Alongside Warren Buffett, Ed Thorp is considered one of the godfathers of financial investing. Now 91 years old, Thorp has truly proven himself to be a man for all markets, as his popular book attests. Within this article, we shine a spotlight on the story of Edward O. Thorp, a man who has committed his life to academia and challenging statistics and probability in the stock markets.
At a young age, Thorp would often be left to his own devices. It was this that gave him the freedom to explore real and imaginary worlds in greater detail. He would read plenty of books given to him by his father. It was his thirst for knowledge and desire to work things out on his own terms that would form the future foundations for his financial success.
From MIT professor to Vegas winner
An adoration of physics and maths meant that Thorp would go on to study both subjects at college. His studies were largely funded by a California state scholarship, awarded to him for achieving the highest score in his high-school physics examination. He would go on to finish his doctorate in mathematics at the University of California. Thorp was a professor of maths at MIT and latterly the New Mexico State University and the University of California, Irvine.
However, his number-one passion was established around the same time as his graduation in 1958. Thorp ventured to the shiny mecca of Las Vegas in the heart of the Nevada desert. He believed he could beat the casino game of roulette using a computer. However, it was blackjack that would eventually catch his eye, as he discovered a strategy that minimized the casino’s house edge to almost break-even.
Thorp was one of the first to conduct academic research into the game of blackjack. It was his analysis and subsequent book, titled Beat the Dealer, which captured the imagination of casino-goers, who have long since adopted Thorp’s basic strategy and his approach to the game. Although a great number of variants exist online today, basic blackjack strategy can still be deployed by players. The strategy that Thorp assembled is most effective with blackjack games that use the fewest number of playing card decks to help reduce in-game variance.
Over time, Thorp refined his basic blackjack strategy with the aid of an IBM mainframe computer – the same used by Microsoft prodigy Bill Gates – and perfected his skills at the game.
Mimicking his risk-reward approach to blackjack in the financial markets
Shortly after his stint in Las Vegas, Thorp promptly shifted his attention from ‘Sin City’ to Wall Street. Having been bitten by some hefty losses during his first foray into the stock markets, Thorp pondered whether his methodology could yield a comparable edge in the financial markets.
Thorp soon recognized that casino games and financial investing have similar characteristics, with the need to base the size of bets and investments on the probability of it being a win or a loss. In the same way that Thorp’s blackjack strategy enabled him to bet big when the probabilities were in his favor, his quantitative approach – now known as the Kelly Criterion formula – to the stock markets enabled him to take full advantage of mispriced assets.
Thorp’s strategy for the financial markets, revealed in his book Beat the Market, was later copied by Myron Scholes and Fischer Black. The formula was eventually labelled the Black-Scholes model, with Scholes eventually going on to claim the Nobel Prize for Economics in 1997. This all seemed somewhat unfair given that Thorp was the mastermind behind their ability to forecast derivative prices with greater accuracy.
Thorp would go on to manage his own hedge fund and invest in Warren Buffet’s Berkshire Hathaway fund. More recently, Thorp has enjoyed a quiet life. Although it was approximately half-a-million bucks less than he anticipated, Thorp remains a true mastermind of the financial world. His books remain an inspiration for anyone looking to invest intelligently for the future.