#92 Ed Thorp and Claude Shannon

What I learned from reading Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone. ---- Claude Shannon was as close to a sure thing as existed [2:53] The beginning of information theory [7:11] Project X [9:09] introduction to Ed Thorpe [15:05] using math and physics to beat Las Vegas [18:03] Ed Thorp and Claude Shannon meet [20:45] testing Thorpe’s Blackjack theory [26:00] The core of John Kelly’s philosophy of risk can be stated without math. It is that even unlikely events must come to pass eventually. Therefore, anyone who accepts small risks of losing everything will lose everything, sooner or later. The ultimate compound return rate is acutely sensitive to fat tails. [28:23] I’d be a bum in the street with a tin cup if the markets were efficient. —Warren Buffett [44:30] how Claude Shannon begins studying the stock market [46:45] Claude Shannon and Henry Singleton [48:16] why and how Ed Thorp started investing in stocks [49:49] Thorp starts a hedge fund and starts working remotely [52:49] Ed Thorp meets Warren Buffett [54:20] An acid test of Princeton/Newport’s market neutrality came in the Black Monday crash of October 19, 1987. The Dow Jones index lost 23 percent of its value in a single day. Princeton/Newport’s $ 600 million portfolio shed only about $ 2 million in the crash. Princeton Newport’s return for the year was an astonishing 34 percent. [59:36] the implosion of Long Term Capital Management [1:07:00] The thing you should do is the opposite of what you feel you should do. –Jim Clayton [1:09:10] A quote from 1738: A man who risks his entire fortune acts like a simpleton, however great may be the possible gain. — Daniel Bernoulli [1:13:00] Claude Shannon: A smart investor should understand where he has an edge and invest only in those opportunities. The methods Claude Shannon used to invest [1:17:10] ---- Founders Notes gives you the ability to tap into the collective knowledge of history's greatest entrepreneurs on demand. Use it to supplement the decisions you make in your work. Get access to Founders Notes here. ---- “I have listened to every episode released and look forward to every episode that comes out. The only criticism I would have is that after each podcast I usually want to buy the book because I am interested so my poor wallet suffers. ” — Gareth Be like Gareth. Buy a book: All the books featured on Founders Podcast

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Senra?

  Much useful thought in data collection has supported the idea that neither securities markets nor betting systems prevent some ventureurs from gaining highly satisfactory, way above average results through unusual skill. William Poundstone's book Fortune's Formula collects much of the modern evidence on this point in a highly entertaining way. Moreover, the book contains an account of the Lollapalooza investment record of Claude Shannon, pioneer scientist in information theory, that makes Shannon's methods look much like those of Charlie Munger. Okay, so a few weeks ago, when I was reading through poor Charlie's Almanac, I came across that paragraph.

• 0:45David Senra?

  Charlie Munger is one of the smartest people I've ever come across, so when he recommends reading a book, it's kind of a no-brainer to just order it immediately. So, the full title of the book is Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street, and it was written by William Poundstone. So, for today, there's a lot of different characters in the book, and I'm going to focus on two of them: Claude Shannon and Edward Thorp. And both of them also have biographies, which will be featured in the next few weeks on Founder's Podcasts. Now, a note about the format of this podcast, okay? Fortune's Formula is wildly entertaining, but it's written in a very odd and unique way. So, some of, a lot of the stuff I'm going to share with you, they're going to seem

• 1:27David Senra?

  like non-sequiturs, because I wouldn't describe Fortune's Formula as like a cohesive narrative. It's more like 30 or 40 individual essays that kind of tie together this theme. It ties together, it ties together this theme that there are people in the world that can actually have better-than-average performance through unusual skill. And so, they're, they're separated by like chapters, but I almost consider them like essays, because some of the chapters are like a page, maybe two pages, maybe three pages, they're very short. So, what I did is I just extracted my highlights and notes I took pertaining to the overall theme of the book, and specifically the applications of that theme by Claude Shannon and Edward Thorp.

• 2:10David Senra?

  And I think we're going to learn a lot today, but this, this story is insane and crazy, and you'll see even more when I cover, I'm going to cover Edward Thorp's autobiography next week. It's called A Man of All Markets: The Sky Is An Insane Life, as is Claude Shannon. Okay, so let me go ahead and jump on right in. I'm going to start with Claude Shannon. I'm going to go back and forth between Claude Shannon and Ed Thorp. And we have to start with understanding why Claude Shannon is so famous. It's because he invented information theory, which is basically the foundation of our entire economy and the entire world we live in right now. And then specifically how they apply what they learned as academics to investing investments and making a ton of money. Okay, so it says, "Life is a gamble. There are few sure things.

• 2:55David Senra?

  Claude Shannon was as close to a sure thing as existed. Shannon had done what practically no one had done since the Renaissance. He had single-handedly invented an important new science. Shannon's information theory is an abstract science of communication that lies behind computers, the internet, and all digital media. It is one of the few times in history where somebody founded the field, asked all the right questions, and answered them at once. There were many who compared Shannon's insights to Einstein's. Others found that comparison unfair, unfair to Shannon. Einstein's work had virtually no effect on the life of the average human being. The consequences of Shannon's work were already being felt in the 1950s.

• 3:40David Senra?

  In our digital age, where if people were asked to characterize Shannon's achievements, are often apt to be at a loss for words. It's like saying how much influence the inventor of the alphabet has had on literature. Shannon's supreme opus, information theory, turned out to be one of those all-encompassing ideas." I do agree with Munger when he talks about like why he reads so many biographies, because he says, "I think when you are trying to teach the great concepts that work, it helps to tie them into the lives and personalities of the people who developed them." So I've been doing that, obviously, on the podcast for a long time, but I want to focus a little bit about Shannon's early life and personality. He says, "Shannon was born in Michigan in 1916. He grew up in a town of barely 3,000 people.

• 4:24David Senra?

  There was inventing in the family blood. Thomas Edison was of distant relation. Shannon's grandfather was a farmer and inventor who designed an automatic washing machine. Claude built things with his hands almost compulsively from youth to old age."

• 4:41David Senra?

  The ability to see clean and elegant solutions to complex problems distinguish Shannon throughout his life. He, a little bit about his personality. He was a shy, courteous man, seemingly without envy, spite, or ambition. He did his best work alone. He slept when he felt like sleeping and would spend hours at the kitchen table thinking. So when I read that part, I had two thoughts. One, how often does that happen in modern life? Like, how, let me ask you the question. Like, how much do you, how much time do you spend just thinking? No input from anybody else but your own mind. And then the second thing I thought of was, this echoes what we learned when we studied Thomas Watson, the founder of IBM.

• 5:25David Senra?

  And IBM is famous for having the word "think" as one of their company mottos. And in his biography, he talks about, like, if he had something he couldn't figure out, he wouldn't go to the office. He would just sit at his kitchen table and think for several hours till he figured it out, and then he would go and go about, like, continue his day. I think that's severely missing from modern life. I'm speaking my own self, too. And something that I think is extremely valuable, just dedicating some time to see what your thoughts are actually are, to like, to download the computation that your brain is doing automatically. I think to do so, you need, you know, some empty time where you're not having input from anybody else but your own mind. Okay, continuing back to Shannon. He would write eccentric memoranda to himself.

• 6:08David Senra?

  One of the memos is a list of sometime passions. This gives you an idea that he was, he was, some people say, like, he was hard to focus. It's not, I don't, I didn't take that. I think he just allowed, gave himself the freedom to focus on whatever was most interesting to him at that time. So the list of sometime passions, it says it includes chess, unicycles, juggling, the stock market, genealogy, running, and musical instruments.

• 6:33David Senra?

  So, fast forwarding in his life, in 1936, he got his Bachelor of Science at the University of Michigan. And the note I have myself is here is like, this guy's obviously genius, and even geniuses sometimes don't know what they want to do in life. And right around the time he graduates college, Claude Shannon was explaining the same thing. And he had a rather fortuitous event. He had little notion of what he wanted to do next. He happened to see a postcard on the wall saying that the Massachusetts Institute of Technology, MIT, needed someone to maintain its new computer, the differential analyzer. Shannon applied for the job. So this is a very important point in his life, because this is going to be the beginning of information theory. What Shannon discovers here creates the foundation for our modern life,

• 7:16David Senra?

  and, that's not, that's not the only reason I'm telling this, it also creates the foundation for his wild success that he has in investing. He'll talk about what he learned from developing information theory and how he studied the stock market. They were almost, I think he uses the word like they're almost inseparable. Alright, so let's go first to before he develops that. So he says, "Shannon understood that the differential analyzer was two machines in one. It was a mechanical computer regulated by an electrical computer." Remember, there's no such really, there's really no such thing as what we feel is the modern computer at this time. "Thinking about the machine convinced Shannon that electrical circuits could compute more efficiently than mechanical linkages.

• 7:58David Senra?

  Shannon envisioned an ideal computer in which numbers would be represented by states of electrical circuits." So he is fantasizing about a world in which we live in right now. "There would be nothing to lubricate and a lot less to break. As an undergraduate, Shannon learned Boolean algebra, an unusual subject for engineers. Boolean algebra deals in the simple notions like true or false, and logical relationships such as and, or, not, and if." And why is that important? Because any logical relationship may be put together from a combination of these elements. Shannon posed himself the problem of encoding each of these logical ideas in an electrical circuit. To his delight, he succeeded.

• 8:43David Senra?

  In effect, so what was the result of all this work? He proved that an electrical digital computer could compute anything.

• 8:52David Senra?

  So I want to take a small tangent here because there is cameos for all sorts of historical figures in this book and I'm only going to mention a few but like I said this is one of the most unique books. I can definitely see why Charlie Munger recommends it and so I want to, I think this story about this thing called Project X also illustrates like Shannon was just a very, like he was a man of many talents and what I think he did a good job of is taking all the different experiences and things he learned in life and combining them together in unique ways later on. So Project X is an example of that. So what is Project X? It says, "In the midst of Shannon's personal crisis, he was going

• 9:32David Senra?

  to divorce at the time, he was offered a job at Bell Labs. Shannon accepted." This wasn't the first time he was offered a job at Bell Labs. People say Bell Labs because at the time AT&T had a major, they called it like a benign monopoly that it was like a, it was a place for really smart people to be able to run experiments and never worry about running out of money. So Shannon's working there, a bunch of other smart people are there, but he accepted the job at this time. He says, "And once again Shannon turned his polymorphic genius to something completely different. It was called Project X and at the time it was classified. The only reason we know about it because it was declassified like two decades, three decades later in 1976." So what was Project X? "Project X

• 10:15David Senra?

  was a joint effort of Bell Labs and Britain's Government Code and Cypher School. It had a scientific pedigree rivaling that of the Manhattan Project. For the British-American team included not only Shannon but also Alan Turing." So you've probably heard that name before, I'll tell you, you'll realize why, in case you haven't heard of Alan Turing before, why he was important. I'll get there in one second. He says, "They were building a system known as SIG SALLY" and that's an acronym and that's how I pronounce it. I have no idea if that's how it's pronounced. "SIG SALLY was the first digitally scrambled wireless phone." This was also used during World War II, which is why the entire project exists. It says Alan Turing cracked the German Enigma cipher,

• 10:56David Senra?

  allowing the Allies to eavesdrop on the German commands messages, which also led to helping the Allies defeat the Nazis in World War II. The point of "Six Sally" was to ensure the Germans could not do the same. Part of Shannon's job was to prove that the system was indeed impossible for anyone lacking a key to crack. Shannon, now this is the important part, why I'm bringing this up, because it ties to everything else that we're talking about today. Shannon later said that thinking about how to conceal messages with random noise motivated some of the insights of information theory. So we see this point, and I just want to stop here for a second, because I see this point over and over and over again when reading biographies. There's like past learnings and experiences wind up playing

• 11:40David Senra?

  an unexpected role in your future. So what the lesson I've learned from all these biographies is like, you need to collect as much of these experiences and learnings as you can, because it's unpredictable how you can apply them in the future. And that can open up opportunities that are unavailable to anybody else that did not have that unique set of experiences or learnings. Alright, so back to Shannon. "A secrecy system is almost identical with a noisy communication system," he claimed. "The two lines of inquiry were so close together that you couldn't separate them." Shannon informed Turing that he was working on a way of measuring information, and this is going to sound familiar to you, because it's the world we live in. He used a unit called the BIT.

• 12:22David Senra?

  BIT was short for binary digit. So I'm gonna, I'll go into more about information theory when I read Claude Shannon's biography in the next few weeks. So one thing I do, I'm going to skip all that part now, because I gotta get back to Ed Thorp and the whole point of this book. But something I wanted to bring, to point out to you right now is that... It was, a lot of people criticized Shannon because, you know, he started this new field and then kind of just abandoned it. And this is Shannon, there's two things that are gonna happen to what I'm about to read to you. Two, he explains why he did that, and also talks about his other varied interests, which kind of relate to his first point, right? So he says Shannon, this was Shannon

• 13:04David Senra?

  on his near abandonment of the field he created. And he says, "I just developed different interests. As life goes on, you change your direction." This is another insight, in my opinion, of his personality. He allowed himself to work on and think about whatever that was most interesting to him at that time. Now, what is something else that he was interested in? And I'm currently going through, so I consider podcasts, especially when you're learning, you're using them for education, like, to me, they're just courses, right? So, "Founders" is just a course on the history of entrepreneurship, right? And the foundation of this course we're using is biographies of entrepreneurs. That kind of makes sense, right? I'm currently listening to and using Lex

• 13:47David Senra?

  Friedman's podcast on artificial intelligence as a course that I'm taking to learn more about artificial intelligence, because I like, it's talked about constantly. It's used, there's no concrete definition, there's different, like, a lot of different opinions. I'm like, okay, I don't know anything about this, so what's a really effective way to learn about it rapidly? And my, like, the outcome of my decision was like, well, let me just listen to and take notes on this, these podcasts. And the foundation of that podcast and that course is just interviews with people working in the field currently, right? So, I'm interested in this because I'm learning about it right now, or attempting to learn about it, I should say. But what blew my mind when I read

• 14:27David Senra?

  this book is Claude Shannon was interested in artificial intelligence 63 years ago, which is also why I think it's important to study, because a lot of the things people say today are really just things that people were saying 60 years ago. So that's why I was like, oh, you know, any time you see that, that's a good indication that a lot of, there's a lot of mimicry, and not as much learning. And so I think, like, I need to dive into that. But anyways, one of the interests that pulled Shannon away from information theory is artificial intelligence. And Shannon organized the first major academic conference on the subject in 1956. So this blew my mind. Alright, so now I want to switch back, I'm gonna go back and forth. And I want to introduce you to Ed Thorp.

• 15:11David Senra?

  And like I said, next week, I'm currently, I've already started reading his biography, which is mind blowing, and I'll cover that on next week's podcast. Alright, so this is an intro into Ed Thorp, a little bit about his personality and a little bit about his early life. Alright, so let's go to the book. "One friend described Ed Thorp as 'the most precise man I've ever met.' This zeal for measurement was evident from his earliest youth. Ed did not utter his first words until he was nearly three. From that moment on, Ed conversed almost like an adult." So the first time his parents heard him speak was in a complete sentence, which is kind of mind blowing. So it says, "From that point forward, he conversed like an adult." "Six months after that, after his first sentence, Ed knew how to count to a million.

• 15:54David Senra?

  He could read and had a near photographic memory. Growing up in hard times, Ed turned his wits to making money. He bet a grocer he could total customers' bills in his head faster than the grocer could use, could using an adding machine. Ed won, earning ice cream cones for his performance. While both parents were working, Ed and his younger brother were latchkey kids. The absence of parental supervision facilitated an interest in blowing things up. Ed whacked homemade nitrocellulose," not sure if that's how you pronounce it, "with a sledgehammer to blow holes in the sidewalk. He built pipe bombs to blow craters into cliffs. He built a gunpowder propelled rocket car."

• 16:36David Senra?

  Interesting enough, in his, um, in his biography, he calls himself a "misfit," which I love. "In spring 1955, Thorp was a physics undergraduate student at UCLA. He made do on a budget of $100 a month. His rent was $50 a month plus four hours of work per week. Since time was money, Thorp put in 50 to 60 hours a week of classes and study. He read books on psychology for tips on how to learn faster." So this is actually one of the, I've been not only reading his biography, but I've watched and taken notes on, I don't know, like three or four of his talks. And they're on YouTube. And this is something I learned from Ed Thorp.

• 17:15David Senra?

  He was fascinated with increasing a skill per hour, which I've never thought about before. So he wanted like, for his example, for example, he wanted to optimize things like how fast he could learn something per hour, or how much money he could make per hour. Not just like, I'm not talking about, oh, this is like the salary they're offering me. Literally taking how much money he tries to make at like in Las Vegas and dividing it on like a per hour basis. That's a really unique idea that I want to, I want to like maintain in my own mind and kind of like adopt to my own life. Like, what's the fastest I can do something and still get like the result I want from it? I think it's very, it's applicable to almost anything. Alright, so he's a grad student, he's a physics grad student, and they're at a party and they

• 18:00David Senra?

  start having a conversation. And this is where Ed gets interested in trying to use math and physics to beat Las Vegas. And again, I have to set the foundation because the same ideas that he learns here, he applies to investing later on. Alright, so the conversation turned to ways, to ways to make easy money. Someone mentioned roulette. The group was unanimous in the conviction that gambling systems are worthless, meaning way, like, there's no point in trying to figure out a way to beat them, to beat like a Las Vegas game. The discussion had to do with physics. Are roulette wheels so perfect that predicting likely numbers is impossible? Thorp and most of them arrived at the conclusion that yes, that was the case. Thorp had the most original argument.

• 18:44David Senra?

  He said you could make money either way. If the wheels are physically perfect, simple physics can predict where the ball is going to go. If the wheels have flaws, some of the numbers ought to be favored. So he decides to try to solve this impossible, quote unquote, impossible problem. And this is interesting that he says that you can make money either way because he's famous for, he's like the father of quants, one of the first people to, to, to start a quantitative hedge fund. And he calls his hedge fund a market neutral, market neutral hedge fund, which kind of echoes like what he's saying here about, about roulette, that like you could figure out how to make money in any environment. So while he's studying, he's trying to figure out how he can apply physics and math to beating roulette.

• 19:27David Senra?

  But while studying roulette, he comes across a paper that studies the odds of blackjack. He's like, oh, that's interesting. Like, I won't need, because he needs like a machine. He winds up building like one of the first like portable computer devices and he builds it to try to beat roulette, but. He decides, "Hey, I could start studying to see if I can figure out a system to beat Blackjack too." So it says, "Until the computer," and this thought he has is going to lead his life into intersecting with Claude Shannon. So he says, "Until the computer age, it was impractical to calculate the exact probabilities in Blackjack and many other card games. After a couple of weeks, he concluded that the problem was too big to solve by hand. Then he realized that he might be able to do the computations on MIT's mainframe computer.

• 20:10David Senra?

  It was an IBM 704, a real programmable electronic computer. It had some free time during the summer break," meaning, remember, these were all shared, like you had to book time on it. Thorp, so he's like, "Okay, I'll use that," but he didn't know how to use a computer, so he has to first teach himself how to program. So it says, "Thorpe taught himself the FORTRAN programming language and programmed the computer himself. Thorpe decided to publish his system." Okay, so he wants to write a paper, he wants to have it published by other academics, but there's a problem. And this is where Thorpe and Shannon are going to meet. Articles had to be submitted by a National Academy member. And there was only one Academy member at MIT who was a mathematician.

• 20:54David Senra?

  That was the famous Claude Shannon. So we're past the point where Shannon already invented information theory. He's obviously famous at this time, and he's working on other things. So it says, "Thorpe called Shannon's secretary and made an appointment to meet him. Before Thorpe went in, the secretary warned him that Shannon had only a few minutes to spare. He did not spend time on subjects that did not interest him." And so Shannon, Thorpe tells him about his paper on Blackjack. Shannon and Thorpe are about to agree to work together. So Shannon agrees to submit the paper on Blackjack. "Are you working on anything else in the gambling area?" Shannon asked. Thorpe told Shannon about the roulette idea. Shannon was riveted.

• 21:40David Senra?

  He was possibly more interested in the roulette scheme than the Blackjack system because there was a gadget to build. They spoke for several hours. By the time they adjourned, Thorpe had inadvertently set one of the century's greatest minds on yet another tangent. It was agreed that Shannon and Thorpe would collaborate on building a roulette prediction machine." Let me back up. What a great sentence. Thorpe had inadvertently set one of the century's great minds on yet another tangent. Shannon said the best place to work would be his home. The device they built was the size of a cigarette pack. It contained 12 transistors and slipped into a pocket. The user needed to measure the initial position and velocity of the two moving objects. And in the case of roulette, that was the ball and the rotor.

• 22:26David Senra?

  It says to do that, the user mentally picked a reference point. When a point on the rotor passed this reference point, the user clicked a toe-operated switch concealed in his shoe. So this is like some Ocean's Eleven stuff. I mean, it's pretty crazy. They actually go to Vegas and test this out. And it's bananas. From this data, the device predicted the segment of the wheel in which the ball was most likely to land, hence where you should be betting, right? Now, this next section is going to give you an insight into how their minds worked and the level of thought that they put into this. So it says, "The roulette computer was finished by late spring 1961. In a dry run lasting a few hours, Shannon and Thorpe multiplied a virtual bankroll of a few hundred

• 23:10David Senra?

  into an impressive, though fictional, $24,000. Thorpe did a full dress rehearsal in Shannon's workshop. They used the finest wire practical, barely as thick as a hair, to connect the earphone to the pocket unit, because it's going to play a series of musical notes in Thorpe's ear. And each note corresponds with a place on the roulette wheel. And Thorpe then knows where to bet, where's the most likely part where the ball's going to land. Says, "The wire was glued to his skin with gum. Then the wires were painted to match Thorpe's skin and hair." So they take this machine to Vegas. And keep in mind, this was really fascinating.

• 23:53David Senra?

  Now, because of the work of Thorpe and Shannon, there's actually laws passed in the 80s by Congress to outlaw what they're doing. But at this time, using a device to predict roulette was perfectly legal. Now, it's legal, but part of the, a large part of this book is that a lot of these betting systems that people are trying to, to, uh, to beat, or you're not only like they're gangsters and mobsters and thugs that are trying to do this, but also the people that own the casinos are also extremely violent people, which we'll get to in a minute. Uh, so it says, "But the group knew well, even though it's legal, they knew well aware that the casino people would take a dim view on their experience, on their experiment.

• 24:34David Senra?

  Unlike the blackjack system, this scheme used a device," meaning the blackjack system, they, they, like, there's no way they could prove that you're counting cards, right? They'll just kick you out of the casino, which they do, do do later. But with the roulette system, like, you can't hide a device. If they capture you and search you, they're gonna find it. So, "There was no deniability. Claude stood by the wheel and recorded the numbers that came up on a piece of paper. This was a smokescreen. Claude was really timing the ball and rotor with his toe switches." So, he's got switches in his feet that correspond and play that, that musical note in Thorpe's ear. "The computer relayed its musical tone prediction to the better, who pretended not to know Claude." The thin, here's the problem I ran into. "The thin wires kept breaking.

• 25:17David Senra?

  Every time that happened, they had to go back to their rooms for repair. They brought soldering iron, soldering irons with them. These problems prevented any serious gambling." So, it was actually unsuccessful. Uh, "The collaboration between Shannon and Thorpe ended with this Las Vegas trip. That same month, Thorpe got a job offer from the mathematics department of, of New Mexico State University." So, he winds up having to move across the country. So, around this time, Thorpe's like, "Well, I can, I just focus on my blackjack theory because then I don't have to worry about a machine. It's just, it's a lot easier. I could just do the math in my head." He's the one that kind of, that is credited for inventing card counting. He wrote a bestselling book called Beat the Dealer, that's back in the 60s, that, that, uh, sold well over a million copies.

• 25:59David Senra?

  Alright, so, this is where Thorpe gets the idea, like, "Let me test my blackjack theory, but I'm broke, I don't have any money." So, uh, he's at a conference, he says, "Ed Thorpe was presenting a version of the paper Shannon submitted to the National Academy. Thorpe titled it Fortune's Formula: A Winning Strategy for Blackjack." Now, you see where the, where, uh, the author, Poundstone, got his idea for his title of his book. And so he makes this, this speech, it gets a lot of attention. He says Ed decides to test his theory in a casino. He needs someone to bankroll him. Now, this is where I left a note to myself. What's fascinating to me is Ed Thorp becomes an unbelievably wealthy man, right? But at this time, he doesn't even have any money. He's just an academic.

• 26:40David Senra?

  He's not doing that well. He got a little bit of money from, from like an advance of the book or some royalty of the book. It winds up selling over a million copies like years later. It's popular at the time, but people still buy it to this day is my point. And what I found fascinating at this point is I just told you like he becomes one of the most successful investors ever, right? He was 32 years old before he ever, he ever thought about finance. To me, that's, knowing that is like really inspiring.

• 27:11David Senra?

  And why is that inspiring? Cause he winds up becoming one of the most successful investors of all time and he gets what many people would consider like a later start in life. So. Um, anyways, as a result of this, as a speech, gamblers from all over the country began calling Thorpe's hotel to ask for copies of his paper. Some wanted to finance Thorpe in the casinos for a share of the profit. Thorpe wanted to accept one of the offers. It would be fun to try the blackjack system out in a real casino. Thorpe discussed the situation with Shannon. Now, this is another very important point of this entire book. Shannon suggested that Thorpe use Kelly's formula to decide how much to bet.

• 27:52David Senra?

  So another person that worked at Bell Labs was this guy named John Kelly and he's most famous uh, for creating something called the Kelly formula, called the Kelly criterion. It has a bunch of names, right? But this is something that, let me just, it's a mathematical form, uh, equation, right? And I'm obviously not going to explain that on the podcast and to be frank, there's no way I even understand it. But the core of John Kelly's philosophy of risk can be stated without math and it's as follows. Uh, it is that even unlikely events must come to pass eventually. Therefore, anyone who accepts small risks of losing everything will lose everything sooner or later.

• 28:33David Senra?

  This is important for investors, entrepreneurs, for everybody in life. The ultimate compound return rate is acutely sensitive to fat tails. Fat tail is just another way to state an unlikely event. Okay. So Shannon.

• 28:46David Senra?

  Thorp, it's rumored Buffett, Munger, a bunch of other people, Mark Spitznagel, who I did on a podcast on the Dow of Capital, they all use and are know about Kelly's criterion. There's also a book Thorp wrote about it, if you wanted to learn more, or you could just read the Wikipedia page too, but also, I think I'm gonna order the book, it's fascinating. But, this is extremely important part of the entire book, because the reason this book is important is because it's essentially like a book about the difference between entrepreneurs and academics, and the people that practice and live in the real world, entrepreneurship,

• 29:28David Senra?

  are the people that live in like fantasy land, in theory, academics, right? And so on one side in this book, you have Shannon, Munger, Buffett, Thorp, and they're saying, the idea, like, yes, you can, you can gain an unusual advantage in life through unusual skill, on the other side, you have people like Paul Samuelson and other economists and academics are saying, no, the market is perfectly efficient, no one can make more money, like you're an idiot for trying, right? And, what the entrepreneurs, and it's really important how you apply this to your own life, is they, the reason that Buffett and Shannon and all these people wind up being successful is because they understood the Kelly formula, the Kelly criterion, the fact that you are a fool if you accept any risk, however small you think it is, of losing

• 30:13David Senra?

  everything. And I'm gonna tell you later on, a lot of the academics that criticized Thorp and Buffett and the rest of these guys, wind up, starting a hedge fund, long-term capital management, which is famous, and not understanding the Kelly formula, and blowing up and needing to be bailed out by the US Treasury. So that, I'm not really ruining the point of this podcast, but I think understanding that now is gonna, it makes sense why I'm tying all these, these things that, that seem to be unrelated, together. That is a huge important part of understanding, like, what we're all trying to learn here, that you are, it is unacceptable to accept even a tiny, tiny, tiny risk of losing everything. To be a successful entrepreneur, you have to first survive.

• 30:56David Senra?

  If your business blows up, you're done. You're out of the game. That's, that's, so that's of course, the very first thing that you should avoid. That's what Shannon's avoiding, what Thorpe's avoiding. And see how they're, this is what's fascinating to me. They're applying this to blackjack years before they apply it to the stock market. So it's that same, what I mentioned earlier, how you need to collect all these learnings, experiences in your life, because you never know what you could apply it to later. This idea, they were just tinkering around with casino and casino games winds up making them wealthy. Shannon, and to Shannon's point, like, less wealthy, because he has a fantastic rate of return, but he also didn't really care about accumulating wealth. He had a varied interest. So anyways, I'll get there. Alright, so it says, "Thorpe decided that the best offer was the biggest one.

• 31:40David Senra?

  A syndicate of two wealthy New Yorkers was offering $100,000," now this is, would be over a million dollars today, "to take on the Nevada casinos. Thorpe dialed the number on the letter and asked to speak to Emmanuel Kimmel." So this is the only part of the podcast where I'm going to get into like, all these underworld figures, because it's fascinating. And if you're interested in that kind of stuff, I'd recommend reading the book. Again, don't even listen to me. Charlie Munger's telling you to read it, you should probably read it. So this is an intro to Manny Kimmel. Emmanuel Kimmel is known as Manny Kimmel. And I'm gonna, he's also tied to this other gangster. Literally, these are mafia guys. Zwillman, I don't know how to pronounce his name, but there's a reason I'm bringing that up. I'm not just doing it because I found it entertaining.

• 32:24David Senra?

  Alright, so first, let's talk about Manny. Because to understand Thorpe and the wild, crazy life he has, you have to understand some of the people he associated with. He didn't know they were mafia. Like, he was kind of, he found out later and then he started, he stopped associating with them, obviously. But he was very much, you know, the land of horse betting and casinos and, and marketing manipulation, also the kind of crazy stuff is, you know, there's going to be a lot of, you know, organized crime in it. Alright, so Manny Kimmel. Manny would bet on anything, at any time, as long as the odds were to his liking. Kimmel taught himself calculus, trigonometry, and probability theory. Or at least, he said he had. And I don't know if he ever did. "Within his brain was a combination of street smarts and autodidactic book learning that

• 33:09David Senra?

  could swiftly analyze propositions." He was, you know, rather smart, though. I just don't know if he knew all the other stuff. "He memorized sucker bets. One of his favorites was betting that two people in a group would have the same birthday. Kimmel's victims would take even money. Kimmel knew he had an edge whenever there were more than 22 people. Kimmel's edge was not always strictly mathematical and not always strictly ethical." So, let me go back to Thorpe and Kimmel. "Kimmel appeared to be interested only in finding out whether Thorpe's system worked. He showed no interest in Thorpe's paper, and as far as Thorpe could tell, the math was Greek to Kimmel. Kimmel demanded that they play each other.

• 33:53David Senra?

  Thorpe flew to New York each Wednesday to play cards against Kimmel. He won regularly, convincing Kimmel of his playing skills and the merit of the counting system. Kimmel occasionally presented Thorpe with a gift of a salami." I just included that, because when I read it, it made me laugh. Like, alright, thanks for beating me, here's some salami. Alright, now, this is another, I keep saying this, how many crazy surprising things there are in this book, but this is one of really crazy ones. So, Kimmel is involved with this guy named Swilman. And he is definitely a mafia guy. And, the reason I put this in the story is because Thorpe is gonna run into some of these people.

• 34:34David Senra?

  And, I think, just something you should learn in life, that I think is obvious, like, there are some people in life that you should just not mess with. And I always go back to like, that book I did on Cornelius Vanderbilt, where, yeah, he's a businessman, he's an entrepreneur... Yeah, he's the wealthiest person in the world at the time, but he also will break the law and try to have you killed if you go against him. If you remember what he did to, in the book, Tycoon's War, when, when somebody thought they had the good idea of confiscating some of the ships. He went and sent assassins and mercenaries and other countries' armies after him. So, you just have to understand that in life, like, there's just certain people that don't care about rules, and if you mess with them, like, you could have consequences, which

• 35:19David Senra?

  is what makes what Thorpe is doing right now extremely dangerous. And this is an example of somebody, I'm gonna call him Wilman, because it's Z-W-I, we're gonna call him Wilman. Wilman is, he has a racket, a numbers racket, which is a way for people to gamble, which is very popular at the time for, for the way certain mafia figures make money. So, it says, "A minor thug named Leo began roughing up Wilman's numbers runners. He was given a warning. Leo responded that he'd kick Wilman in the balls to teach him a lesson. Wilman insisted on handling this insult personally. He tracked Leo to a bar, to a bar, and shot him once in the testicles."

• 36:03David Senra?

  So, Wilman has all these other, like, he's extremely wealthy, he made money off prohibition, running, running illegal liquor into the United States. He has a bunch of gambling businesses, he owns like, part owner in like, a bunch of parking lots, like, all kinds of stuff. So, something happens where Wilman dies, and it looks like he committed suicide, most likely, he was murdered by other mafia members, okay? Now, the reason I'm bringing this up is because when Wilman dies, Manny is then, he benefits from Wilman's death, well, let me just read it. "Wilman's death left Manny Kimmel holding a portfolio of businesses, okay? Some legitimate and some not.

• 36:45David Senra?

  Some owned by Kimmel and others apparently in partnership with Wilman's estate and other murky entities. Wilmore had an idea for parlaying this wealth. That idea was to try to beat, to gamble in not only the Las Vegas casinos..."

• 37:01David Senra?

  But also the stock market. Now, the reason I bring this up is because this was one of the most surprising facts in the book, is that the businesses that Willman and Manny owned together, it starts out as like really successful, they own like sixty something parking lots in New York City, and I think the revenue on the parking lots is something like a million, over a million and a half dollars a day or something like that. In one of the strangest twists in life, that business winds up becoming Warner Communications, which is today known as Warner Media, which is a huge media conglomerate.

• 37:32David Senra?

  That thing just blew my mind, how like these things could start as so unrelated and over time morph into something unpredictable. Okay, so back to Manny, that's the end of Willman in the story. Let's go back to Manny and Thorpe. So they go to Vegas. Kimball pulled out a wad of bills and counted out ten thousand dollars for Thorpe. Thorpe started gambling. They won five hundred dollars in fifteen minutes, and then the dealer pressed the secret button on the floor. So I'm gonna skip over major parts of the book, but what's happening here is, they don't care if they can prove you're counting cards, or if you have a system for beating blackjack. When you're too successful, especially at this time, they immediately start cheating,

• 38:15David Senra?

  or kicking you out of casino, or in some cases, trying to kill you. So, eventually, they're all identified, they're identified at all the casinos they go to. So they walk into a casino and they're immediately like pushed out. So, they make money, though. And again, Manny wanted to start with a hundred thousand dollars. Thorpe was the one that brought it down to ten, right? You can imagine how much money they would've made if they would've started with a hundred thousand dollars. But this is a, so once they become too well-known in Vegas, it terminates their experiment. Now here's the result of that. By Thorpe's estimation, they had built ten thousand dollars into twenty-one thousand dollars in about thirty hours of play.

• 38:58David Senra?

  Had and that was after Kimmel wasn't listening to Thorpe and wind up burning through $11,000 like he didn't know what he was doing. So essentially it should have been $32,000 but it was 20 they made 20 they made $11,000. So it says, uh, this is how profitable per and then this is how Thorpe thinks about it. He breaks it down profitable per hour. Thorpe's system, uh, $11,000 profit in 30 hours is $366 per hour playing blackjack. If Manny didn't mess it up, they would have made $733 per hour. So it's safe to say that, um, that, that Ed Thorpe has found a way to indeed beat the dealer. And not only

• 39:40David Senra?

  is the system effective, but he's also using, uh, the Kelly system, Kelly criterion, uh, to figure out how much to bet. So I want to talk to you a little bit more about that real quick. Um, and again, it's, it's, it's just states that even in unlikely events must come to pass eventually. So it says, given a favorable betting opportunity, the Kelly system promises maximum profit and protection against ruin. The reason I think this is important because according to Ed Thorpe and others, this is the single best system to build wealth. Okay. All right. So given a favorable betting opportunity, the Kelly system promises maximum profit and protection against ruin. These goals may sound antithetical. It is worth note looking at how the Kelly formula works in a casino

• 40:21David Senra?

  situation. The Kelly system avoids gamblers ruin quite simply. It is a proportional betting system. That means that each wager is scaled to the current size of the bankroll. Since you bet only a prescribed fraction of what you currently got, you can never run out of money. When you lose repeatedly, as will happen in any game of chance, bets scale down in proportion to your diminished wealth. The exponential growth of wealth in the Kelly system is also a consequence of proportional betting. As the bankroll grows, you make larger bets. Assuming you have an edge, and that is the biggest, biggest, biggest part, one

• 41:03David Senra?

  of the biggest parts, maybe, no, let me say it's the biggest part. Assuming you have an edge, in the long run, you will win more than you lose. This is important to investors. It's important to entrepreneurs. There's no point in starting a business if you don't feel you have an edge. Buffett, Munger, Thorpe, and Shannon all agree. If you don't have an edge, you don't bet and you don't compete.

• 41:26David Senra?

  Now, what's so special about the specific system that Kelly devised? The answer is simply that the Kelly system grows wealth faster than any other. Alright, um, so, let's go back to Ed Thorp. At this point, it's funny to me, because if you really think about the life story of Ed Thorp, he's a kid that's born poor, and yet he goes on to learn and build more wealth than he could ever spend. And the reason he moves across the country, stops working with Shannon, is because he needed the money. New Mexico state offered a salary of about 50% more than Thorpe was making. Living costs would be much less as well. The money weighed heavily on Thorpe, as he and his wife were now raising a family. So Thorpe accepts the offer. Thorpe writes a bestselling book called Beat the Dealer, and then he starts using his counting system to make some side money. So now he's going to other, now he's on his own.

• 42:10David Senra?

  He's not with Manny and all these other mafia guys. He obviously realizes they're in the mafia by now. So, as doing some press for Beat the Dealer, he gets profiled by a magazine. And it says, "The 1966 magazine profile on Thorpe contained probably the first mention of the Kelly system in a general publication." And he says, "One of the most ingenious aspects of Thorpe's strategy today involves his application of the Kelly system. A mathematical theory for the management of capital conceived by Bell Labs research scientist." That's John Kelly, we already mentioned earlier. "It is this element of play which ensures him against going broke. The man or woman who constantly overbets, even in favorable situation, is certain to

• 42:53David Senra?

  do so." So, this is the problem, though. He's drawing a lot of attention to himself, so even if they don't, they're not recognizing him because he's walked into their casino before, he starts, people obviously in the gambling industry are gonna hear about his book. And so, even though Thorpe is playing on his own, the casinos fight back. And this is what I mentioned earlier, like, there's no rule in life that's saying that other humans are gonna play by the rules. And if you don't understand that, you could put yourself in a very dangerous situation, and Ed Thorpe almost died doing so. It says, "No interference from casinos was becoming an unrealistic assumption. While playing at one casino, Thorpe was offered a drink. After drinking it, he noticed he had problems concentrating. Thorpe staggered up from the table and got to his room. His eyes were dilated.

• 43:38David Senra?

  It took about eight hours for the effect to wear off." I know of three beatings Thorpe said. One was a well-known blackjack card counter and he had a lot of his face caved in. Another guy I know had his arms held and every time he tried to catch his breath, they'd punch him in the solar plexus. So he's like, alright, this is stupid. I've gotta find a different way to do this. And he realizes, this is where Shannon and Thorpe start applying what they learned from gambling to the stock market. And they believe that the idea that markets are perfectly efficient to be false. Again, I've kind of talked about this a lot over the past few weeks because Buffett mentions it over and over again in his shareholder letters, Munger talks about it. And, well, we'll get into it here.

• 44:23David Senra?

  He says, "I'd be a bum in the street with a tin cup if the markets were efficient," Warren Buffett once said. Buffett had already made a name for himself with a successful hedge fund and had founded Berkshire Hathaway when Paul Samuelson, this is the guy that popularized efficient market theory, wrote that "a loose version of the efficient market or random walk hypothesis accords with the facts of life." The truth is, this is Paul Samuelson still talking. "The truth is," this is what he thinks. He says, "This truth, it must be emphasized, is a truth about New York, Chicago, and Omaha." Samuelson was apparently felt that Buffett's success was best filed with a small minority of unexplained cases. So this is my problem with Paul Samuelson.

• 45:08David Senra?

  Is, he had like, the book says he had spirited advocacy for the efficient market hypothesis that swept the academic community in 1960s and 70s. He winds up winning a Nobel Prize for this theory. My problem is, Samuelson was a liar. Because he's talking about, oh, he's very condescending to people that don't agree with it. He calls them fools and everything else. And yet, so he's talking about like, this is stupid, like, you're dumb for believing this. And he's preaching that you should just, you know, just, you shouldn't even try. And, but, so that's what he's saying with his mouth, but what is he doing with his actions? He's buying Berkshire Hathaway's stock.

• 45:46David Senra?

  So that tells you he doesn't believe what he's saying. Buffett, it was interesting to me when I was reading his shareholder letters. Buffett kept mentioning a person who popularized EMT, which is efficient market theory, but who's also a Berkshire investor. It wasn't until I read Fortune's formula that I knew who he was referring to. And so that's something I like, I hold dear in my life. And something that's helped me is like, I try not to pay attention to what people say. I try to pay attention to what they do. I think our actions reveal like, it's the difference between like, revealed preference to stated preference. Like, you just watch what they do, and you'll see what they actually believe in. And so in his case, like, he obviously didn't believe that because if, he wouldn't think he could make above market average, above average market returns by investing in a

• 46:31David Senra?

  single stock, which is what he was doing. And I don't, I just, I hate people like that. It bothers me. It's like they're, I consider it lying. Alright, so let's go back to Shannon. Says, "In the late 1950s, Shannon began an intensive study of the stock market that was motivated both by intellectual curiosity and a desire for gain. He filled three library shelves with something like a hundred books on economics and investing. At the time he was designing the roulette computer with Thorp, Shannon kept notes in an MIT notebook. Part of the notebook is devoted to a wildly disconnected set of stock market musings. Shannon wondered about the statistical structure of the market's random walk, and whether information theory could provide useful insights."

• 47:13David Senra?

  This is how he's applying something he learned two decades prior, a decade and a half earlier, to what he's doing now. "He considered margin trading and short selling, stop-loss orders, and the effects of market panics, capital gain taxes and transaction costs. He notes of such success stories as The Lone Wolf, who ran about $10,000 into a million into about, in 10 years, and Hetty Green, the Witch of Wall Street, who ran a million into 100 million in 30 years." Uh, this is Shannon specifically on the efficient market theory. "You know, the economists talk about the efficient market where everything is equalized out and nobody can make any money. Really, it's all luck and so on," Shannon once said. I don't believe that's true at all.

• 47:55David Senra?

  So Shannon starts to make a lot of money in the stock market and now we're going to be introduced to another person who also is who we've also you might have heard the name from Charlie Munger and Warren Buffett and that that person is Henry Singleton who I'm also reading a book about and will appear on a future founders episode. Says in 1954, Charles Harrison, a Bell Labs scientist Shannon knew, started his own company. Harrison's Laboratories made power supplies for the promising new field of color television. Shannon bought a block of stock. Harrison Labs is not a familiar name today because it was acquired by HP back in 1962. The stock's price zoomed and Shannon got a handsome chunk of Hewlett Packard's stock in the merger.

• 48:40David Senra?

  The size of the paper profit convinced him there was real money to be made in stocks. So it continues, "The experience with Harrison made Shannon receptive when another friend, Henry Singleton, spoke of starting his own company. By 1960, Singleton founded Teledyne, a defense contractor selling digital navigation systems to the Pentagon. Shannon bought a couple thousand shares at the initial price of a dollar a share. By 1967, it hit $24 a share. As the company's shares skyrocketed, Singleton used that inflated market value to buy other companies. He bought about 130. Teledyne came to own insurance companies, offshore oil wells, and the manufacture of

• 49:25David Senra?

  the water pick teeth cleaners." So I think Buffett, he says something like Singleton is the single best allocator of capital in history? And once I heard that, I was like, okay, well, I definitely have to read about this person. He sounds fascinating. All right, Ed Thorp starts investing in stocks and why does he do that? He says, "I realized that if I pushed it sooner or later, some unpleasant physical things would happen in Nevada. He decided to direct his talents toward the biggest casino of all, the stock market." So he starts out, but he doesn't really know too much about investing and he loses a large percentage of the little money he has speculating on silver and he learns a very valuable lesson.

• 50:04David Senra?

  That kind of ties into Buffett's ideas, among others, about never betting or investing your time or money in an area where you have no edge. So Thorpe says, "I learned an expensive lesson regarding all the money he lost in silver." And he says, "The lesson was, you are unlikely to get an edge out of what you see in the news." So Thorpe decides, "Hey, I gotta look where I have an edge." He has some unique insights on options and warrants. And at this point in his life, Ed Thorpe is gonna move to Southern California, and he's gonna start his work on options. He switches schools to UC Irvine. So it says, "Summer in 1964 brought changes in Thorpe's life. The grant supporting his appointment at New Mexico State had run out.

• 50:48David Senra?

  On Thorpe's first day at UC Irvine, he had happened to mention his interest in warrants to Julian Feldman, the head of the computer sciences department. 'Oh,' Feldman said, 'we've got a guy who's doing the same thing. He was talking about the economist named Sheen Kasoff.' Feldman introduced Thorpe to Kasoff, and they resolved to do a weekly research seminar on the subject. But there were no students. Thorpe and Kasoff simply met weekly to figure out how to get rich. Thorpe began trading warrants. His hedging system," and he calls this the delta hedging system, and his hedging system worked as he had hoped.

• 51:30David Senra?

  By 1967, Thorpe had parlayed his original $40,000 into $100,000." So Thorpe writes a letter to Shannon, and he tells him, he's like, "Listen, after several first starts, I have finally hit pay dirt with the stock market. I have constructed a complete mathematical model for a small section of the market. A major portion of my modest resources has been invested for several months. We set a tentative first goal of doubling the capital every two years. It isn't far away now." So Thorpe winds up being successful. He winds up wanting to run money for other people, for outside investors. So he writes a book, publishing his system. And then he's looking for partners.

• 52:15David Senra?

  And you have to pick, lesson here is, you have to pick the right business partners. And the reason Thorpe doesn't pick Kasoff, because there's a philosophical difference. It says, "Kasoff believed that he could sometimes predict in which direction certain stocks were going to move." Kasoff was willing to buy stocks he thought were going up and sell short stocks he thought were going down. Thorpe wasn't. He was unconvinced that Kasoff, or anyone, could predict the market that way. So he winds up, I know I left myself, as Thorpe finds the right partner and starts a hedge fund. I find out later on that that may not have been the case. He definitely started a hedge fund, not sure he found the right partner. But now, this is gonna, this is the beginning of

• 52:58David Senra?

  one of the most successful hedge funds of all time. And it's called Princeton Newport. And Thorpe finds this guy named Regan. And Thorpe lives in California, Regan lives on the East Coast. And what blew my mind is Thorpe starts working remotely. And this is, I think, back in, starting back in the 60s. Alright, so this is Thorpe talking. He says, "Regan was a natural promoter and extrovert. He was gonna have, he was going to do the things I didn't want to do, which were like interface with brokers, accounting, run around Wall Street getting information, that sort of thing. What I wanted to do was think, work out theories, and try to put them into action. We were actually happy being separate because we had different styles and very different personalities. Being separate was one of the oddest parts of this arrangement." So they're

• 53:42David Senra?

  talking about the fact that this is a remote company. "Thorpe did not want to give up his UC Irvine post or California." It's kind of crazy that he's running one of the most successful hedge funds, and then he finally quits years later. But this kind of shows you how cautious he is. "It was agreed from the outset that would be a bi-coastal partnership, connected by a wire, a wire of phone and data lines. Thorpe and a staff would do the math in California, and they would transmit trade instructions to Regan, to Regan and staff on the East Coast. The East Coast branch would handle the business end of things, including most of the recruitment of investors." Now, along this time, Thorpe is trying to get people invested with him. One of

• 54:24David Senra?

  them is a dean at UC Irvine. And this is where, what leads him to meet a young Warren Buffett. This is still in the 60s, so they're probably in their 30s. They're like, let's say, late 30s, maybe, at this time. Says, "Before committing any money to Thorpe," this guy's name's Gerard, "Gerard wanted his money manager to meet Thorpe and size him up. The manager was Warren Buffett. Thorpe and wife, Thorpe and his wife met Buffett and his wife for a night of bridge. Thorpe was impressed with Buffett's breadth of interests. He believed that Buffett will one day become the richest man in America." Buffett's verdict on Thorp was also positive. Gerard, who had done quite well with Buffett, decided to invest with Thorp. And so they're kind of bonding over the fact that they're Thorp, Shannon, Buffett,

• 55:09David Senra?

  they're the direct opposite of this idea that the market is efficient. And Thorp says, "The question wasn't is the market efficient? But rather, how inefficient is the market? And how can we exploit this?" So Thorp's approach is completely different than others at this time. And anytime you're going to do anything different, you can be expected to be criticized and be told that you're wrong. So now is he applying math, but he's using computers. And so The Wall Street Journal does a story on Thorp and his new Princeton Newport hedge fund. And the journal writes, "The journal writer was amazed at Thorp's disregard of fundamental analysis and his reliance on computers. In 1974, the journal's average reader had as much hands-on experience with computers

• 55:53David Senra?

  as with moon rockets. 'The whole computer model bit is ridiculous because the real investment world is too complicated to be reduced to a model,' an unnamed mutual fund manager was quoted as saying. 'You can't replace the money manager using security analysis and market feel with a machine.' Yet, the Journal reported that Thorp's machine outperformed all but one of the 400 mutual funds tracked." This is Thorp on it, on the one that beat him. He says, "The better one was one of those crazy funds that invested only in gold stocks." And so I'm going to fast forward a little bit here. Now, this is the update on the progress of Thorp's first company. I just want you to notice that I said first company.

• 56:37David Senra?

  At fiscal, at the year end of 1982, Thorp and Regan could boast that a dollar invested at the outset had grown to $6.61 in 13 years. By that time, Thorp and Regan had turned a conviction that the market can be beaten into one of the most successful investment partnerships of all time. It was rare enough to achieve greater than market return over 13 consecutive years. Skeptical academics and some traders tended to judge such exceptional performance as a Faustian bargain. They said, sooner or later, they were going to lose big.

• 57:15David Senra?

  Thorp, remember, but what's going to prevent them from losing the Kelly criterion, right? Thorp was introspective, approaching the challenges of his work as a scientist. I think this is also a smart way for entrepreneurs to do so. He measured his words like he measured everything else. Thorp was careful to characterize his son's, his son's performance as getting rich slowly. So what I mean about approaching things as a scientist is like, he has a theory, then he needs, he needs to test that theory in the real world. And as a result of testing your theories in the real world, you're going to get unexpected results. That's what I meant about that. Okay. Um, so it took him until 1982 until he quit his day job teaching at UC Irvine. So that's pretty crazy. That's what, close to 15 years.

• 57:57David Senra?

  Thorp was slow to display his now considerable wealth. In the office, he dressed like a California professor on his day off in shirts and sandals. When the Thorps finally decided it was time to buy a big house, they chose a hillside 10 bathroom home said to be the largest in Newport Beach. This kind of gives you an idea of how he's doing. I've seen interviews, he won't tell how much money he's made. It had, it had a fallout shelter with 16 inch thick concrete walls and steel doors. And why do I bring that up? Like, why am I including that part in the podcast? It's not just to talk about big houses. It's because it gives you an insight into his mind. Ever mindful of the odds, Thorp computed that it could withstand a one megaton, megaton hydrogen bomb blast as close as a mile away.

• 58:42David Senra?

  Neither Thorp nor Regan could have imagined how soon it would all end, or how. And this is going to be another, I keep, I feel like I keep saying that over and over again, but this is another insane story in the book, how their hedge fund winds up coming to an end. So there's this illustration I really like, and it will tell you how the proponents of the Kelly side are thinking about things. So I'm just going to read it to you. "The growth of dollars under various money management schemes may be compared objectively, like the growth of bacteria in Petri dishes." Okay, so just think about it as a money management system. "The dollars subjected to the Kelly system survive and grow faster than those subjected to any other system. The experiment can be repeated as many times as it takes to convince the skeptic.

• 59:27David Senra?

  And then you ask, which system would you prefer for your money?" An acid test of Princeton Newport's market neutrality came in the form of the Black Monday crash in October 1987. The Dow Jones lost 23% of its value in a single day, the biggest single day drop ever. Princeton Newport's $600 million portfolio shed only about $2 million in the crash. Thorpe's computer immediately began alerting him to rich opportunities in the panic valuations. Princeton Newport closed October 1987 just about even for the month. Most mutual funds were down 20% or more. Princeton Newport's return for the year was an astonishing 34%.

• 1:00:12David Senra?

  Black Monday was also a severe test to the efficient market hypothesis. It was difficult for many to see how a rational assessment of the market's value could have changed 23% in a single day. Black Monday caused, and this is the, I mean, I was gonna say the surprising result, but kind of not surprising result when people identify themselves with their ideas. Like a good advice is like, you're not your ideas. You should like discard them when you find information that clearly contradicts them. Well, the economists didn't. Black Monday caused few economists to reject the efficient market hypothesis. Um, all right. So now I gotta tell you when Thorpe's hedge fund is raided. And you might be saying, what, the note I left myself is WTF?

• 1:00:55David Senra?

  Like when I got to this part of the book, it's what, what are you talking, what was going on here? All right. December 1987, vans pull up in front of Princeton Newport building. They contained 50 federal agents of the FBI, Treasury Department, and ATF. They were armed and wearing bulletproof vests. They went through the filing cabinets, packing documents into 300 boxes. They were under orders to look for audiotapes especially. So this is when Ed Thorpe heard the news, his initial reaction was that it was nonsense. He had followed the string of arrests on Wall Street like everybody else. This was happening at the time. The raid seemed to be some publicity stunt on the part of Rudy Giuliani. Rudy Giuliani is the prosecutor of the Southern District of New York, and a lot of people are saying he was doing this to, to get publicity for eventual run at either Senate or governorship.

• 1:01:39David Senra?

  Now, here's the problem, though. I said earlier, it's important to pick the right business partners. And then I left myself, I was like, oh, did Thorpe actually have bad business? Bad partner? Ominously, Reagan did not have much to enlighten Thorpe. "Everybody lawyered up," explained Thorpe. "Trying to run a partnership was very difficult under these circumstances." "Action spoke louder than words." "Some of the East Coast partners took about fifteen million dollars out of the fund and replaced it under the names of their wives." So that looks real bad, doesn't it? It turned out that someone had saved some tapes from December 1984. This is three years earlier. "Stock parking would normally take place at the end of the tax year." So that's what they're doing. At the time, Thorpe and his partner have a...

• 1:02:23David Senra?

  One of their brokers is Michael Milken. The famous guy who winds up inventing junk bonds and going to jail for a few years. And Reagan and some of the people in the office... Well, I don't know if Reagan was actually involved, but some traders in the office were doing this thing called "stock parking", which they would... Basically, two different companies are pretending to transfer assets to one another to avoid taxes. That's like an oversimplified way to think about it, right? But this is going on in the East Coast office. Thorpe didn't know what was going on. So Thorpe got one call from the prosecution team. They wanted him to come and testify in New York. And he told them, "If I do it, I'm gonna take the Fifth." The US Attorney's Office took no further direction against Thorpe. So he was never even involved in all this.

• 1:03:07David Senra?

  And he says, "My theory on taking the Fifth was, I didn't know anything." "So I had no upside in going in and plenty of downside." So this is another trait that I find constantly in these biographies, is these people know how to limit, to cap their downside. "The decision to testify was just a prudent calculation." And here's the problem, it didn't matter that he didn't do anything. Because they were being charged, the people thought they were guilty, and Giuliani is using the RICO Act, which is mainly used to fight organized crime. So this is the end of their hedge fund. With Rico's charges looming, the fund's investors wanted out. In 1988, Thorpe and Reagan dissolved the partnership. Positions were liquidated and the money returned to investors. He blames the situation on the dysfunctional partnership.

• 1:03:52David Senra?

  "We didn't really connect well as people," Thorpe said of himself and Reagan. That was probably the crack and the edifice. "If I'd realized the actions were being taken that were more aggressively bold, closer to the line, and I dare contemplate, the whole thing wouldn't have happened." And Ed was pretty mad about this because he's like, "We had a great run and you're trying to like save a little bit on taxes." So he says, "This is the financial results of their partnership." "To many portfolio managers today, the 19-year record of Princeton-Newport Partners is the definitive home run. A dollar invested in the fund at the beginning would have been close to $15 by the time the fund ceased. Over 19 years, the compound return rate averaged 15.1% after fees." During that same time period, the S&P averaged 8%.

• 1:04:36David Senra?

  So again, Samuelson and others say it's impossible to do, and Thorpe doesn't care. If he thinks it's impossible, he'll just go out and do it. And this is him on the end of the Princeton-Newport. "Regan and other Princeton-Newport defendants appealed their cases. All six convictions were overturned." So they wind up not even being able to convict them permanently. Thorpe came out unscathed from charges, but what he's upset about is they interrupted their compounding. "This is a destruction of wealth that's huge," Thorpe observed. "The partnership employed about 80 people on two coasts. They managed $272 million of other people's money. Together, Thorpe and Reagan were collecting $16 million a year in general partner fees." This is in the 80s.

• 1:05:21David Senra?

  "Their own investments in the fund were compounding at an impressive rate." And what happens? You never interrupt compounding. And a Rico case is going to interrupt your compounding. So he's really upset about that. From there on in, he runs this thing called Edward Thorpe and Associates, like a series of hedge funds. I'm not sure if he invests other people's money. I think he does, but I think mostly he's just running his own money too. And he's getting like 20-something percent returns. So that's what he's been doing from the point in this story to today. He's still alive. He's 87 years old, and he wrote his memoirs two years ago, and then he did a lot of publicity at 85 years old for the book. I recommend you just putting in Edward Thorpe or Ed Thorpe into YouTube. And I've showed the video to three or four different people now.

• 1:06:06David Senra?

  Everybody's, I was like, how old's that guy? Tell me how old he is. They're like, I don't know, 60, 65? It's remarkable. I've never seen an 85-year-old person look as good as him and then not only that, like, still be so on point mentally. It's remarkable. Um, alright, so now I want to get to the point that now we know that Thorpe did well. I want to talk about the people that thought, so I want to talk about the, the idea that, that, uh, there's people that were not adhering to the Kelly criterion who wind up blowing up. So Thorpe had a chance to get to invest in LTCM, which is long-term capital management, one of the most famous, like, hedge funds to blow up ever. And he declines for obvious reasons. So it says, Ed, Ed Thorpe first heard of Meriwether.

• 1:06:49David Senra?

  Meriwether is the person that starts, that begins LTCM. So he's first heard of Meriwether's fund through a mutual friend. "It's going to be a great investment," Thorpe was told, "and for $10 million, you can get into it." "Like most of the new group of fund managers, Meriwether promised better-than-market returns through science and software." "Meriwether did not himself possess a first-rate mathematical mind. Instead, he recruited the top academic talent. No finance professor was more respected than Robert C. Merton." So he recruits him. "And his other greatest coop was recruiting Myron Scholes." Now, here's the thing. They also believe in, um, the efficient market hypothesis, but they're saying is

• 1:07:29David Senra?

  there's tiny, tiny, tiny parts temporarily where the market is not efficient and you can make like five cents. So their point is they're going to use massive amounts of leverage so they could pick up a bunch of nickels. But what they're really doing is they're picking a bunch of nickels in front of a steamroller and they just don't know that they're doing that yet. Okay? So it says Thorpe decided not to put any money in his fund. "He was concerned that Merton and Scholes had little experience investing other people's money. And it didn't help that Merton was a critic of the Kelly criterion." The general chatter was also that Merriweather was a high roller. The story was that if he got in a hole, if things went against him, he would bet more. If things still went against him, he'd bet even more. And this is what winds up doing,

• 1:08:13David Senra?

  what he winds up doing at LTCM. And it's kind of the exact opposite of when I was describing the Kelly criterion to you earlier. It's a proportional betting system. As your bankroll goes up, you bet more. As it goes down, you bet less. What happens is LTCM starts blowing up and they bet more. A larger percentage. Says LTCM trading secrets were secrets. One thing was disclosed. LTCM used a lot of leverage. For every dollar invested investor money, the fund borrowed $29 more.

• 1:08:46David Senra?

  So this is, this is the definition of gambler's ruin. This is also the way I want you to think about this is this is what Thorpe and Shannon wisely avoided. This is, and this is, and LTCM did not. One term for gambler's ruin among the traders is blowing up. To blow up an account is to lose everything in high-risk trades with borrowed money. A stellar career can end in a few miserable days or hours. And so there's a, there's a quote, if you listen to the podcast I did last week on Jim Clayton, that he compares, and we've talked about this a lot, right? The fact that starting a company, running a company, a lot of times it's counterintuitive.

• 1:09:28David Senra?

  Right? So the thing you think you should do is the exact opposite of what you should be doing. That's what makes it so difficult, right? And it's a complex adaptive system. It's not, it's not going to behave in ways that are predictable. So Jim compared that to flying, uh, cause he's a pilot too. And he said, he said something that I thought about and I, I've like kept a note. And he says, "The thing you should do is the opposite." Like you can get yourself in a situation flying in a business where the thing you should do is the opposite of what you feel you should do.

• 1:10:01David Senra?

  So LTCM runs into the same thing. They're collapsing. And in the middle of the collapse, they do the exact opposite thing that they should. Says when they first started losing, obviously, they had less discretionary wealth. So they should have pulled down their leverage multiple on a proportional basis. Right? Instead, they allowed that leverage to drift up to like 60 times. That was a horrible mistake. No Las Vegas gambler would ever make that mistake. No surviving one. And so that is the almost the entire point of this podcast is to never put you. You want to put yourself in a position, you cannot be successful. You don't survive. So therefore never risk your survival ever.

• 1:10:48David Senra?

  These guys didn't even understand that. They came from a different world. They thought, oh, we have it all figured out. We're so smart. And so I want to read this quote. Well, let me get to it. Warren Buffett is going to, you know, I don't even need to say it because Warren Buffett's quote here is amazing on it. And then this next part I'm going to read to you. When I left, when I read it, I left a note to myself and it's that Steve Isman quote, the guy from the big short, who made over a billion dollars shorting the, during the housing crisis and the financial crisis in 2008, 2009. And it's just amazing how many situations this quote applies to. And he says, the quote, he's like, they mistook leverage for genius. And Isman was talking about the late 2000s financial crisis.

• 1:11:32David Senra?

  It's, it can, the same thing applies to what's happening in the end of the 90s and will apply in the future and a hundred years in the future, a hundred years ago. This is human nature and human nature does not change. So, many of the partners had substantial fortunes before LTCM that they rolled over into the fund. One partner was said to be in tears in one meeting. Why would you be in tears? Because he had taken out a personal loan of $24 million to increase his stake in the fund. What is he doing? He's using leverage to buy his own fund, which itself was operating at nosebleed leverage levels.

• 1:12:08David Senra?

  His net worth went from something like over a hundred million dollars to negative twenty million dollars. He requested that the bailout covers personal debts. Remember, this is such a huge loss. The US Treasury had to bail him out. The consortium said no. And what a jerk. This guy wants the taxpayer to pay. I mean, why am I even surprised at something like this? Like, I should know better right now. He requested that the bailout covers personal debts. Like, that's a terrible person. Now, this is what I was mentioning earlier. I love this. Warren Buffett marveled at how ten or fifteen guys with an average IQ of maybe one hundred and seventy could get themselves into a position where they can lose all their money.

• 1:12:51David Senra?

  And that statement by Warren Buffett is really just echoing something, a statement that was, said two hundred years in the past, in seventeen thirty-eight, by this guy named Danielle Bernoulli. I don't know how to pronounce it. He's credited with, like, being, maybe even like, the most pioneering work in probability and statistics. And this is what he said. This is what he wrote in seventeen thirty-eight. "A man who risks his entire fortune acts like a simpleton, however great may be the possible gain." They're telling you to avoid, you should avoid risk of ruin. You should avoid fat tails. It says, "Storpe linked the LTCM collapse to Merton and Stoll's intellectual critique of the Kelly system." So Ed continues. He says, "I could see that he didn't understand how it controlled the danger of extreme risk

• 1:13:36David Senra?

  and the danger of fat-tailed distributions. It came back to haunt them in a grand way. Estimates about market probabilities are always just going to be that: estimates. It is a good practice to have a sense of how far off these estimates may be. Margins of error are themselves estimates, and human nature often skews these estimates optimistically. A decade rarely passes without a market event that some respected economist claims, with a straight face, to be a perfect storm. A ten sigma event, or a catastrophe so fantastically improbable that it should not have been expected to occur in the history, entire history of the universe." If they keep happening, that means they should be expected, shouldn't they? Like, that's obvious on its face.

• 1:14:19David Senra?

  I don't understand how so-called smart people don't understand that. "In a world where financial models can be so incredibly wrong, the extreme downside caution of Kelly betting is hardly out of place."

• 1:14:32David Senra?

  Alright, so now we're gonna go back to Claude Shannon. This is Shannon's performance applying his ideas to the market. Now, this is just fantastic. In 1986, Barron's ran an article ranking the recent performance of 77 money managers. Claude Shannon, though not mentioned in the article, had done better than all but three of the pros. And he's basically doing it as part-time. The Barron money managers were mostly firms with up to 100 people. Shannon worked with his wife and a decrepit Apple II computer. The August 11, 1986 Barron's reported on the recent performance of 1,026 mutual funds. Shannon achieved a higher return than 1,025 of them.

• 1:15:17David Senra?

  When Warren Buffett bought Berkshire Hathaway in 1965, over 30 years, he had a return of 27%. By the late 50s through 1986, Shannon's stock, return on his stock portfolio was 28%. It's also worth noting, it's a little harder to do with larger amounts. Warren was working with larger amounts, but still, Shannon's record's amazing. Right? Again, this is what I like about Shannon. He had an idea and he backed it up. He's like, "No, I think efficient market theory is bull crap, and I'm gonna see if I can teach myself how to do this." And he did. Okay, so, I wanna, we're almost done, but I wanna go over this. So, this guy, a few years later, unfortunately Claude Shannon winds up suffering from Alzheimer's

• 1:16:02David Senra?

  disease. So, they're writing, there's this guy named Hirschberg, who was a, he was writing an article on Shannon's portfolio, but he never published it. But Shannon's wife got a copy and gave it to, I think, I don't know if he gave it to this author or somebody. Somehow, William Poundstone got his hands on it. So, it says, "A draft of Hirschberg's article, along with Hirschberg's recollections, give the most complete view of how Shannon achieved these returns. It had nothing to do with arbitrage. Shannon was a buy-and-hold fundamental investor." Now, here's what Shannon's gonna tell Hirschberg. "In a way, this is close to some of the work I'd done relating to communication and extraction of signals from noise."

• 1:16:46David Senra?

  He said, Shannon, he said that a smart investor should understand where he has an edge and invest only in those opportunities. And I know I've said this before, but Buffett and Munger say the same thing over and over and over again in different ways throughout multiple decades. Only invest where you have an edge. Find your edge and invest in it. This is more on how Shannon thought about price and value and the methods he used to invest. In the early 1960s, Shannon had played around with technical analysis. He had rejected such systems. He, uh, this is Shannon's talking now. He says, "I think that the technicians who work so much with price charts and head and

• 1:17:27David Senra?

  shoulders formations and plunging necklines are working with what I call a very noisy reproduction of the important data." Shannon emphasized, "While we can extrapolate about the growth of earnings in the next few years from our evaluation of the company management and the future demand for the company's products, stock prices will, in the long run, follow earnings growth." Therefore, he paid little attention to price momentum or volatility. The key data in my view, this is Shannon talking, uh, the key data is, in my view, not how much the stock price has changed in the past few days or months, but how the earnings have changed in the past few years.

• 1:18:10David Senra?

  Shannon plotted company earnings on logarithmic graph paper and tried to draw a trend line into the future. He also tried to surmise what factors might cause the exponential trend to continue or sputter out. The Shannons would also visit startup technology companies and talk with the people running them. Shannon became a board member of Teledyne. He was not just a distinguished name in the annual report, but was actively scouting potential acquisitions for CEO Henry Singleton. In other words, he had an edge. He knew, he knew, he had a, he had an understanding and access to information that other people did not. And this is also tells you why I'm going to be reading about Singleton soon and it's going to be a podcast that you're going to be able to listen to.

• 1:18:55David Senra?

  Warren Buffett himself said that Singleton had the best operating and capital deployment record in American business. It is, it is at least conceivable that Shannon's judgment played a supporting role in this success.

• 1:19:09David Senra?

  And this next section, the note I left myself is this is also why for entrepreneurs that own a profitable private business, it makes sense to do what Warren Buffett advises, to treat your business as if it's the only asset your family has had for the next 50 years. If you do that, it causes you to focus, and you're focusing on an area where you have an edge. See how that kind of plays together? Shannon's portfolio would have appalled Harry Markowitz. Markowitz is the guy that created Martin Portfolio Theory, which needless to say, people like Buffett and Munger criticize heavily. I think it's a twaddle. Alright, so Shannon's portfolio would have appalled Harry Markowitz. By this point, nearly 81% of the portfolio was in a single stock, Teledyne.

• 1:19:51David Senra?

  The three largest holdings consisted of 98% of the portfolio. Shannon says, "We have not at any time in the past 30 years, attempted to balance our portfolio." And what does this echo? This echoes what Carnegie said. Andrew Carnegie told us, "Study how the great fortunes are made. It's not a scattershot approach. It's putting all your eggs in one basket and watching that basket," which is what he did with his steel company. And I'll close on this. This is Thorpe's investment record. It says, "In May 1998, Thorpe reported that his investments had grown at an average of 20% annual return over 28 years. To help persuade you that this may not be luck," Thorpe wrote, "I estimate that I have

• 1:20:35David Senra?

  made $80 billion worth of purchases and sales for my investors. This breaks down into something like 1 and 1/4 million individual bets, averaging $65,000 each, with on average hundreds of positions in place at any one time. Overall, it would seem to be a moderately long run, with a high probability that the excess performance is more than chance." And I stop there because that last sentence, I think, is what we're all trying to do in our individual lives. We're trying to have a high probability of excess performance that's more than chance.

• 1:21:17David Senra?

  So if you want to read the entire story, which I'd obviously recommend doing, I'll leave a link, it's an Amazon affiliate link, which means if you buy using that link, it also supports the podcast. And you can also go to amazon.com/shop/FoundersPodcast. And if you buy this book or any of the other books, I also receive a small percentage of that sale. And if you want to see what, I guess I already told you. I was going to say, if you're treating this podcast like a book club and you're going to read with me, when you go to amazon.com/shop/FoundersPodcast, I always post the book I'm currently working on there, so you can order it right away. If you can read it in a week, you've already read it by the time the podcast comes out. So it's kind of like this large book club, which is really cool.

• 1:22:00David Senra?

  And if you don't want to do that, you can go to founderspodcast.com and you can see all the books there as well. Thank you very much for the support. Thank you for listening, and I'll be back next week, and we'll talk more about the wonderful life of Ed Thorp.