Speaker 1: about He knew that fact about Roulette, and he also
Speaker 1: understood the edge that casino has had and how the
Speaker 1: mathematical ledge would grind down players who knew that mathematics
Speaker 1: had shown you couldn't beat roulette in the normal fashion
Speaker 1: of varying your bets up and down. In other words,
Speaker 1: it's a game of chance. It's a random outcome, and
Speaker 1: ultimately the house wins if you play long enough. Exactly.
Speaker 1: So he knew those two things, and he himself had
Speaker 1: been in Las Vegas and he saw he saw a
Speaker 1: guy wandering around betting on red and black and roulette wheels.
Speaker 1: So he said of the guy, look, I'll bank roll
Speaker 1: it for you. The guy was betting five dollars a hand.
Speaker 1: He said, just bet with me. The guy would go
Speaker 1: over and you say red and the wheel would spend,
Speaker 1: and if he won, five would pay him five dollars,
Speaker 1: and if he lost, he paid fiveman five dollars. This
Speaker 1: went on for a while until Fine one was down
Speaker 1: eighty dollars or so, at which point Biman quit. So, uh,
Speaker 1: that's pretty random that he's just banning one way or another.
Speaker 1: And what Fireman didn't realize was that psychologically his bank
Speaker 1: roll was eighty dollars and that wasn't big enough to
Speaker 1: be a casino. It makes a lot of sense. So
Speaker 1: so when Fynman said I don't think this could be done,
Speaker 1: that encouraged you, and I figured, here's here's one of
Speaker 1: the best physicists on earth. He knows about Roulette, he
Speaker 1: knows about a lot of math, and yet he thinks
Speaker 1: it's not possible. But I think it's possible. So if
Speaker 1: he thinks it's not possible, probably everybody else does too.
Speaker 1: So that means I've got this all to myself. That
Speaker 1: that's ah, that's a fascinating way. That's like the little
Speaker 1: Kid and the pony, the old the old joke. Hey,
Speaker 1: if Fynman doesn't think it, then there's got to be
Speaker 1: a pony in here nowhere. Um. Another quote from the book,
Speaker 1: most market participants have no demonstrable advantage for them, just
Speaker 1: as the cards in black Jacks or the numbers that
Speaker 1: Roulette seem to appear at random. The market appears to
Speaker 1: be completely af But you disagree with that assessment. Well,
Speaker 1: when people talk about efficient markets, I think it's a
Speaker 1: property of the market, but I think that's not the
Speaker 1: way to look at it. It's the market is a
Speaker 1: process that goes on and we have, depending on who
Speaker 1: we are, different degrees of knowledge about different parts of
Speaker 1: that process. I'll give you an example. Suppose I take
Speaker 1: a coin here where we're sitting, and I flip it
Speaker 1: up and let you call it heads your tails. You'll
Speaker 1: probably think that the outcome is random, and assuming it's
Speaker 1: a true coin, sure, yes so, and people can argue
Speaker 1: about whether coins are true or not, but the distinctions
Speaker 1: are very minor. Essentially, it's fifty, so you can say, well,
Speaker 1: you know it's random. I I'm willing to call you
Speaker 1: the heads their tails. Not. Suppose that I, like Claude Shannon,
Speaker 1: take a sandbox and a little level with a cup
Speaker 1: on it and move the level down a measured amount
Speaker 1: and let it flip the coin. Well, what Shannon found
Speaker 1: out was that the coin would flip a number of
Speaker 1: turns that he could calculate depending on how far down
Speaker 1: he pulled a lever before he released it, so he
Speaker 1: could have it spend three and a half times, for example,
Speaker 1: So if heads were up and he spent a three
Speaker 1: and a half times, it would land tails. A simple
Speaker 1: problem of force, angular momentum, and an amount of distance
Speaker 1: it travels exactly. So given the extra information, that coin
Speaker 1: becomes fairly predictable. So it's the same with markets, depending
Speaker 1: it depends on any information you have, And of course
Speaker 1: people who do inside or trading do a pretty good
Speaker 1: job of predicting a market that seems random to most people.
Speaker 1: So a few quotes of yours that I find fascinating
Speaker 1: gambling is investing simplified. I think that's really interesting that
Speaker 1: investing has become more complex than gambling. Why is that. Well,
Speaker 1: with most gambling aims, you can calculate probabilities, and so
Speaker 1: you know what the odds are in any given situation,
Speaker 1: and you can figure out pretty accurately how much to that.
Speaker 1: With a security it's more difficult. You only have rough estimates.
Speaker 1: For example, there's something called the long normal probability distribution
Speaker 1: that is a rough model for how stock prices change,
Speaker 1: but it's not an exact model, and it has parameters
Speaker 1: and like volatility, and if you make a supposition as
Speaker 1: that what the volatility is going to be in the
Speaker 1: near future, you can get an idea of the distribution
Speaker 1: of prices of a particular stock in the future, but
Speaker 1: you might be off in what you think the volatility
Speaker 1: is going to be, and so your distribution will be off.
Speaker 1: So anyhow, it's it's a matter of estimating things that
Speaker 1: you can't get exactly, you can't know. So so how
Speaker 1: natural was that progression from the casinos to Wall Street
Speaker 1: other than they're both big, interesting mathematical riddles to be solved. Well,
Speaker 1: I learned a lot of things in the casino, I
Speaker 1: would say, just as an aside um, using a winning
Speaker 1: gambling system of the casino is per training for the
Speaker 1: investment world. And the reason is that you learn how
Speaker 1: to manage money, You learn how much to bet. When
Speaker 1: you know what your edge is, you get a certain
Speaker 1: discipline in conducting a strategy that you think is right.
Speaker 1: For example, let's suppose that you're an index fund investor.
Speaker 1: If you understand what the probability distribution has been for
Speaker 1: an index fund in the past, then you have an
Speaker 1: idea of what kind of ups and downs you're going
Speaker 1: to be writing in the future. And when something bad
Speaker 1: happens like two thousand and two tho nine, you don't
Speaker 1: run out like a scared rabbit at the bottom and
Speaker 1: miss the whole climb back up to new highs. And
Speaker 1: yet that seems to be what many people. Many people do,
Speaker 1: they do, but if they had been car counters a
Speaker 1: black tack like the professionals I see the blackjack ball
Speaker 1: once a year if they had been, if they had
Speaker 1: that experience, they wouldn't flinch at all. So in the book,
Speaker 1: you describe sort of your first tentative ventures into markets
Speaker 1: after um the Vegas experience. Tell us how you you
Speaker 1: began investing well after I had made money both from
Speaker 1: book royalties and from card counting at blackjack and baccarat
Speaker 1: in Las Vegas. After I've done that, I had money
Speaker 1: to invest for the first time in my life. Academics
Speaker 1: weren't paid a whole lot then and they're not paid
Speaker 1: a whole lot now, So I find my problem was
Speaker 1: to figure out how to invest the money. So, knowing nothing,
Speaker 1: I made my collection of mistakes. I paid a mr
Speaker 1: Market is rather expensive tuition to learn a bunch of
Speaker 1: basic things that I'm described in the book, things that
Speaker 1: behavioral finance people understand now as foolish mistakes. And then
Speaker 1: I sat down for a whole summer and read everything
Speaker 1: I could on finance in a big bookstore in Beverly Hills.
Speaker 1: You described two summers of of of learning in the
Speaker 1: library and in the books. How many books did you
Speaker 1: play through? What were you reading. Well, my first go
Speaker 1: round and the first summer was to read whatever they
Speaker 1: had in a big Martindale's bookstore on Beverly Hills. So
Speaker 1: it was newspapers, investment books, charting fundamentals, all kinds of advice,
Speaker 1: which which leads me to ask a question. And again
Speaker 1: it's a quote of yours. Most stockpicking stories, advice recommendations
Speaker 1: are completely worthless. Was that was that your takeaway back
Speaker 1: then or is that something you learned over the years. Well,
Speaker 1: it wasn't my instant takeaway, but it was something I
Speaker 1: came to fairly rapidly as I plowed through all these things.
Speaker 1: What what is it that led you to the conclusion,
Speaker 1: which I completely agree with, that a lot of what's
Speaker 1: out there is just either conflicted or self interested, or
Speaker 1: noisy or not well informed commentary. Well, I had a
Speaker 1: science background, and I tend to draw conclusions based on
Speaker 1: nation facts evidence. That's so old school. We don't do
Speaker 1: that anymore. It's it's it's now, it's all about the
Speaker 1: fake facts, fake news. I'm basically immune to all that stuff.
Speaker 1: It's like water running off a dock or whatever. So anyhow,
Speaker 1: you brought a fairly critical eye to whatever was being
Speaker 1: passed off his market advice? Is that a fair statement
Speaker 1: just because people said something wasn't good enough. I had
Speaker 1: that set from the time I was a child. I
Speaker 1: wanted to check it for myself and verify for myself.
Speaker 1: And you blew up a number of chemistry kits and
Speaker 1: other such things which you describe in the book UM.
Speaker 1: So let's talk a little bit about return. So one
Speaker 1: of the things you discovered are pricing inefficiencies, pricing anomalies
Speaker 1: that say, hey, here are two related UM stocks. You
Speaker 1: can either have a stock and a warrants or later
Speaker 1: on a stock and an option, and they should trade parallel,
Speaker 1: but they don't. Sometimes one or the other gets cheap
Speaker 1: and the other gets overvalued. Was anybody else doing those
Speaker 1: sort of paired or hedged trades at the time. No, Actually,
Speaker 1: what happened when I I was sent my set. I
Speaker 1: spent my second summer trying to learn about finance, and
Speaker 1: I got lucky. The first week or so, I got
Speaker 1: a little pamp in the mail from something called r
Speaker 1: h M warrant survey guy named Sydney Freed. I believe
Speaker 1: that his son still runs this survey, and so it
Speaker 1: told tales buying warrants for pennies and cashing him out
Speaker 1: for dollars in the future. So as I read through it,
Speaker 1: I learned what I warrant was, and I said, hey,
Speaker 1: wait a minute. This simplifies the investing problem tremendously because
Speaker 1: the price of a warrant and the price of this
Speaker 1: underlying stock are related. So I don't have to worry
Speaker 1: about all these fundamental things. I don't have to go
Speaker 1: out and talk to CEOs and read balance and income
Speaker 1: statements and compare companies one to another. If these things
Speaker 1: moved together, then if they get out of whack, I
Speaker 1: had to be able to set up some kind of
Speaker 1: investment short one along the other that will make money
Speaker 1: for me. So I began to think then about how
Speaker 1: how to price it warrant, how to know when I
Speaker 1: was at a proper price or overpriced or underpriced? And
Speaker 1: you were using some pretty early computer technology at the time. Yes,
Speaker 1: I had actually got into using computers with Blackjack. I
Speaker 1: had done that back at M I T and sixty.
Speaker 1: They had an IBM seven oh four that was available then.
Speaker 1: So I taught myself for tran and the programmed to
Speaker 1: figure out the equations solve the equations that I needed
Speaker 1: to decide which cards were good to have in the
Speaker 1: deck in blackjack and which cards were good to have
Speaker 1: out of the deck. So anyhow, I had the experience
Speaker 1: with the computers, which was fortunate. So then when I
Speaker 1: got to think about warrants, I had the computer background.
Speaker 1: Two actually mathematic size and draw graphs and do that
Speaker 1: sort of thing. Made it much more easy for me.
Speaker 1: And so you would find when these two related securities
Speaker 1: were out of out of sync, and basically made the
Speaker 1: bet that was did any of them ever go against
Speaker 1: you in an unanticipated way? Or did everything perform as expected.
Speaker 1: The first things we found were overpriced warrants, and I
Speaker 1: happened to run into a professor at U see I
Speaker 1: the first day that you See I opened for classes
Speaker 1: back in we're both new faculty members, and he had
Speaker 1: written a thesis about warrants name Machine Kasuf. And so
Speaker 1: we got together and met every every day for about
Speaker 1: a year or two to develop the theory further, and
Speaker 1: then we wrote a book Beat the Market about it
Speaker 1: and the warrants that we found that were overpriced. We
Speaker 1: were short and we would buy common stock, long hedge,
Speaker 1: and every one of those was a winner m hm.
Speaker 1: And every one of them historically had been winner, so
Speaker 1: we knew that these overpriced warrants somehow eluded the market.
Speaker 1: There were warrants with two years or less ago, and
Speaker 1: investors seemed to think that two years was forever, so
Speaker 1: they proaced the warrants way high, and then the warrants
Speaker 1: when they would wake up as the clock ran on
Speaker 1: the two years, the warrants would collapse in price. So
Speaker 1: you could short the warrant about the stock. And it
Speaker 1: was just one annualized event after another and compounded. How
Speaker 1: did this investment end up running? What did you end
Speaker 1: up putting up his returns? Well, we made about a
Speaker 1: year gross and we had investors, faculty members at you
Speaker 1: see I that sort of thing that rode along with us.
Speaker 1: So after our our fee, which was the profits and
Speaker 1: no more, uh, they needed twenty percent a year. And
Speaker 1: we did this for several years and then um I
Speaker 1: went into business for myself and she went off and
Speaker 1: went into business for himself, and you you launched a
Speaker 1: couple of hedge funds we're going to talk about in
Speaker 1: a little bit. I want to ask you about one
Speaker 1: other quote of yours that I really enjoyed. That's related
Speaker 1: to this. Every stock market system with an edge is
Speaker 1: necessarily limited in the amount of money it can use
Speaker 1: and still produce extra returns. In other words, every edge
Speaker 1: has a scale limit. It can only get so big. Yes,
Speaker 1: and and how did how did you come to that conclusion?
Speaker 1: What made you realize, hey, this can only go so far. Well,
Speaker 1: let me say, first of all, the scale limit could
Speaker 1: be huge. It could be tens of billions, or could
Speaker 1: be ten or twenty or fifty million. I have a
Speaker 1: friend who has a commodity hedge fund that's one of
Speaker 1: the best performing ones around, and it it's limit is
Speaker 1: like seventy million dollars. Because trading costs get too high.
Speaker 1: What happens is if you find a pair of securities
Speaker 1: that out of line, if one's overpriced and one's underpriced.
Speaker 1: If you start selling short the overpriced one, you'll drive
Speaker 1: its priced down so it'll be less overpriced. If you
Speaker 1: start buying the enterpriced one, you'll lift its price so
Speaker 1: it will become less underpriced. So your action in trading
Speaker 1: misprice securities tends to drive them towards the correct price, which,
Speaker 1: by the way, is a service to the other people
Speaker 1: in the market because then they see securities that are
Speaker 1: more fairly priced that they would be otherwise. So not
Speaker 1: quite shouting those cat you you actually are affecting this
Speaker 1: by training it as opposed to a bigger liquid equity
Speaker 1: where a few million dollars and gonna move the price
Speaker 1: very much. And by the way, that's one of the
Speaker 1: huge things between that is a difference between finance and physics.
Speaker 1: In physics, you can do the same experiment over and
Speaker 1: over and you doesn't affect the natural world. But in finance,
Speaker 1: what you do affects the human world. You're you're a
Speaker 1: You're an observer and a participant and affect the outcome
Speaker 1: of everybody else's opportunities. Let's talk about some of the
Speaker 1: interesting things you've done and people you've met over over
Speaker 1: your career. You played bridge with Warren Buffett. Uh tell
Speaker 1: us how that came about. Well, when I was at
Speaker 1: U c Irvine, after I had figured out how to
Speaker 1: value warrants, I started trading for my own account and
Speaker 1: then the word spread and I signed up people at
Speaker 1: the university who wanted me to trade for their accounts.
Speaker 1: And one of the people was the dean of the
Speaker 1: graduate division, A fellow named Ralph Waldo Gerard, National Academy
Speaker 1: of Science member, among other things, and so he wanted
Speaker 1: to get to know me and find out more about
Speaker 1: this trading. So I was introduced to a friend of
Speaker 1: his who was going to I didn't know this, but
Speaker 1: the friend was going to kind of check me out.
Speaker 1: And the friend was the young Warren Buffett. So we
Speaker 1: had a dinner at the Gerard house with our wives
Speaker 1: and then we end up playing bridge, and I went
Speaker 1: down to Emerald Bay where Warren had one house and
Speaker 1: later two houses. That's not too far from here. Lodona
Speaker 1: or Emerald Bay is about four or five miles right
Speaker 1: down the coast. It's at the north end of Laguna Beach.
Speaker 1: Lovely part of the world. And you actually said something
Speaker 1: to your wife, I think that Warren Buffett guy is
Speaker 1: going to be the wealthiest person in America. Exactly How
Speaker 1: did that thought process come about? Well, he was cashing
Speaker 1: out his partnership, which had about a hundred million dollars
Speaker 1: in it then it was. It was the biggest hedge
Speaker 1: fund around and also the only really successful one at
Speaker 1: that point. The runner up is Michael Stronhardt's fund, which
Speaker 1: was up slightly during a pretty bad period in UM
Speaker 1: seventy and Buffet's partnership was still doing well, but he
Speaker 1: said things are so overpriced. I'm cashing out, which is
Speaker 1: why Ralph Gerard was looking at me. He wanted someplace
Speaker 1: to put his money that was coming out of Buffett
Speaker 1: Partners and Buffett was vetting you to see if you
Speaker 1: were okay to take their money, which is not a
Speaker 1: bad person to be vetted by. So we got along
Speaker 1: just fine and talked about a lot of different things,
Speaker 1: and the way we thought about things was similar, that is,
Speaker 1: you know, rational, evidence based and so forth. His method
Speaker 1: of investing, though it was a lot more hands on
Speaker 1: that I wanted to be. I wasn't an invest I
Speaker 1: wasn't interested in spending my total percent energy and life
Speaker 1: just investing. I just thought it was an interesting thing
Speaker 1: to be involved in because I had some money to
Speaker 1: invest at the time. So the nine letter from Buffett
Speaker 1: to his partner's explains he's winding down and eventually he
Speaker 1: takes Berkshire Hathaway and relaunches it. Um not too not
Speaker 1: too far off from the distance. You were one of
Speaker 1: the first investors in in Berkshire Hathway Is that a
Speaker 1: fair statement, No, not so early. What happened was Buffett
Speaker 1: didn't tell his limited partners that what he was going
Speaker 1: to do next. What he was going to do next
Speaker 1: was turned Berkshire Hathaway into his own private mutual fund.
Speaker 1: So he had stock to distribute, and he could either
Speaker 1: distribute stock to the investors or give them money, and
Speaker 1: he preferred, I think, to keep the stock and give
Speaker 1: them money. So mostly the investors were cashing out. Some
Speaker 1: of them took some Burkshire stock and not not a
Speaker 1: whole lot happened with Berkshire for the next decade, and
Speaker 1: I was unaware that he was turning it into his
Speaker 1: own mutual fund. But I was sitting around doing something
Speaker 1: or other with the hedge fund. I was then and
Speaker 1: running Princeton Newport Partners, and heard some news item about
Speaker 1: Berkshire Hathaway and Warren Buffett, so I focused on it,
Speaker 1: and I realized right away what had happened in the
Speaker 1: intervening fourteen or fifteen years, that Buffett had turned this
Speaker 1: uh sick textile company into his own private investment tool.
Speaker 1: So had I had I known that? I had I
Speaker 1: been able to invest in Berkshire Hathaway in to I
Speaker 1: might have invested somewhere in the twelve or fifty dollar range.
Speaker 1: But but now, but now, the stock with two dollars
Speaker 1: so most people was a g It's already had a
Speaker 1: huge multiple. You don't want to buy it now? I said, yes,
Speaker 1: I want to buy it now. So I began buying
Speaker 1: in and And how long did you hold on to
Speaker 1: Berkshire hath You still have it to this day. So
Speaker 1: I'm compelled to ask, a hundred dollars invested in Berkshire
Speaker 1: hath Away when you put that in in eighty two,
Speaker 1: what would a hundred dollar be worth today? Well, it's
Speaker 1: easier for me to think in hers with a thousand,
Speaker 1: because that was stocker slutly less. So it's worth roughly two.
Speaker 1: That's a pretty good return. Well, how does what does
Speaker 1: that average out compounded that mid twenties? Something like that
Speaker 1: two D and fifty four thirty five years, two D
Speaker 1: and fifty thirty five years. I'm guessing mid twenties, but
Speaker 1: I'm sure I could just punch it into the computer
Speaker 1: and get the actual answer. But by any stretch of
Speaker 1: the imagination, it's a fabulous return. And the consistency over
Speaker 1: such a long time. There is nothing comparable to that,
Speaker 1: is there that? That's amazing? How did you never get
Speaker 1: tempted to sell? Let's see if I can figure it out. Okay,
Speaker 1: I want to take the route of two and fifty
Speaker 1: so um, so it's about to the five point six
Speaker 1: over thirty five. So I would say, I'm just this
Speaker 1: is rough. I could be off a few maybe analyzed,
Speaker 1: Oh that's no big deal. He's you know, he should
Speaker 1: have given up for a very long time. That's astonishing.
Speaker 1: You know. One of the things, and we just talked
Speaker 1: about it earlier, is eventually everything reaches a capacity. You
Speaker 1: can't just find an edge and scale it forever unless
Speaker 1: you're Warren Buffett, whose edges a tremendous amount of um
Speaker 1: not only intellectual capacity, but discipline and the ability to
Speaker 1: say I don't care about this, I don't care about that,
Speaker 1: I don't care about technology. This is what I do well,
Speaker 1: and I'm going to stick to my knitting. A lot
Speaker 1: of smart people don't have that ability. Well. Warren Buffett
Speaker 1: um agrees with the point we made earlier that as
Speaker 1: you get bigger and bigger, you tend to have capacity problems,
Speaker 1: and so you can see that in the performance of
Speaker 1: Burshire Hathway. There's a table in my book which shows
Speaker 1: how the decade by decade how the return has dropped
Speaker 1: compared with the SMP. So it's converged too fairly close
Speaker 1: to the SMP five hundred in this last time period.
Speaker 1: So at this point you're gonna say he's as big
Speaker 1: as he can get and continue to outperform. Yes, but
Speaker 1: Burrshire still has some advantages when you can. Let's suppose
Speaker 1: that does exactly the same as an index fun going forward,
Speaker 1: which may not be a bad rough estimate. It doesn't
Speaker 1: pay dividends, so you don't pay any taxes until you
Speaker 1: sell your stock. When you sell your stock, if you
Speaker 1: hold it more than a year, you'll be paying long
Speaker 1: term capital gain, which is less than you'd pay if
Speaker 1: you were a trader and generating short term gains or um.
Speaker 1: And as far as the dividends go, the company that well,
Speaker 1: I'm not sure where the tax taxation is going to
Speaker 1: be on dividends now or by the time this broadcasts.
Speaker 1: Who even knows what I want? But what what is
Speaker 1: long term capital gains fifteen versus or or higher? I
Speaker 1: don't know. I've I've lost track. Yeah, but it's considerably
Speaker 1: lower long term than than short term. I don't plan
Speaker 1: to pay me for a while, so I'm not paying attention.
Speaker 1: Were you ever tempted to sell? Did you ever look
Speaker 1: at this and saying or do you just not pay
Speaker 1: attention to it? I don't pay a whole lot of
Speaker 1: attention to me. It's a buy and whole situation. And
Speaker 1: if I do sell, I'm gonna have to pay all
Speaker 1: these taxes because I have a low basis, a very
Speaker 1: low basis, so I get I get punished for selling. Well,
Speaker 1: that's reason to hold on to it. I'm sure. I'm
Speaker 1: sure Warrant appreciates that sort of loyalty amongst its stockholders. UM.
Speaker 1: On a related note, you were at at Citadel Ken Griffins.
Speaker 1: You were his first limited partner. What what did you
Speaker 1: see in Ken Griffin that made you say this guy
Speaker 1: is onto something interesting. He's he's clearly of a mathematical bends.
Speaker 1: I'm willing to give him money and see what he
Speaker 1: can do with it. Well, the guy who discovered Ken
Speaker 1: Griffin is a fellow named Frank Meyer, who was a
Speaker 1: friend of mine and who I got acquainted with in
Speaker 1: the early days of Prince and Newport Partners because he
Speaker 1: was he was representing some investors who wanted to get
Speaker 1: in to Prince and Newport Partners. So anyhow, when Prince
Speaker 1: and new Park Partners closed down in nine, Frank had
Speaker 1: just discovered this um Harvard student who was trading out
Speaker 1: of his dorm. And what Ken Griffin was doing was
Speaker 1: trading derivatives, convertibles, lawrants, options and so on, pretty much
Speaker 1: in the style that I've been trading them. And so
Speaker 1: Frank decided to set him up in business. So he
Speaker 1: was his mentor guru, um business organizer. Ken was a
Speaker 1: young guy then, so smart but still new to all this.
Speaker 1: And since I was shutting down Prince and Newport, it
Speaker 1: was natural for me to talk with Frank and Ken
Speaker 1: and explain to them what I did and how I
Speaker 1: did it, and basically give them my business road map.
Speaker 1: And they initially followed that, and of course it evolved
Speaker 1: into its own great thing, and the Citadel is phenomenal success.
Speaker 1: Are you still an investor in sid Adel? So you
Speaker 1: are really a buy and hold investor. You look at
Speaker 1: things over the long haul. That's fascinating. Let's talk about
Speaker 1: start with a quote of yours. Any edge in the
Speaker 1: market is limited, small, temporary, and quickly captured by the
Speaker 1: smartest or best informed investors. Still true today, I'd modify
Speaker 1: that a little bit. I think that that's true of
Speaker 1: most of the edges. Some of the small edges have
Speaker 1: fairly large scope to them. I'll give you one simple example.
Speaker 1: There's something called a tax loss harvesting, and that's a
Speaker 1: politically created edge. You could, for instance, set up a
Speaker 1: thing like an index fund, a thing that tracks an
Speaker 1: index fund, and at the end of the year, sell
Speaker 1: your losers and take the tax loss and use the
Speaker 1: money to buy new stocks. That would keep your collection
Speaker 1: of stocks tracking the index fairly well, and just keep
Speaker 1: doing that. You could sell one SMP index and buy
Speaker 1: a different SMP next. Well, you know that's you can't
Speaker 1: do that, because be a wash has to be something
Speaker 1: slightly different. Different. You could take let's say, of the
Speaker 1: stocks in the SMP index and buy them on day one.
Speaker 1: You can let it run for a year minus a day,
Speaker 1: look at the losers, sell them, take the tax loss,
Speaker 1: use the money to replace those losers with some of
Speaker 1: the stocks you didn't already hold. So you have four
Speaker 1: d stocks you haven't bought, you have a hundred that
Speaker 1: you did have, so you move into some of the
Speaker 1: four and then you let it run for another year,
Speaker 1: and you do it again and again, so you keep
Speaker 1: taking losses and collecting money from the government. And that's
Speaker 1: an edge that's persists. It's a politically created edge. Got
Speaker 1: it because of the tax code, Yes, because of the
Speaker 1: tax code. So nineteen sixty nine was a famously tough
Speaker 1: year for hedge funds. Carol Loomis wrote a big article
Speaker 1: about it in in Fortune and and she ultimately ended
Speaker 1: up being um a really interesting and important journalists. But
Speaker 1: in in nineteen sixty nine, your hedge fund was just
Speaker 1: launching or about to launch. We launched in November of
Speaker 1: nineteen sixty nine, the year that's so terrible. Yes, and
Speaker 1: there was there were There were articles in Fortune and
Speaker 1: maybe Forbes, I don't remember which now, which listed twenty
Speaker 1: some odd of the largest hedge funds and they're all
Speaker 1: losing going out of business, except for Buffet Partners Limited,
Speaker 1: which is going out of business for lack of opportunity.
Speaker 1: And uh, I think that Steinhardt hung in there. He
Speaker 1: was up maybe five percent, but it was a disaster.
Speaker 1: So we we started in the middle of a blood bath,
Speaker 1: and how did you do? How was that first year
Speaker 1: in business as a hedge fund, Well, we were wondering
Speaker 1: what was going to happen. So the first two months
Speaker 1: the market was down four or five and we were
Speaker 1: up four percent, So that was a That was a
Speaker 1: good start. And I made as much money then as
Speaker 1: I was making at the university just in the first
Speaker 1: two months, so that's a good sign. Then the next
Speaker 1: year we were up again and the market was down,
Speaker 1: and so we opened up a big gap on the
Speaker 1: market fairly early, and that continued. Seventy three the SMP falls,
Speaker 1: you're up seven. In the SMP five hundred falls, seven,
Speaker 1: you're up nine percent. At what point do people start
Speaker 1: knocking on your door saying, Hey, I have some money
Speaker 1: for you to manage. For us, we had a steady
Speaker 1: waiting list and we started out with I think a
Speaker 1: fifty dollar minimum, and it rapidly rose. Um eventually was
Speaker 1: ten million, and then finally we just couldn't take any
Speaker 1: more investors. So it grew over the years from initial
Speaker 1: one point four million to about two hundred and seventy
Speaker 1: million under management. And you understood all the math behind this.
Speaker 1: You understood the probabilistic edge you had, but were you
Speaker 1: ever surprised by, Hey, this is really working out better
Speaker 1: than we imagined. Uh, that's an interesting question. When I
Speaker 1: sat down with my then principal partner fellow named J.
Speaker 1: Reagan back in sixty nine, I estimated what was going
Speaker 1: to happen, and I said, I think that by five,
Speaker 1: with the way we're going to grow and the fees
Speaker 1: we're going to have, will each be worth a million dollars.
Speaker 1: And you actually hit that number right on time. That's
Speaker 1: pretty much. Yeah. So in five I sent him a
Speaker 1: copy of what I've written what I already sent him
Speaker 1: nine sixty nine, just as a little reminder and at
Speaker 1: at at what point did it sort of did or
Speaker 1: I should ask the question, did it ever scale to
Speaker 1: a point where you said, Gee, this has really gone
Speaker 1: far beyond what I was expecting. I don't think so. Um.
Speaker 1: One of the things I learned at the casino table
Speaker 1: was that scaling is a very interesting psychological thing. When
Speaker 1: I first started playing blackjack, on my first big trip,
Speaker 1: I went with a couple of multimillionaires who wanted to
Speaker 1: bank or on me for a hundred thousand dollars I said, no,
Speaker 1: I don't know how to handle money. I'm gonna be
Speaker 1: and if anything goes wrong, you're not gonna like this.
Speaker 1: You're not gonna like it in spades. So let's only
Speaker 1: go with ten thousand. And the first eight hours I
Speaker 1: sat down there betting one dollar when it wasn't favorable
Speaker 1: and ten dollars when it was favorable, and they just
Speaker 1: about went out of their skulls with this penny andy betting.
Speaker 1: But then I got used to it after eight hours,
Speaker 1: and then I went to two dollars small bets, twenty
Speaker 1: dollars big bets, and that lasted a couple of hours,
Speaker 1: and then I got used to that, and then I
Speaker 1: went to five to fifty and the top bet they
Speaker 1: would allow at that point. So what I found was
Speaker 1: you could scale up, and when you get used to scaling,
Speaker 1: you do the same things, same kind of thinking that
Speaker 1: you did at the small scale on bigger and bigger scales,
Speaker 1: So that that stayed with me all the way up.
Speaker 1: It's just the process getting used to the larger numbers.
Speaker 1: But that's a physical and a psychological adjustment where when
Speaker 1: you start out at one and ten five dollars sounds
Speaker 1: like a lot of money, but you have to stare,
Speaker 1: step your way up until you're comfortable. Was it was
Speaker 1: it the same with the hedge fund, starting out relatively
Speaker 1: small and at a certain point and the biggest you've
Speaker 1: got in terms of assets under management was we had
Speaker 1: about a billion long and about a billion short, but
Speaker 1: we had about two d seventy million behind that. I
Speaker 1: will I will say this to Bill Gross who used
Speaker 1: to be here in next door pimp go literally, I'm
Speaker 1: looking out the window at the Pimco tower right next
Speaker 1: to yours. So he got his start playing blackjack too,
Speaker 1: as you got in the book. And so he took
Speaker 1: two hundred dollars like the book beat the dealer said
Speaker 1: he would, went out, slaved away for four months, turned
Speaker 1: into ten thousand like it said he would. And then
Speaker 1: when he went to Pimco, he was really used to
Speaker 1: scaling up. And there came a point when PIMCO had
Speaker 1: just under two trillion under management. So that's a lot
Speaker 1: of scaling up from from literally a very small division
Speaker 1: that was wanting was a Pacific life for they were
Speaker 1: running the money of a local insurance company and decided
Speaker 1: to set it out as a as a separate entity. Well,
Speaker 1: the way all this happened was after reading Beat the
Speaker 1: Dealer bill read Beat the Market, and so he decided
Speaker 1: to write his thesis in the convertible bonds at U
Speaker 1: C l A. And then it was one he was
Speaker 1: looking for a job and his mom said, oh, they're
Speaker 1: looking for people over at a Pacific Mutual Life. So
Speaker 1: he went over and they at oh, we don't need
Speaker 1: any bond guys here. He said, well, I wrote my
Speaker 1: thesis in convertible bonds. I said, oh, we don't have
Speaker 1: one of those. So that's how he got high. And
Speaker 1: literally literally Pacific Life is not that far from here either.
Speaker 1: It's right up the right up the road. That thing
Speaker 1: I call the mushroom building. Oh that's it. That's that's
Speaker 1: so funny. So a couple of really fascinating things that
Speaker 1: took place with with you and and the hedge funds. First,
Speaker 1: not only did you never have a losing year, you
Speaker 1: never had a losing quarter. That's a remarkable run. How
Speaker 1: is that consistency possible? Well, I was a child of
Speaker 1: the Depression, so I'm highly risk averse, Okay, So I
Speaker 1: decided that I wasn't going to lose money, and that's
Speaker 1: what I liked about hedging, and and by its nature
Speaker 1: you try and put positions on that even if it
Speaker 1: goes against you. The downside is is limited due to
Speaker 1: the hedge. Yes, and I put a lot of positions
Speaker 1: on uh, so I was diversified over hedges. I kept
Speaker 1: track of how the hedges did for one period in
Speaker 1: the earlier mid seventies. I kept track of two of them,
Speaker 1: and about a hundred eighty of them were winners, about
Speaker 1: ten of them were pretty close to pushes, and then
Speaker 1: about ten or more losers, and the winners were bigger
Speaker 1: than the losers on average. So that that's how stable
Speaker 1: and solid these hedges were. So with a diversified portfolio
Speaker 1: of hedges, it was almost inevitable would come out ahead
Speaker 1: every month. We only had three down months and those
Speaker 1: are less than one percent, so we could call those
Speaker 1: a push. Let's let's let's talk about black shoals. So
Speaker 1: both with the warrants and with the training options against
Speaker 1: the common stock, you created your own pricing model to
Speaker 1: figure out when the either the warren or the option
Speaker 1: was overpriced and priced relative to the underlying security, which
Speaker 1: essentially was the black shoals option pricing. You invented black
Speaker 1: shoals option pricing before black shoals. How does that come about?
Speaker 1: The way that happened was, Uh, there was a great book,
Speaker 1: one of the first quantitative finance books, called The Random
Speaker 1: Character of Stock Market Prices came out kind of came
Speaker 1: out of m I T. Paul Kotner, revised, updated, and
Speaker 1: I happened to read that book. And they had some
Speaker 1: warrant models in the book, and the warrant models had
Speaker 1: two parameters that nobody knew what to do with. Nobel
Speaker 1: Prizewinner Future Nobel Prizewinner Paul Samson didn't know what to
Speaker 1: do with these parameters, nor did anybody else. And the
Speaker 1: two parameters were the unknown rate of growth of the
Speaker 1: stock and the proper discount rate for the uncertain hay
Speaker 1: off from the warrant or option. And so I understood
Speaker 1: that model. I had actually worked it out myself, and
Speaker 1: then I saw that it was already in the book.
Speaker 1: So I did something everybody already knew. And I thought
Speaker 1: about for a while, and then I said, you know,
Speaker 1: I'm doing hedges that are essentially risk neutral. And so
Speaker 1: is there a world in which those parameters could be chosen? Yes,
Speaker 1: if the world's risk neutral, then I choose the risks
Speaker 1: rate for those parameters. So I stuck the risks right
Speaker 1: THEW and lo and behold, magic, wonderful formula. Tried the
Speaker 1: formula out all kinds of different ways logically to see
Speaker 1: if it did what it was supposed to, and it
Speaker 1: did so. Now I had a formula for value and options,
Speaker 1: which was the future Black Sholes formula. This Black, by
Speaker 1: the way, told me later on when we had conversations,
Speaker 1: that they had figured this thing out in sixty nine,
Speaker 1: but they were rejected for publication a number of times,
Speaker 1: and only when they got some help, I think from
Speaker 1: Samuels then that they were able to get their article
Speaker 1: in print. They got the first one in print in
Speaker 1: nineteen seventy two. Now you've been using this model for
Speaker 1: four or five years at that point, and what what
Speaker 1: was your Well, I was 'mentilally unaware of the world
Speaker 1: of academic finance because I was just doing all this
Speaker 1: stuff on my own myself, like I was used to
Speaker 1: doing when I was a kid, learning science by myself.
Speaker 1: And then the cbo EA Chicago Board Options Exchange decided
Speaker 1: to create list of options, which revolutionized the whole h
Speaker 1: over the counter options in the warrant market. So in
Speaker 1: other words, ZSER trading on an exchange, you don't have
Speaker 1: to go through a specific so that made the cost
Speaker 1: much more more reasonable, and it also allowed you to
Speaker 1: trade a much broader set of vehicles. That that was
Speaker 1: the plan there was supposed to happen in I think
Speaker 1: April of Vree. So I had been operating my hedge
Speaker 1: fund for already almost four years, and I had been
Speaker 1: training options and weren't using the Black Sholes formula among
Speaker 1: other things, and also value well, you were really training
Speaker 1: using the ed Thorpe formula because black Sholes didn't exist,
Speaker 1: and I didn't as far as I knew, that were
Speaker 1: no such people as black controls. So then I was
Speaker 1: sitting there about a month before it opened, and I
Speaker 1: get a brown envelope with a mimeographed article in it
Speaker 1: and a letter from a FELLO named Fisher Black, who
Speaker 1: I said, I as I said, I'd never heard of,
Speaker 1: and he was saying, I'm an admirer of your work.
Speaker 1: And we took the idea from beat the Market the
Speaker 1: hedging idea and use dynamic dging, and we've derived this formula.
Speaker 1: And so I started reading the paper, and I said, gee,
Speaker 1: this looks a lot like my formula, and so I
Speaker 1: programmed it on my little helipacker computer which drew graphs,
Speaker 1: and I drew the curves and they were saying, curves,
Speaker 1: I've been drawn. So I said, oh, it is the
Speaker 1: same formula. Let's let's look at it algebraically. So I
Speaker 1: saw that the algebra translated in the formula. They were
Speaker 1: the same thing. And I realized more. I actually had
Speaker 1: a triple of formulas, and not just one. And the
Speaker 1: triple took care of two cases that were then important
Speaker 1: in the market, your short warrants and long stock and
Speaker 1: you can't get the short sale proceeds used that broker
Speaker 1: pockets it and use it to pay his own debit
Speaker 1: balances down. And the other formula, uh, that was a
Speaker 1: second formula. The third formula was the reverse your short
Speaker 1: stock and long warrants and deprived of the short sale proceeds.
Speaker 1: Black controls assumed the main formula that you got the
Speaker 1: use of the short sale proceeds, which you did, or
Speaker 1: you would when you traded on the exchange. But before
Speaker 1: the cbo E people did not get the benefit of
Speaker 1: using the short sale proceeds. So you needed three formulas,
Speaker 1: and so I had them all and there there's was
Speaker 1: the middle of the three. And there was something else
Speaker 1: about the formula I had, which was it used a
Speaker 1: method that was different. H used something from basically what's
Speaker 1: now high school calculus, just integration. And that means that
Speaker 1: my formula could be applied to probability distributions that were
Speaker 1: different than the long normal distribution, which was the one
Speaker 1: that underlied the Black Rolls formula. So it was a
Speaker 1: more general attack on problems. So you get the package
Speaker 1: from from Black. You see that your secret sauce is
Speaker 1: now out in the public, even though it's not quite
Speaker 1: as comprehensive or robust as your version of it. Do
Speaker 1: you say to yourself, Oh, cats out of the bag
Speaker 1: and this is no longer going to be a money
Speaker 1: maker for I figured I don't have the competitive edge
Speaker 1: that I thought I had. But it turns out that
Speaker 1: the act American finance world was fairly slow moving, as
Speaker 1: was the collection of market makers. So when the CBO
Speaker 1: CBO we opened on day one. We were down there
Speaker 1: with our traders and our formulas and our charts, and
Speaker 1: it was it was wonderful there was no competition really.
Speaker 1: Now you wanted to bring down um small calculators and
Speaker 1: handheld devices, and they really gave you a lot of
Speaker 1: grief about that. Well, it was what we wanted to
Speaker 1: do was bring down hand held calculators so we could
Speaker 1: just punch out the formula values right on the floor.
Speaker 1: But they wouldn't let us do it because it was
Speaker 1: unfair to the old guard that the old Guard didn't
Speaker 1: have this advantage. And we asked if we could use
Speaker 1: walkie talkies and they said no, we couldn't do that either.
Speaker 1: So what we resorted to doing was printing enormous tables
Speaker 1: that had all the possibilities in them. And these tables
Speaker 1: were on z fold paper eleven by seventeen. They were
Speaker 1: probably oh three inches thick because they covered lots of
Speaker 1: cases and prices and options and that had to be
Speaker 1: updated daily correct. We ran. We ran printers four or
Speaker 1: five hours every night, and air freighted our tables to
Speaker 1: our traders, uh initially on the cbo E and then
Speaker 1: on the m X the Pacific and Philadelphia exchanges, so
Speaker 1: it's a day or so behind, but close enough that
Speaker 1: it was an advantage to them. Well, we covered a
Speaker 1: wide enough range of prices so that we caught most
Speaker 1: of the moves for a week or so, and so
Speaker 1: the tables were usually good for a week, and that
Speaker 1: gave you guys a statistical edge. And in the actual
Speaker 1: tables had all our traders had to do was take
Speaker 1: the tables down to the post flip and decide what
Speaker 1: trades they wanted to make. And they what What did
Speaker 1: the CBO we have to say about that? They they
Speaker 1: they let us do that. They didn't recognize the advantage
Speaker 1: it was giving you. I think they did. The Wall
Speaker 1: Street Journal had an article about it in nineteen seventy
Speaker 1: four front page article. And what was the net result
Speaker 1: after the article? Did the any more pushback or I
Speaker 1: think it encouraged people to try to come up to speed.
Speaker 1: So so even after black Sholes is out, even after
Speaker 1: all of the mathematical advantages that you had identified were
Speaker 1: well known, you're still running a big advantage over everybody else.
Speaker 1: And the fund continues to perform very well for the
Speaker 1: next how many years, Well, we ran from late nine
Speaker 1: through the end of eight, and we did fine through
Speaker 1: the whole period. In fact, we got higher rates of
Speaker 1: return in the later period that we did in the
Speaker 1: lower So what made you decide to finally shut that
Speaker 1: fun fun down? Fellow named Rudy Giuliani made me decide
Speaker 1: to set up So, so let's talk about that. Because
Speaker 1: Giuliani and others open and invested an investigation. You, I'm
Speaker 1: going to cut to the end. You did nothing wrong.
Speaker 1: You're completely exonerated. However, this is a giant pain in
Speaker 1: the neck, isn't it. Well, what happened was really Julianni,
Speaker 1: in my opinion, decided that his career would be advanced
Speaker 1: greatly if while he was um ahead of the Southern
Speaker 1: District in New York U S Attorney's of Attorney's Office,
Speaker 1: that if he prosecuted inside or trading, it would be
Speaker 1: a great benefit to his future, which it was, And
Speaker 1: so he found various targets. One of them was Michael Milken,
Speaker 1: who was everybody's target because Michael Milken was on horsing
Speaker 1: the old guard by funding drunk bond people who were
Speaker 1: taking over companies and kicking the old guys out. So
Speaker 1: his his head had to roll. And fortunately for the
Speaker 1: people who wanted to kick him out, they were able
Speaker 1: to find some things to get them with. And Robert
Speaker 1: Freeman of Goldman. Sachs was another guy that they were after.
Speaker 1: I don't recall what the reason was. It turned out
Speaker 1: my partner, Jay Regan, was his roommate at Dartmouth and
Speaker 1: they were pals. And also we did a fair amount
Speaker 1: of trading with Michael Milken and his company, so there
Speaker 1: was a big grade of our offices. The idea was
Speaker 1: to get Jay Reagan to say something that would help
Speaker 1: convict a freeman and Milican. Well, what happened was they
Speaker 1: never got anything from Jay Regan or any of the
Speaker 1: other people in Princeton, but they're able to make enough
Speaker 1: of the case so that it dragged through the courts
Speaker 1: for like two and a half years. Meanwhile, Giuliani split
Speaker 1: and went on to other things. And there was an
Speaker 1: initial trial which and conviction which was thrown out of
Speaker 1: five people in the Princeton office, and then the government
Speaker 1: elected not to retry. And when all it's more cleared, Uh,
Speaker 1: nobody paid any money. Nobody did at any time, but
Speaker 1: they spent ten or fifty million dollars on legal fees.
Speaker 1: So is it fair to say that you're not a
Speaker 1: big fan of Rudy Julian and you should you should
Speaker 1: know that most New Yorkers share your opinion. And I'm
Speaker 1: not being political when I say that people forget. I'm
Speaker 1: gonna let me digress. People forget. Right before September eleven,
Speaker 1: he was cheating on his wife. It was about an
Speaker 1: ugly divorce. His political career had, you know, had plummeted
Speaker 1: nine eleven, resurrected his career if it wasn't for that,
Speaker 1: And you know, the President wasn't very visible then and
Speaker 1: Rudy stepped into the void, and that basically really gave
Speaker 1: him a whole second, a second run on a political career.
Speaker 1: But a lot of New Yorkers, you you asking year, well,
Speaker 1: you know, they got the bombs off, the the squeegee
Speaker 1: guys were gone, and there's no begging in the subway.
Speaker 1: But that second term, he just whatever credibility and goodwill
Speaker 1: he had accumulated, he completely frittered away. So that leads
Speaker 1: to an interesting quote of yours um about money and
Speaker 1: so cess. And I thought this was fascinating quote. Success
Speaker 1: on Wall Street was getting the most money. Success for
Speaker 1: us was having the best life. That is a fairly
Speaker 1: philosophical perspective that is often missing, at least on the
Speaker 1: East Coast. Or in New York. Tell us a little
Speaker 1: bit about that philosophy. Well, what I learned over the
Speaker 1: decades was that it's it's how you live your life
Speaker 1: that matters, and the people that you spend your time
Speaker 1: with that matters, and the stuff you pile up doesn't
Speaker 1: really matter very much. Having money helps, It makes living
Speaker 1: easier pleasanter. You have more fun, better medical care and
Speaker 1: so forth. And your kids and your grandkids, you can
Speaker 1: help take care of them and make sure things are fine.
Speaker 1: But I don't need to own an island in Hawaii.
Speaker 1: I don't need to have villas all over I don't
Speaker 1: need to have private jets. And you know, a lot
Speaker 1: of other people feel the same way. I mean, they'll
Speaker 1: take Warren Buffett for instance. He doesn't spend that much
Speaker 1: money when you consider he is one of the two
Speaker 1: or three richest guys in the world for the longest time. Well,
Speaker 1: what makes him happy is doing his job. He tap
Speaker 1: dances to work, and not a lot of people get
Speaker 1: to do that. And he realizes the same thing as
Speaker 1: he said, it's it's kind of the people you love
Speaker 1: and the people who love you that matter the most,
Speaker 1: to say the least. By the way. Have you seen
Speaker 1: the HBO documentary on Buffett. It's quite charming. He's he's he's.
Speaker 1: I know a lot of people think his stick is, oh,
Speaker 1: he's just being that down home, but he comes across
Speaker 1: is very genuine and he seems like a real person.
Speaker 1: If you get a chance, it's I think it's about
Speaker 1: an hour, it's it's for it. Although you you know
Speaker 1: him personally, so maybe you'll you'll see it differently, But
Speaker 1: I should say I knew him personally. I haven't seen
Speaker 1: it for a long time. But so, um, let's let's
Speaker 1: keep talking about Princeton Newport Partners. That's a better name
Speaker 1: than Convertible Hedge Associates m but that's why, that's why
Speaker 1: we changed it. So so that was simply, oh, this
Speaker 1: is a little uh one partners in Princeton, the other
Speaker 1: partners in Port Beach, and and that's a fair enough name.
Speaker 1: So when you first started it, who were some of
Speaker 1: the early investors. Let's see, there was Bob Evans, who
Speaker 1: later became head of Paramount Studios, was married to McGraw
Speaker 1: and and put out a number of really seminal movies.
Speaker 1: If if memories says um anybody else of note that
Speaker 1: goes Charles Langman of the RITZ. I don't remember much
Speaker 1: about him. Most of these partners were pretty quiet. We
Speaker 1: just kept making money. So then to bother us that
Speaker 1: that those are the best types of partners, especially if
Speaker 1: you keep making them money. Um, So you eventually decide
Speaker 1: to close UM Princeton Newport partners down after the Giuliani
Speaker 1: It was too it was too hard to operate in
Speaker 1: that atmosphere, and it was too difficult to keep reassuring
Speaker 1: them into partners that first of all, he threatened partnership
Speaker 1: with Rico, so they had the fear that through some
Speaker 1: quirk or other, their assets might get confiscated for unknown
Speaker 1: lengths of time. And we knew that there was no
Speaker 1: risk of them losing. But also it was just too harrowing.
Speaker 1: And I said to myself, I don't need more money anyhow.
Speaker 1: So there's a famous quote, and I know I'm mangling this,
Speaker 1: but it's there. There are a few things more dangerous
Speaker 1: than an over zealous prosecutor and run amuck. And I
Speaker 1: think that describes the circumstances with Rudy. Way back when
Speaker 1: you didn't need the money, but at a certain point
Speaker 1: you decided to start PNP. What motivated you to get
Speaker 1: back into hedge fund games? It was let's see Richline
Speaker 1: Partners that I started, and what happened was I took
Speaker 1: a break from and then one of my UM previous partners,
Speaker 1: who was now working for UH, a very large pension
Speaker 1: profit sharing plan, said, you know statistical arbitrage, which we've
Speaker 1: been running, and which I might say, as far as
Speaker 1: I know, we were the first discoverers of back statistical arbitrage.
Speaker 1: You're doing really well. We'd like you to get back
Speaker 1: in this game. So I said, well, I'll take a look,
Speaker 1: and I said, oh, it is doing it quite well.
Speaker 1: Sure we'll we'll run some money for you. And it
Speaker 1: was easy to do. I could do it with about
Speaker 1: three full time equivalence as opposed to a staff of
Speaker 1: eighty which I was using for Princeton Newport Partners. And
Speaker 1: I didn't get the sense you're a big fan of
Speaker 1: managing a large staff. That's a lot of work. It
Speaker 1: turns out what I learned was if you manage five people,
Speaker 1: then you're spending maybe a third or half your time managing,
Speaker 1: and then you've got to find somebody. If you have
Speaker 1: five more people, you've gotta have somebody to help manage them,
Speaker 1: and it sort of grows exponentially. You get this big
Speaker 1: pyramid and you keep getting farther and farther to remove
Speaker 1: from what's really happening. Right, So, so PNP you're doing
Speaker 1: statistical arbitrage? Actually can rich line Partners were doing rich
Speaker 1: Line Partners? And and and what was the performance numbers
Speaker 1: like for rich Line We did about twenty percent a
Speaker 1: year with a little more variability than P m P.
Speaker 1: I don't We didn't make money every month, but we
Speaker 1: made money nearly every month, and it was somewhat event
Speaker 1: driven because the arbitrage opportunities would come along through M
Speaker 1: and A or through what what was the underlying The
Speaker 1: biggest The biggest event that we experienced was in with
Speaker 1: the long term capital management. It turned out that lots
Speaker 1: of people who were competitors now began to bail out,
Speaker 1: and so that caused four or five day dip. We
Speaker 1: had the first loss that we had of any significance.
Speaker 1: It was just three or four and that was a shocker.
Speaker 1: But those those days passed and then we had the
Speaker 1: greatest run we've ever had. We think we made like
Speaker 1: scent in six months. Not to share be and then
Speaker 1: the another hedge fund pnp UM In the twelve months
Speaker 1: ending August, the limited Partners, I guess this is Netta.
Speaker 1: Fees were up over seventy from a market neutral portfolio
Speaker 1: that used less than two to one leverage. That's that's
Speaker 1: Origin Line Partners. Oh so why do I keep calling
Speaker 1: this pnp PPM in so it might be Uh so
Speaker 1: that's the old one. And then Ridgeline took over. So
Speaker 1: back to Ridgeline in you're up se from market neutral,
Speaker 1: very little leverage. How did this come about? And why
Speaker 1: would you ever want to shut that down? Well, the
Speaker 1: reason we had that glorious run was because our competitors
Speaker 1: went away, and as they bailed out, they created opportunity. Okay,
Speaker 1: they disrupt the market places they exit, and that creates
Speaker 1: arbitrage opportunities. And they also don't control the excursions from
Speaker 1: favalue as much, so the excursions got bigger and so
Speaker 1: more more profits to be had. How much longer did
Speaker 1: you keep Ridge Line open after we went from actually
Speaker 1: nineteen two two thousand and two, and then I shut
Speaker 1: down not because we're doing badly, but because we're doing
Speaker 1: just so so, making maybe ten percent a year so
Speaker 1: and the opportunities had had just gone away. Is that
Speaker 1: is that basically I think that there was more competition
Speaker 1: and so the deviations from fair value that we're exploiting
Speaker 1: word is big. And at that point I said to myself,
Speaker 1: you know, why am I doing this? I'd rather just
Speaker 1: manage my own money in a more passive way and
Speaker 1: enjoy life. So let's talk a little bit about that.
Speaker 1: Passive investing has caught on a great deal. UH. It's
Speaker 1: a long time coming. It's finally, um, finally made its
Speaker 1: way to a number of people. Black Rock is one
Speaker 1: of the big underwriters of ETFs in passive investing, not exclusively,
Speaker 1: but they're up to five trillion. Vanguard is probably best
Speaker 1: known as the inventor of the passive index, or at
Speaker 1: least the first company that was created to roll out
Speaker 1: a passive index that people can invest in. They're now
Speaker 1: up to four trillion. Have have mom and pop investors
Speaker 1: finally figured out that for them, a passive investment is
Speaker 1: better than stock picking or market timing, some of them have.
Speaker 1: So you make a convincing argument that if you cannot
Speaker 1: demonstrate your edge, your advantage over a passive uh index,
Speaker 1: then then you shouldn't be doing anything but a passive
Speaker 1: index too. It seems perfectly logical and rational to me.
Speaker 1: Do you get pushed back from people about that? No,
Speaker 1: what I did is probably a lack of alertness discussing it,
Speaker 1: So I have to that's gonna. That leads me to
Speaker 1: a question I didn't ask before, but I have to.
Speaker 1: You seem incredibly grounded and a regular, low key sort
Speaker 1: of guy. You took the California Test of of um
Speaker 1: Mental Maturity. It's an i Q test as a kid.
Speaker 1: You had the highest score they had ever seen. How
Speaker 1: do you manage to keep high school at your at
Speaker 1: your high school, but in the world, not in the world. Okay,
Speaker 1: so that makes it I'm gonna that makes the question easy.
Speaker 1: How do you keep your ego in check? But still
Speaker 1: you all joking aside? You invent card counting, you invent
Speaker 1: statistical arbitrage, you invent um paired training. Go down the
Speaker 1: list of things that you did that are really unique
Speaker 1: in the world of finance as an investor, how do
Speaker 1: you manage to keep your ego in check? What you
Speaker 1: have to do is look all the other things that
Speaker 1: people do. There's so many great things that people are
Speaker 1: doing all the time. And if you meet any individual,
Speaker 1: the person sitting next to you on a bus or
Speaker 1: a plane or whatever, that person will be able to
Speaker 1: do things or no things that you can't know or
Speaker 1: can't do. Maybe they can sing better, maybe they know
Speaker 1: a language you don't know. Maybe they know how to
Speaker 1: um fix a car. Just you know, one thing after another,
Speaker 1: identify the car has been been rigged against you. And
Speaker 1: you think that's basically helps you keep your ego in check,
Speaker 1: helps anybody keep their ego and check. I find it
Speaker 1: hard to understand why so many people have such big egos. Okay,
Speaker 1: that's that's a fair enough thing there, especially those people
Speaker 1: who haven't created a body of accomplishments. I kind of
Speaker 1: think that maybe the big ego is a substitute for
Speaker 1: feeling like they're falling short here and there, a little
Speaker 1: over compensation. So that's fair enough. Um. In in the book,
Speaker 1: chapter you say, beat most investors by indexing, and chapters one,
Speaker 1: can you beat the market? Should you try? Um? When
Speaker 1: should somebody try to beat the market? Well, my simplified
Speaker 1: views go something like this bit roughly, the three kinds
Speaker 1: of investors. There are guys who don't want to really
Speaker 1: do any work. They just want to have their money grow.
Speaker 1: Those people should be thinking about indexing makes perfect sense.
Speaker 1: Then there are people who really are interested in the
Speaker 1: market and it's kind of fun for them. Those people,
Speaker 1: if they want to learn more, should go out and
Speaker 1: have their go and try to make some money. But
Speaker 1: they shouldn't use the bulk of their resources to do this.
Speaker 1: They should just a fun account, yeah, exactly, And then
Speaker 1: if they find something that really works, then they can
Speaker 1: start putting more money into it. They'll find that most
Speaker 1: of the time they haven't really found anything that really works,
Speaker 1: a little fooled by randomness, exactly. And then there's a
Speaker 1: third group, which are the professional people, some of whom
Speaker 1: actually get on edge, most of whom don't, but some
Speaker 1: of whom do. And those people get a start somehow
Speaker 1: in the market. Just like I gotta start with an
Speaker 1: options formula, and so I have an edge, I get in.
Speaker 1: I build an organization which is small, and it gradually grows,
Speaker 1: It gets more and more skills, it gets into more
Speaker 1: and more kinds of investing. So you basically get over
Speaker 1: the hurdle and get yourself established. If you can do
Speaker 1: that as a professional, then you're kind of on your
Speaker 1: way to collecting what people call alpha access return. Then
Speaker 1: there's a fourth group, which I don't have much interest in,
Speaker 1: and those are the ones who are simply asset gathers
Speaker 1: and they're they're in there to collect feest and get rich,
Speaker 1: but there's nothing really very interesting what they do. That's
Speaker 1: a You've described a huge part of what takes place
Speaker 1: in finance. Most of it people who are trying and
Speaker 1: not getting anywhere. People have just given up and said
Speaker 1: I'm going to go passive. And people who are are
Speaker 1: don't have an a special advantage, but they're just a
Speaker 1: commulating assets and manage them, managing them in some better
Speaker 1: or worse way. Referring to indexes in past of investing,
Speaker 1: people are now describing, oh, this has gotten too large,
Speaker 1: it's a bubble, that it's distorting price discovery. Passive indexes
Speaker 1: are going to cause the next crash. What what do
Speaker 1: you make of that? Well, suppose that half of all
Speaker 1: the list of equities in the United States we're in
Speaker 1: index funds. Then the other half would not be. The
Speaker 1: half has not be that would not be is a
Speaker 1: lot bigger than the market was ten or twenty years ago.
Speaker 1: So I don't see that putting half of the UM
Speaker 1: stocks into the next funds is going to cause any problem,
Speaker 1: except there's one thing. There's the question of the float
Speaker 1: in different companies. Some companies are more closely held than others.
Speaker 1: So you might have a company in which sevent is
Speaker 1: closely held, it never trades and only up for trading.
Speaker 1: So I believe that the index funds, the SMP Vanguard anyhow,
Speaker 1: has changed so that they use a proportion of the
Speaker 1: float rather than a proportion of the total market cap.
Speaker 1: And they've compared how that tracks with UH if they
Speaker 1: had been able to use the proportion of total market
Speaker 1: cap rather than proportion of the float, and the tracks
Speaker 1: has been extremely closed so far, So so far, no problem.
Speaker 1: I think it was Andrew Lowe and might Taste said
Speaker 1: you could get down to passive ten percent active. That's
Speaker 1: enough for price discovery as long as it's sufficient liquidity.
Speaker 1: So there could theoretically be a ways to go if
Speaker 1: he's right sure on the case. There is supposed that
Speaker 1: you had in an exponse not forgetting about the float issue,
Speaker 1: which which might cause some divergence. Well, ten percent of
Speaker 1: the current market is probably a good deal larger than
Speaker 1: the market was fifty years ago. Sure, so you still
Speaker 1: have price discovery even even if that. Here's another quote
Speaker 1: of yours that I really like. Whether or not you
Speaker 1: try to beat the market, you can do better by
Speaker 1: properly managing your wealth. Explain that where was that quote,
Speaker 1: let's take I don't know it was here on my page.
Speaker 1: I think it's from this book, and it's it's in
Speaker 1: the context of of why more people it's either twenty
Speaker 1: five or chapter twenty six about why more people should
Speaker 1: be doing passive. Whether or not you beat the market,
Speaker 1: you could still do better, you know what. Let's see
Speaker 1: if I can find that, I'll tell you what I
Speaker 1: think it is. I think it has to do with
Speaker 1: the fact that there are what Buffett calls fee collectors
Speaker 1: or toll takers. And the upshot is that when you
Speaker 1: think about fees collected by advisors or managers, and also
Speaker 1: the losses due to active trading, both market impact and commissions,
Speaker 1: it adds up to roughly a couple of percent a
Speaker 1: year drain on assets. So if you could make let's
Speaker 1: say ten percent a year in a stock index one
Speaker 1: long term, anything can happen in the short term, then
Speaker 1: maybe you're making eight percent a year before taxes if
Speaker 1: you're paying all these fees and tolls. So just shifting
Speaker 1: to passive investing, get your extra two percent for basically
Speaker 1: no work, and compound that over forty years, and that
Speaker 1: really adds up. Using the UM rule seventy two for instance,
Speaker 1: roughly thirty six years. Actually thirty five closer, because the
Speaker 1: rule varies from seventy two depending what the interest rate is.
Speaker 1: Using the rule of seventy two, in a little less
Speaker 1: than thirty six years, you have twice as much money
Speaker 1: if you invest this way then if you pay the
Speaker 1: two percent toll, So it makes a big difference. We
Speaker 1: have been speaking to Edward Thorpe, professional investor, trader, gambler, mathematician. UH.
Speaker 1: If you want to find out more about the works
Speaker 1: of ed Thorpe, you can read his most recent book,
Speaker 1: I'm and for All Markets Beat The Dealer Beat the
Speaker 1: Markets are both classic books. You may have to hunt
Speaker 1: around to find find them. UM. If anybody wants to
Speaker 1: find anything else you've written, these are really the main
Speaker 1: places to look. Is there to what? What is the website?
Speaker 1: It's uh Edward Ohthorpe dot com, Edward oh Thorpe dot com.
Speaker 1: It also has another second website links to it, a
Speaker 1: Man for All Markets dot com. If you enjoy this conversation,
Speaker 1: be sure and check out our podcast AFTRAS, where we
Speaker 1: keep the tape rolling and continue to discuss all things investing.
Speaker 1: Check out my daily column on Bloomberg at Bloomberg View
Speaker 1: dot com. You can follow me on Twitter at rid Alts.
Speaker 1: We love your comments, feedback and suggestions right to us
Speaker 1: at m IB podcast at Bloomberg dot net. I'm very Ridholts.
Speaker 1: You're listening to Masters in Business on Bloomberg Radio. If
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Speaker 1: A d R dot org resolve faster. Welcome to the podcast.
Speaker 1: Thank you and for doing this. I'm really enjoying this
Speaker 1: conversation and I appreciate you being so generous with your time. Uh,
Speaker 1: you've led a fascinating life. You've also led a well
Speaker 1: lived life. Which are some of the things you talked
Speaker 1: about in the book. It's not about money, it's not
Speaker 1: about accumulating toys, it's not about just piling up junk.
Speaker 1: It's spending time in a way that matters. As you know.
Speaker 1: I totally agree. I read the book. I know. So,
Speaker 1: so let's let's talk a little bit about some of
Speaker 1: um my favorite questions. I ask these of all my guests,
Speaker 1: and we often find some interesting things. What do you
Speaker 1: think is the most interesting or important thing that people
Speaker 1: don't know about your background? I would say that I'm
Speaker 1: consistently rational over a rare wide range of things. And
Speaker 1: you meet a lot of people who are I recall
Speaker 1: locally rational. That is, they do things very sensibly and
Speaker 1: logically in some areas, and then there's a total breakdown
Speaker 1: in some other areas where they act very strange and
Speaker 1: don't use good sense. So, in other words, the logical
Speaker 1: part of their brain only limited to certain subjects. Um. Well,
Speaker 1: I hope we all endeavor to be logical across logical
Speaker 1: growth everything. But I think a lot of people, um
Speaker 1: don't behave that way. Let's let's talk about some of
Speaker 1: your early mentors. Who are the people who really influenced
Speaker 1: you and helped you along your career. Well, I was
Speaker 1: obviously deprived in that way, so I don't have much
Speaker 1: in that category. My father help me a lot from
Speaker 1: ages three to five. Okay, that was enough to really
Speaker 1: get me started. How about colleagues you worked with? Who? Who?
Speaker 1: Who did you really enjoy working with at at various schools.
Speaker 1: I think the most fun I had was working with
Speaker 1: Claude Shannon at M I T. Because he was a
Speaker 1: very creative thinker, and we could just sit there and
Speaker 1: talk about the widest range of topics, and we kind
Speaker 1: of played off each other, and we we thought alike
Speaker 1: about so many things, but we also had different experiences
Speaker 1: in background, so it made a really good team. And
Speaker 1: you ended up creating was it the Wearable Computer? With him? Well,
Speaker 1: it turned out, yes, we're trying to beat Roulette, and
Speaker 1: so we built a computer to wear on the body
Speaker 1: that was hidden and this computer head switches to input
Speaker 1: information about the Roulette wheel, ball and rotor as they
Speaker 1: were moving, and then it would make an immediate prediction
Speaker 1: as to what was going to happen. So, so you
Speaker 1: know the arrangement of numbers and colors on roulette wheel,
Speaker 1: you're you have a certain spin in one direction of
Speaker 1: the ball and the rotors in the other direction, and
Speaker 1: you basically were able to calculate as long as I
Speaker 1: could get a timing fairly accurate when the ball is
Speaker 1: moving this way, we can have a pretty comfortable guess
Speaker 1: as to the cluster of outcomes. Yeah, basically we were
Speaker 1: able to time the ball and the rotor, so we
Speaker 1: know what speed they were both going at, and the
Speaker 1: computer would know where they were at any time, and
Speaker 1: then it could forecast roughly where the ball was going
Speaker 1: to fall. And there are a lot of uncertainties in
Speaker 1: the wheel that are delivered. The ball will bounce off
Speaker 1: little veins on the side, it will spatter over the
Speaker 1: viders between pockets. But it turned out the prediction, the
Speaker 1: predicting was so strong that we got a forty percent edge,
Speaker 1: which is hute. Yes, so gigantic, you can't believe it.
Speaker 1: So you mentioned Warren Buffett, any other investors influence the
Speaker 1: way you approached investing or was it pretty much all
Speaker 1: based on your own research and math? It was pretty
Speaker 1: much thinking for myself, which was both good and bad.
Speaker 1: It was good because I thought of things that I
Speaker 1: wouldn't have thought of if I had been taught the
Speaker 1: formal academic way. It was bad because I had to
Speaker 1: rediscover some things that I would have known easily had
Speaker 1: I taken, you know, formal training. So let's talk about books.
Speaker 1: This is one of the favorite questions of of listeners.
Speaker 1: What are some of your favorite books, be they finance
Speaker 1: or nonfinance, fiction or nonfiction? What do you what do
Speaker 1: you enjoy reading? What have you enjoyed reading. Well, that's
Speaker 1: a very broadcuestion. I probably have currently in my libraries,
Speaker 1: both here and at home, ten thousand books. And I
Speaker 1: haven't read every page of every book, but I've read
Speaker 1: some pages in every book, and I've read some books
Speaker 1: in their entirety. And human knowledge is so vast that
Speaker 1: I can't just pick out a few books and say
Speaker 1: these are the great books from all those thousands and
Speaker 1: thousands of books. And by the way, besides the ten thousand,
Speaker 1: there are others that I've read that aren't in my library,
Speaker 1: many others. And then so I would say that I
Speaker 1: look at things kind of like Charlie Monker, And it's
Speaker 1: multiple mental models in which you focused on certain ideas
Speaker 1: in certain areas, Like here's one from psychology. There's something
Speaker 1: called the Meyer Briggs personality index, and so, uh, there
Speaker 1: are four four dimensions they type people on the first
Speaker 1: one is easy extrovert, introvert. And so if there are
Speaker 1: four dimensions and there are two choices, then you have
Speaker 1: sixteen pure types of people. None people aren't typically that's simple.
Speaker 1: They don't fall into those categories. But you can get
Speaker 1: a surprising amount of information by estimating what type of
Speaker 1: person is um But there's they're sensing. Sensing versus feeling
Speaker 1: is another dimension, and so a sensing person is very
Speaker 1: aware of everything that's going on around him, and a
Speaker 1: feeling person is a highly emotional person and so forth. Anyhow,
Speaker 1: it's an easy way to have a first cut thought
Speaker 1: about people, and it teaches you that people are very different,
Speaker 1: but there's no good or no bad in the various types.
Speaker 1: They're just different and helps you understand so that that's
Speaker 1: a simple mental model. Or there's anchoring in the stock markets,
Speaker 1: something I learned to my pain very early. I bought
Speaker 1: a stock at forty it went down to twenty I
Speaker 1: didn't want to let go till I came back to
Speaker 1: forty a little. Just let me get break even exactly,
Speaker 1: the losing cries of losing investors everywhere. Four years later,
Speaker 1: I get break even, I get out, but of course
Speaker 1: there's inflations, so I haven't really gotten out even, and
Speaker 1: I've deprived myself of investing the money somewhere else where
Speaker 1: it might have been done a lot better, and so forth.
Speaker 1: So the price I bought at forty is a price
Speaker 1: particular only to meet. There's no relation to anything going
Speaker 1: on in the outside world, and so to be anchored
Speaker 1: at that prices uh idiocy. And and yet people do
Speaker 1: it all the time because they're they're subjective perspective takes
Speaker 1: over from a more global perspective. So you have ten
Speaker 1: thousand books. I'm looking at a handful of books over here.
Speaker 1: Nothing really leaps out, as these aren't necessarily these are
Speaker 1: the five seminal books you have to read. But what
Speaker 1: books did you find interesting? Or or let me make
Speaker 1: it more recent, what's the last book you read that
Speaker 1: you really enjoyed? There are five six struggling Okay, well,
Speaker 1: one of them I enjoyed quite a bit. Was a
Speaker 1: well known one Philip Tatlock's super Forecasters, so by the
Speaker 1: way previous guests on the show, and absolutely a delightful
Speaker 1: human being. Yes. In fact, I was at a conference
Speaker 1: a few years ago that he and I both spoke at,
Speaker 1: so I kind of got to know a little bit
Speaker 1: more about his thoughts and ideas there. But yeah, very
Speaker 1: interesting piece of work, well worth knowing. Another one was
Speaker 1: The Accidental Accidental Superpower by guy named Peter's Eye Hand,
Speaker 1: and he's a Stratford type. By the way, I might
Speaker 1: say that if I read a book and I find
Speaker 1: it interesting, it doesn't mean that I'm endorsing that book
Speaker 1: kind of percent. It's just that I'm finding things that
Speaker 1: are worth thinking about in that book. And I may
Speaker 1: may come out with a different conclusion, but he's provoking
Speaker 1: a thought process and make you think about an issue. Hey,
Speaker 1: I hadn't really considered this quite in this context. That's fascinating. Yes,
Speaker 1: So I'd rather read a book that doesn't just reinforce
Speaker 1: opinions I already hold. I want a book that's going
Speaker 1: to add something that I don't know that's information, if
Speaker 1: it's new, if it's the same stuff over and over,
Speaker 1: that I've already thought about. That's not information, so more
Speaker 1: confirmation biases and how you select books. All right, So
Speaker 1: that's to give us one more and we'll let you
Speaker 1: off the hook with this. Okay. There's a one by
Speaker 1: Paul Wilmock. It's called The Money Formula, and it's it's
Speaker 1: just it's just out and it's about how quants have
Speaker 1: help screw things up in the financial world. Screw things up.
Speaker 1: Well they I don't know if that's the right phrase.
Speaker 1: They they've certainly helped mix things up and change things.
Speaker 1: But I would argue for the better, and I think
Speaker 1: you are going to be an agreement with that. Well,
Speaker 1: perhaps I put that too simplistically, but um, what I
Speaker 1: think part of his thrust is that the cell side
Speaker 1: on Wall Street has taken quant product us to use
Speaker 1: to market to people, and they haven't been discriminating about
Speaker 1: the products that they've marketed, a collateralized mortgage obligations being
Speaker 1: a case in point. Well, any tool could be used
Speaker 1: for good or evil, to say the least, but you know,
Speaker 1: it's it's anything is only a sausage is only as
Speaker 1: good as the meat that goes in. Well, you know,
Speaker 1: take coals, both good and evil. It pollutes, but it
Speaker 1: also keeps us warm and supplies this energy. It got
Speaker 1: us to the point where we can now start looking
Speaker 1: at less polluting energy options. And you know, when we
Speaker 1: look at that transition that's taking place not just with
Speaker 1: cold and natural gas, but quantitative is replacing the old
Speaker 1: qualitative for a reason because it's demonstrably superior in so
Speaker 1: many ways. I think that's a fair statement. I agree. Um,
Speaker 1: So you you started in this industry, in the finance
Speaker 1: industry forty plus years ago. Um, what it? What do
Speaker 1: you think is the most significant change that's taken place
Speaker 1: over that time? There's more than one. One of the
Speaker 1: big ones has been the computerization and the quantification of investing.
Speaker 1: That's really two big ones, right, So technology is everywhere
Speaker 1: and applying it mathematically seems to be the dominant thing.
Speaker 1: What else? The second has been the aggregation of money
Speaker 1: management into huge firms that are offering what seemed to
Speaker 1: be choices but are largely just playing vanilla in different packages.
Speaker 1: Is that is that still going on? Or is that
Speaker 1: now getting bigger and bigger? I think that the big
Speaker 1: firms are getting relatively bigger. Uh. The thing I read
Speaker 1: about hedge funds. Recently on a psyche bi got very riskful.
Speaker 1: I think I've heard of him was the number of
Speaker 1: new hedge funds is smaller than the number of Hatche
Speaker 1: funds that are disappearing, but that the total assets under
Speaker 1: management for hedge funds is increasing over three trillion dollars.
Speaker 1: So you know, Jim, I'm fond of repeating Jim Chanos's quote.
Speaker 1: He said when he started in hedge funds thirty years ago,
Speaker 1: there were a couple of hundred hedge funds. They all
Speaker 1: created alpha. Now there's almost ten thousand hedge funds and
Speaker 1: those same thirty hedge funds of the alpha generators. And
Speaker 1: there is some truth to that. There is. It is
Speaker 1: not a true Gaussing distribution. That's very much a fat
Speaker 1: head in a long tail um and not not everybody
Speaker 1: who's running a hedge fund is capable of putting up
Speaker 1: the sort of numbers that you put up. Well. In
Speaker 1: the nineties, I could find hetche funds when I didn't
Speaker 1: feel like managing money of my own. I could find
Speaker 1: hedge funds that we're making annualized. And then in the
Speaker 1: two thousands they kept dying. The numbers drop for Cliff
Speaker 1: and I want to say it's Simon Lacks book The
Speaker 1: hedge fund He said in the book, the losses hedge
Speaker 1: funds suffered in O eight oh nine had wiped out
Speaker 1: all of their previous profits in total. It didn't wipe
Speaker 1: out manager's fees, but it wiped out all the all
Speaker 1: the profits and other than those top let's call it
Speaker 1: five hedge funds, it's certainly not thirty these days. The
Speaker 1: balance really don't seem to be generating any sort of alpha.
Speaker 1: So you have a skewed when you look at the returns.
Speaker 1: They're so skewed not by the big hedge funds, but
Speaker 1: by all the rest that are under performing. Well. I
Speaker 1: think it's probably a first apement to say that all
Speaker 1: the money that have ever been put into hedge funds
Speaker 1: and then put it into X funds. The investors who
Speaker 1: did that would be far better off than they actually were.
Speaker 1: Renaissance technologies accepting in a handful of others. But that
Speaker 1: you could you could very well be right. Um, let's
Speaker 1: let's go to the next question. Tell us about a
Speaker 1: time you failed. And I know you wrote a few
Speaker 1: times in the book about things he failed and what
Speaker 1: you learned from the experience. Well back when I was
Speaker 1: in high school, I heard about a chemistry contest. It
Speaker 1: was the Southern California Chemistry Teachers Contest, and I happened
Speaker 1: to love chemistry, and I was at a school where
Speaker 1: basically there weren't any academics. But I decided that I
Speaker 1: would study for this test because if I were able
Speaker 1: to win it, I could choose a scholarship to a
Speaker 1: place I could not otherwise afford to go, like calchech
Speaker 1: or UC Berkeley or whatever. So I trained up for
Speaker 1: this test really hard, and the typical winning score was
Speaker 1: about Basically there was a couple of hundred of the
Speaker 1: best high school chemistry students from southern California would compete
Speaker 1: each year, and I competed as a fifteen year old
Speaker 1: as a junior. People who were basically seniors who were
Speaker 1: seventeen and eighteen years old, and I thought I was
Speaker 1: going to get the test were higher. So the best
Speaker 1: score by far they had ever seen. And I took
Speaker 1: old tests that my chemistry teacher had assembled over the years,
Speaker 1: and I was scoring that way on the old tests
Speaker 1: one after another. I went into the test and I
Speaker 1: just rolled through the exam. I got just about everything right,
Speaker 1: and then I came to the last part, which was
Speaker 1: a lot of calculating, and they allowed slide rules that year,
Speaker 1: and they didn't say they were necessary, only that you
Speaker 1: could bring one if you wanted to. Turned out the
Speaker 1: tests were designed so that only with a good slide
Speaker 1: rule could you complete that part of the test. I
Speaker 1: had a tense cent slide rule I brought along was worthless.
Speaker 1: It was so inaccurate that there was no chance of
Speaker 1: even bothering. So I did what I could by hand,
Speaker 1: and I completed I think eight hundred and seventy three
Speaker 1: points on the test. I got eight hundred sixty right,
Speaker 1: and but um, I was just crushed by the fact
Speaker 1: that I didn't have a good slide rule, but I
Speaker 1: hadn't prepared and covered that base properly. So that that
Speaker 1: taught me that one of the things you wanted to
Speaker 1: do is look at things redundantly when you can and
Speaker 1: try to cover all the downside possibilities that might occur
Speaker 1: and eliminate them. So that worked in very well later
Speaker 1: when I played in the casinos and when I ran
Speaker 1: hedge fund. Did you end up taking the test again
Speaker 1: when you were a senior Um, that's a good interesting question.
Speaker 1: I asked him if I could, and they said, no,
Speaker 1: you can only take it once. So I thought about that,
Speaker 1: and I found that there was a physics physics test
Speaker 1: that was also given by It was analogous to the
Speaker 1: chemistry test who was given by the physics teachers, and
Speaker 1: another couple of hundred of the best students southern California
Speaker 1: took that. So I crammed for that test. I only
Speaker 1: heard about a short time before, and I wasn't able
Speaker 1: to finish all the studying that I wanted to do,
Speaker 1: but I was able to win that one. Really, so
Speaker 1: and you that, Um, so, that's like a tuition scholarship.
Speaker 1: And you I had a choice of cal Techer Berkeley.
Speaker 1: I found out I wanted to go to cal Tech,
Speaker 1: but I couldn't because I didn't have the money to
Speaker 1: live in your passage, you know. So you went to Berkeley?
Speaker 1: And how did that work out? Well? It worked out
Speaker 1: just fine. I got a full scholarship, and after a
Speaker 1: year at Berkeley, I changed the U c l A
Speaker 1: because I had more friends down there, and I went
Speaker 1: through the UC system and everything went was fine for me.
Speaker 1: You're physically fit, you seem to be in pretty good shape.
Speaker 1: Tell us what you do to stay physically fit and
Speaker 1: what do you do to keep mentally fit? Well physically.
Speaker 1: I've been a long distance I had had been a
Speaker 1: long distance runner for about twenty five years. I used
Speaker 1: to run marathons and have sent ten ks in five ks.
Speaker 1: I'd run about forty miles a week, and then I
Speaker 1: hurt my back weightlifting, so now I just walk. When
Speaker 1: when did you stop running around? What you How old
Speaker 1: were you? I stopped running when I was sixty eight,
Speaker 1: ran my last marathon in New York in and so
Speaker 1: that's twenty years ago. But you're not eighty eight. No,
Speaker 1: I'm doing the math. You sixty eight? Well, seventeen years ago? Seven? Okay?
Speaker 1: And you do you say you do you still lift
Speaker 1: weights or yes? I go to the gym with a
Speaker 1: trainer twice a week. I walk about ten to fifteen
Speaker 1: miles a week, and then I do some hiking in
Speaker 1: the hills. What do you do to to keep mentally active? What?
Speaker 1: What do you enjoy? What? What keeps your focus these days?
Speaker 1: I'd like I still like problems in finance, so I
Speaker 1: take time after work on some of them. I also
Speaker 1: black math problems and chest problems and so forth, play
Speaker 1: word games, um, travel, read a lot, talked to really
Speaker 1: interesting people. Okay, I have a very smart family and
Speaker 1: so they're very stimulating. That sounds like I have a
Speaker 1: I have grandchildren who are all very talented. Three of
Speaker 1: them are triplets, and they're all out of I t Oh, really,
Speaker 1: so you're you're busy all the time. There's there's no
Speaker 1: depth of things to keep you occupying. The last time
Speaker 1: I was born, I think was when I was eleven.
Speaker 1: That's a fair fair statement. So if the triplets and
Speaker 1: M I T or any other millennials or recent graduates
Speaker 1: were to come up to you and say, uh, Ed Thorpe,
Speaker 1: I'm thinking about a career in finance or investing, what
Speaker 1: sort of advice would you give them? I'd say, play
Speaker 1: to your strengths and your skills, do what you like
Speaker 1: to do. And if you do what you like to do,
Speaker 1: then you're gonna do better than if you do something
Speaker 1: that you think you should do but don't want to do.
Speaker 1: And try to plan your life so that you're spending
Speaker 1: your time with good people. That sounds like that sounds
Speaker 1: like good advice. And and my final question what do
Speaker 1: you know today about investing that you wish you knew
Speaker 1: fifty years ago when you were getting started. I would
Speaker 1: like to have known that I could have bought Berkshire
Speaker 1: Hathaway at twelve instead of it instead. So so that's
Speaker 1: the key thing is precience about the success of Warren Buffett.
Speaker 1: I will tell you a lot of people would have
Speaker 1: liked to buy Berkeshire Hathaway under a thousand. So even
Speaker 1: twelve is even even when you got in, is better
Speaker 1: than when most people got in. Um. Ed Thorpe, thank
Speaker 1: you so much for being so this is this has
Speaker 1: been an absolute delight we have been speaking with Ed Thorpe.
Speaker 1: I I will pound the table on a couple of
Speaker 1: his books. A Man for All Markets is his most
Speaker 1: recent book. It's really it's more than than a biograph
Speaker 1: fee It's a history of what's happened in finance over
Speaker 1: the past half century, including the rise of hedge funds,
Speaker 1: the rise of quants, the rise of all sorts of things,
Speaker 1: told from a unique perspective of somebody who not only
Speaker 1: beat the deal or and beat the markets, but as
Speaker 1: as Um, learned a lot of secrets about life that
Speaker 1: that many of us should learn um. If you enjoy
Speaker 1: this conversation, be sure and look up and inch or
Speaker 1: down an inch on Apple iTunes, SoundCloud overcast, or Bloomberg
Speaker 1: dot com and you could see the other hundred and
Speaker 1: fifty or so such conversations we've had. We love your comments,
Speaker 1: feedback and suggestions right to us at m IB podcast
Speaker 1: at Bloomberg dot net. I would be remiss if I
Speaker 1: did not thank some of the people who helped to
Speaker 1: put this podcast together. Michael Batnick is my head of research.
Speaker 1: Taylor Riggs is our producer. Booker Medina Partwada is our
Speaker 1: audio engineer who helps make these things sound as good
Speaker 1: as they actually do. I'm Barry Ridhults. You've been listening
Speaker 1: to Masters in Business on Bloomberg Radio. Masters in Business
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