Thanks to my son in law I got a chance to talk with the trader, professor, and gambler, Edward Thorp, recently. The interview originally ran on Benzinga, but I thought readers of mine might be interested.
Edward Thorp is one of the most well known figures on Wall Street. Throughout his venerable career he’s spent time as a mathematics professor, hedge fund manager, blackjack player, and author. “The father of the wearable computer,” recently released his sixth book, “A Man for All Markets: From Las Vegas to Wall Street, How I Beat the Dealer and the Market.” Tim Melvin recently caught up with the Wall Street legend to discuss his career and outlook on investing. Below is their conversation, slightly edited for length and clarity.
Tim Melvin: You’re really considered to be one of the fathers of quantitative investing, which brings up a certain picture of a guy with a bunch of computers trading wildly. But as I go through the book, you really have a tremendous Warren Buffet-kind of Ben Graham influence on your approach to investing. Can you talk a little bit about that? Because that really surprised me.
Edward Thorp: I came at the securities markets without basically any prior knowledge and I educated myself by sitting down and reading anything I could lay my hands on. I began to get oriented, and then I discovered how to evaluate warrants, at least in an elementary way, and I decided that was a way that I could apply mathematics and logical thinking and maybe get an edge in the market.
Melvin: So you weren’t trading like a mad man, like what we think of quants today. You were setting the trades and letting them run, right?
Thorp: Yes, initially it was slow trading. We’d put on warrant hedges and watch them and every so often, if there was a big move in the underlying stock, we’d change the ratio of warrants to stock. And then that evolved into revertible bond trading and we did pretty much the same thing there. So, then [Thorpe and co-author Sheen Kassouf] both went on to careers managing money.
I started a hedge fund in 1969, after meeting and talking with Warren Buffet for a while in 1968. He’d been running a hedge fund for about a dozen years, and he was just shutting down. And it turned out that stocks were at manic highs then. Which is why he was shutting down, and for me, it didn’t matter because I was putting on market neutral hedges. Something people hadn’t been doing before.
Melvin: Now, in the book you talk a lot about statistical arbitrage, I know you stopped doing it in about 2002, according to an interview I read. But it’s a term that’s used a lot. I don’t think anybody really knows what it means that’s not in the business. Could you kind of describe that a little bit?
Thorp: Sure. As you actually will have seen by reading my new book, “A Man for all Markets”, the idea was discovered by us back at either December 1979 or January 1980. The root idea was a researcher discovered that if you took the stocks that had been the worst performers over the last two or three weeks and bet on them, they would tend to outperform over the next two or three weeks, and the reverse was true too. The stocks acted as though they had some unobservable true value that wandered along some unknown curve, and they set a range back and forth around this curve, and followed it. Sometimes demand would push them up too high, for a while. And sometimes supply would push them too low for a while. So he ran a simulation where he bet on the 10 percent that were the most up for the last couple of weeks, and sold them short. And then bought the ones that were the most down for the last couple of weeks, and set up a hedge portfolio.
Now you might say, “Where’s the hedge?” Well, if you have a diversified pool of stocks that are kind of randomly chosen, they’ll tend to track the market. So the ones that were up the most, we would short, and that group tended to track the opposite of the market. That is, it would tend to move as though you would short the market.
On the other side, we had a pool that were long and they tended to track the market. So when you put them together, the long and the short sides, the market effect was pretty much cancelled out. Now, of course, there were a lot of other effects, all these stocks were traveling around their own random way around their market factor or market component. Well, we got rid of the market part.
So we said, “Gee, this is an interesting new source of profit.” We looked at this and found out that it was somewhat riskier than the other things that we had in our portfolio. So we put it aside. And then as I tell in, “A Man for All Markets,” somebody at Morgan Stanley (NYSE: MS) came across the same idea about two or three years later. And Morgan Stanley turned it into a very profitable product.
Then that person was disaffected by his treatment at Morgan Stanley, he happened to answer an ad that we had put in the newspaper looking for people with good quantitative ideas. I interviewed him. I saw that what he had done was very much like what we had done, only he had improved it a notch because he used groups of stocks in a single industry separately, to set up these long short hedges. So the upshot was we went into business with him, it worked very well. Through the crash of 1987, for example, it made money during that terrible down day. Then it began to lose some of its power as Morgan Stanley and others spread the idea and also put more money into it. So, we devised a new method that got rid of not only the market factor, but lots of other things, oil factor, interest rate factor, that sort of thing. And that ran just fine.
That’s the root idea, and it had a huge impact on the markets, because it’s a natural sequence into the idea of high frequency trading. The reason it’s a natural sequence is because you have computer feeds of the stock ticker. So, prices are pouring into the computer continuously, all day long for statistical arbitrage. Then the machines are recalculating what to bet on, and how to modify the portfolio. So, once you have a high speed data feed that you’re processing all day long, you begin to think, “Well, are there other ways to trade to this data feed, besides putting on trades that are on for an average of ten days or so?” And you begin to look for patterns that are shorter. So there’s a natural segue then into high frequency trading, you’ve got all the equipment, all the background and so forth. And I think that’s probably how people got into high frequency trading.
Melvin: As an individual trader, is it worth the extra effort to try to beat the market today?
Thorp: That depends on the person. I think to myself, “Gee, if I were 25 and I got interested in this, what would I do?” And I’m not sure, but for what I know now, I’d say the Warren Buffett way is a good way if you want to put your whole life into it. I’d probably decide not to want to put my whole life into it. So I would say if you wanted to get really rich and you wanted to trade your whole life for getting really rich, a trade I don’t necessarily recommend, then I’d say that’s the way to go. But if you just want to make lesser amounts of money, I don’t know what to tell a person at this point because you can do so well knowing nothing in the market.
Melvin: In the book, you talk about a way to beat the market that you used at Princeton-Newport, buying deeply discounted closed-end funds and allowing the discount to narrow. Have you considered that much in recent years?
Thorp: I have thought about that. My experience was long ago when there weren’t people tuned into this as much, but I think you could maybe make 15-20 percent a year pretty safely.
Melvin: In the early part of the book, it seems like you were such an intellectually, inquisitive child and pulled remarkable stunts. I love the one with the flare in the balloon, that just cracked me up. But as a parent and as an educator over the years, is there a way to bring out that natural intellectual curiosity in a child?
Thorp: Well, I can tell you what we did with our kids and it seemed to work. We made dinner time a special time, when everybody got together, nobody had any devices, or other activity or distractions. We all sat down, we talked about whatever was on anybody’s mind. So the mean teacher at school, the bully, whether or not there’s a God, whatever came up. The logic behind climate change, or the arguments against it, and so the kids learned to think for themselves. And this power of thinking for yourself is really formidable because it enables you to do many things. Whereas people who don’t do their own thinking kind of have to key off other people to try to figure out what it is that they should be doing. They basically follow the crowd.
The second thing is that we try to give our kids opportunity, so they had choices, but we tried not to steer those choices. So just because I’m a science, math, gambling stock market type guy, doesn’t mean that I try to steer my kids that way. So one kid became a hedge fund manager eventually, one kid became an architect, and one became a district attorney. They went their separate ways, they’re all smart.
Melvin: You talked about that several times in the book. In fact, I have passages underlined. You attribute a lot of your success as an investor because you did it not just for the money, but for the love of the mathematics behind it. And at one point, you say that your discoveries fit in with your life path as a mathematician, leaving you largely free to enjoy your family and pursue a career in the academic world. So you weren’t 18 hours a day bent over a screen. You were enjoying your life, because you enjoyed the work. Not because it was finance, because it was math.
Thorp: That’s exactly right.
Melvin: Now 1948, you apparently spent the entire summer sitting on a beach reading 60 novels that you considered to be classics. Did that make a big impact on the way you thought, the way you approached the rest of your life?
Thorp: I would say yes. It gave me… I’d call it maybe more of a philosophical and humanitarian perspective on life. And it made me think about the big world of society, politics, history, geography and so on. And it gave me a framework for putting things in their place.
Melvin: You talk a lot also about the importance of education, and your concerns about the future of education. Can you talk about that a little bit?
Thorp: Yes. I think of education as a lot like the seed corn for society. And if people are willing to pay for it, if they’re willing to be taxed and if they’re willing to build a good educational system, then I see that the minds that are generated out of that will apply tremendous leverage to society, and society will grow and advance much more rapidly. And many good things will happen and get done. If you had a society that was devoid of education, it would just sit in place and do nothing. It would be the same thing decade after decade, perhaps century after century. It would be like the perhaps inaccurate image that we have of the dark ages where nothing much happens.
So in a place like California, for example, they made a terrible mistake back in 1978. They passed something called Proposition 13. What that did was bust the state budget. The biggest component of the state budget is education. And so education has gotten squeezed ever after in California, at both the elementary, the secondary, and the college level. And tuition has gone up enormously. When I went to the University of California, my tuition was $35 a semester. Of course, that was back in 1949, 1950 and you might say, “Well, inflation’s changed the number quite a bit.” It has maybe 10, 12 times, but just add a zero to $35, $350 a semester, but we’re looking at instead of $700 a year. In today’s dollars, we’re looking at maybe $12,000 a year, or something like that for in-state, maybe $30,000 for out-of-state. So what happens is people can’t afford to get as good an education.
They go to school and even if they can pay the tuition, they have to work in large part to supplement to get the money to pay it because it just isn’t available in so many of the families. If you work while you’re going to school, which I did, you don’t do as well in school as you might. You don’t learn as much. I can think back at the courses I took because I was working, I didn’t learn the courses as well. And the rest of my life, I could feel the impact of that lack of knowledge, that I would have had if only I had been able to focus properly on the course I was taking.
So anyhow, to make a long story longer, I’ve seen charts of how much is invested in science, engineering, and education in a society, as a fraction of their GMP versus the rate of change of GMP. And it’s quite dramatic. Societies that have a higher investment of education advance the growth in their GMP much more rapidly in societies that don’t. And the obvious example is something like Silicon Valley. If we didn’t have a Silicon Valley or the equivalent, or Redmond, Washington, or the equivalent, we wouldn’t have all the computer advancement that we have. Apple would be a giant company in some other place, Japan, Russia, China, something of that sort as opposed to being a giant company in the United States. So anyhow to not spend money in education is a terrible mistake.
And another consequence of that mistake is gambling. There are lottery systems all over, and one of the ways of getting people to accept them is we’re willing to fund education with lottery proceeds. But that’s actually been in California bait and switch. What happens is they have signed a certain fraction of the lottery profits to education, but then they take away money from education with the other hand. So education doesn’t end up getting any more money. California ends up getting more money in the general fund, and ends up with a major gambling problem on top of it.
Melvin: In the book, you think a flat tax might be the answer to solve some of the funding problems at all levels of government.
Thorp: Yes, I do and there’s an obstacle to getting it in, which is that the complicated tax system is one that’s been made that way by politicians who are busy paying off special interests, who in return make campaign contributions to elect or re-elect the politicians. So that’s why the tax code degenerates into horrible complexity over and over. Now flat tax would eliminate most of the power of the politicians to extract benefits from the tax code. So they would oppose it. But, you could probably get support from large parts of society if you made the flat, the change to a flat tax neutral.
So for instance, suppose you take away the carried interest benefit for hedge funds. Just to explain what that is, carried interest is a scheme which has been disguised by an obscure phrase, carried interest, a scheme to tax money made by hedge fund operators at the capital gains rate rather than at the ordinary income rate. And so they pay far less tax. They can also defer the payment of the tax for many years, 10 years or more. Let’s say you took that away. You might get another $20 billion in tax collections that way. What to do with it? Well, go to the politically unconnected rich, the ones who don’t have benefits built into the tax code from bribing politicians. Take the top tax rate down. Apply that $15 or $20 billion tax savings that you capture from the changing the carried interest toward their income, apply that to the top rate. So it comes down from 39.6% to maybe 39% or 38.5% or whatever that comes down to. My idea would be that you keep making changes that are revenue neutral, and if you brought a flat tax in all at once, that would be a massive change that if were done in a revenue neutral way, would have as many winners as losers, so you’d have a lot of people rooting for it.
Melvin: Yeah. I agree. I’ve always said to the first part of your statement, that taxes are not just about raising income. It’s also a very complex reward and punishment system. And that’s been the biggest reason it’s developed into the nightmare that it is. I was surprised to see you comment on it in bringing it out in the book, happily so, but we’re in complete agreement on that.
Thorp: Well, one of the reasons I have some, I’ll call them public policy commentary in the book, is that if you have a math and science background like I do and you believe yourself to be a rational thinker, you end up applying it to as many things as you can. And with a large part of my life spent in finance and economics, I naturally ended up applying a lot of this thinking to public policy and other things that I see in society that have a broad impact. That’s where a fair amount of this is coming from. I believe that if people just learned how to think instead of letting other people do the thinking for them, that we could work our way to a considerably better society.
Melvin: I’ve got one last question for you, and this is the big one. It’s one that I try to ask everybody I run across. What books are you reading now?
Thorp: Right now, I’m reading a book called “The Accidental Superpower” by a guy named Peter Zeihan. And the reason I’m reading it is because one of my friends who I mentioned in the book, Gary Basil, who was a professor of economics and finance over at UCI when I first met him, sent it to me thinking it was going to be interesting, good to read. We had been talking about the election of Donald Trump, what we thought that meant for the country. This book looks at things much differently than I do, and I find that if I read things that may not agree with the way I look at the world, than I’m more likely to learn something than if I just read things that keep telling me, “Yes, you’re right” over and over and over.
This is a geopolitics type book, which basically thinks that geography in demographics are major determinants of how things evolve for societies. It’s an interesting historical perspective, and it has predictions of how the future’s going to go. I’m enjoying working my way through that and seeing where I agree and where I don’t agree with it and what I’ve learned from it or haven’t. That’s one interesting book that I’ve been reading.