07-27-13 10:39 PM - Post#6794
Fortuneâ€™s Formula is a narrative that talks about the discovery and use of an information theory formula, called the Kelly Criterion, and its real-life application in gambling and investing. This is one of the most fascinating books I have read in my life. It is the first book that links my two heroes, Warren Buffett and Ed Thorp together.
After Warren Buffett shut down his Buffett Partnership to run Berkshire Hathaway, Warren recommended a few options to his investors: put their money in Berkshire Hathaway or put their money in the Sequoia Fund, an investment partnership ran by Buffettâ€™s friend, Bill Ruane. One of Buffettâ€™s investors is Benjamin Grahamâ€™s nephew. He had heard about a money manager by the name of Ed Thorp, mathematics professor from the University of Irvine. He asked Warren Buffett if Warren could meet with Ed Thorp and to give him advice whether it is recommendable to invest in Ed Thorpâ€™s partnership.
Warren and Ed Thorp had a long meeting. They talked about math, probability and the intransitive dice. They shared their strategies. After the meeting, Warren told Grahamâ€™s nephew that Ed Thorpâ€™s strategy is an investable strategy. Ed Thorp went home to tell his wife, â€śI think I met the future richest man in the world.â€ť
This story pitted two camps against each other. On one camp are the scientists who believed in the Kelly Formula. These three scientists are Claude Shannon, a genius polymath who developed information theory; John Kelly, a maverick genius, who is directly responsible for the development of Kelly's formula. The third one is a brilliant MIT mathematician, Ed Thorp.
On the opposing camp are the scientists who believed less in Kelly Formula but believed more in Efficient Markets: Paul Samuelson, Fischer Black, and Myron Scholes.
Ed Thorp tested the Kelly formula in both gambling and investing. Also, he came up with a more generalized options valuation formula before Fischer Black and Myron Scholes. Ed Thorp used this formula in practice and made a lot of money in the stock market; whereas, Black and Scholes published their formula and later got Nobel Prize for it. As a result, Ed Thorp remained in obscurity while Black and Scholes became famous.
Ed Thorp used a combination of Kelly Formula, mathematical probability, and other statistical tools in deriving superior returns in both gambling and investing. In gambling, Ed Thorp and Claude Shannon devised a tool that will predict the projectile motion of the ball to gain statistical odds in roulette. He succeeded at Black Jack by developing the card counting method and published his story in â€śBeat the Dealerâ€ť. Later, he ran an investment partnership, called the Princeton-Newport Partners for 20 years until the late 80s and earned a rate of return of 14% handily beating the market's 8% during the period, with much lower volatility than the market. His fund barely lost money on Black Monday in October 1987, when the market crashed by 22%. He exploited market inefficiencies using warrants, options, and convertible bonds. He used the Kelly formula was a risk management discipline.
Claude Shannon accumulated his wealth by recording one of the best investment records, employing the Kelly Formula. Between 1966 and 1986, his record beat even Warren Buffet (28% to 27% respectively). Shannonâ€™s strategy was similar to Buffet. Both their stock portfolios were concentrated, and held for the long term. Shannon achieved his record by holding mainly three stocks (Teledyne, Motorola, and HP). The difference between the two was that Shannon invested in technology because he understood it well, while Buffet did not.
Edited by dailystock_admin on 07-27-13 11:13 PM. Reason for edit: No reason given.