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Thursday, July 5, 2012
The Thorpophile: The Quants Book Review
Ed Thorp's Genius Detailed In Scott Patterson's 'The Quants'
Feb 05, 2010
The amazing career of Ed Thorp -- which has included creating a system to beat the house in blackjack, uncovering the Bernie Madoff scam 17 years before it was made public and racking up eye-popping returns at his hedge funds while avoiding the risk that killed others -- is detailed in a great new book by Wall Street Journal reporter Scott Patterson.
Thorp isn't the primary character in Patterson's bestselling "The Quants," but to this reader the now 77-year-old genius steals the show.
"The Quants" is about the new breed of young math geniuses who guided their hedge funds and investment-banking units to unfathomable returns last decade before crashing to earth in epic fashion. Patterson focuses his attention on four "quants" -- Ken Griffin, Cliff Asness, Peter Muller and Boaz Weinstein.
Each of the quants attended the country's best schools and stood out among their talented peers. Each gravitated to Wall Street, where they racked up impressive gains through their highly complex trading models and hedging strategies. The quants were so sure of their models, which were based on historical data and the belief that market prices were efficient, that they took on massive leverage to juice returns.
The problem with the models, however, was that they assumed investors were rational and that highly unusual market conditions -- the kind Nassim Nicholas Taleb calls "black swans" in his book of that name -- wouldn't persist for any extended time. Highly confident in their models, the quants went "all-in" in the parlance of poker, which many of them played with the same zeal as they brought to their investments.
When the U.S. subprime market cracked in 2007, panicked markets turned irrational. As everyone tried to unwind their trades at the same time to stay afloat, the models stopped working and the quants lost billions.
Meanwhile, coming out of retirement from his office in Newport Beach, Calif., Ed Thorp racked up 18 percent gains in the brutal 2008 market with a non-leveraged trading strategy he called "System X." That was nothing new for Thorp, who had consistently achieved double-digit returns since his days running the hedge fund Princeton/Newport Partners.
Thorp was one of the earliest quants. He developed an early mechanism to price warrants and used that advantage to rack up fantastic returns for his investors. His work inspired numerous quants and other investors, including bond king Bill Gross, whose Pimco office is just down the street from Thorp's.
Thorp avoided the ruin that met other quants by refusing to stick rigidly to models and by employing a system of risk management based on the Kelly criterion (William Poundstone also delves into this in the excellent book "Fortune's Formula").
The Kelly criterion helps gamblers, as well as investors, decide how much to bet on each hand. When the odds are good, you bet a higher percentage of your bankroll. But you don't bet 100 percent of your money unless you have a 100 percent chance of winning.
Thorp learned the Kelly criterion while studying ways to beat casino blackjack, which led to the ground-breaking 1962 book "Beat the Dealer" that inspired many quants. Warren Buffett, whom Thorp met with in 1968 to discuss Buffett's investment partnership structure, is said to use a form of the Kelly criterion in deciding how much money to put into various holdings.
After learning how to beat the casino in blackjack, Thorp delved into the markets. He started Princeton/Newport Partners in 1969 and ran it successfully for decades. In 1991 a company asked Thorp to review its investment portfolio. That's when he learned of Madoff's fund, which he quickly realized couldn't possibly be legitimate based on its reported trades.
In many ways Thorp seems to share commonalities with Buffett -- mathematical genius, constant thought into avoiding catastrophic risk, common sense, honesty, passion for the game and a decades-long track record of success through numerous market conditions. But he hasn't won the same fame that the Oracle of Omaha has.
Happily, "The Quants" shines a well-deserved light on Thorp.