#92 Ed Thorp and Claude Shannon

Summary Notes


In this discussion, the host delves into the investment philosophies of Claude Shannon and Edward Thorpe, as featured in William Poundstone's book "Fortune's Formula." Shannon, known for his groundbreaking work in information theory, applied his analytical skills to the stock market, achieving an impressive 28% return over 30 years by focusing on company earnings rather than market volatility. Thorpe, on the other hand, translated his mathematical prowess into successful blackjack strategies and later founded the Princeton Newport hedge fund, which boasted a 15.1% compound return rate over 19 years. Both men challenged the efficient market hypothesis, leveraging their unique skills to outperform the market and conventional money managers significantly. Their stories exemplify the triumph of skill and strategy over chance in both gambling and investing.

Summary Notes

Introduction to "Fortune's Formula" and Key Characters

  • William Poundstone's book "Fortune's Formula" is a collection of evidence supporting the idea that exceptional skill can yield above-average results in securities markets and betting systems.
  • The book highlights the investment methods of Claude Shannon, comparing them to those of Charlie Munger.
  • The podcast host recommends the book based on Munger's endorsement.
  • The book is structured in a series of essays rather than a cohesive narrative.
  • The podcast will focus on Claude Shannon and Edward Thorpe, both of whom applied academic concepts to investments.

"William Poundstone's book, Fortune's formula, collects much of the modern evidence on this point in a highly entertaining way."

This quote explains the basis of Poundstone's book, which is the central theme of the podcast.

Claude Shannon's Contributions and Methods

  • Claude Shannon invented information theory, the foundation of modern digital communication.
  • Shannon's work has had a profound impact on the digital age, comparable to the inventor of the Alphabet on literature.
  • Shannon's methods in investments were similar to his scientific approach, applying information theory to the stock market.
  • The podcast host agrees with Munger on the importance of tying great concepts to the lives and personalities of those who developed them.

"Claude Shannon was as close to a sure thing as existed. [...] He had single-handedly invented an important new science."

The quote emphasizes Shannon's unique achievement in creating a new scientific discipline and his remarkable skill, which also translated into his investment success.

Claude Shannon's Early Life and Personality

  • Shannon was born in Michigan, with a family background of inventors.
  • He was known for his ability to find elegant solutions to complex problems and was described as shy, courteous, and without envy or ambition.
  • Shannon preferred working alone and would spend hours thinking, a trait he shared with Thomas Watson of IBM.
  • The podcast host reflects on the modern lack of such dedicated thinking time.

"Shannon was born in Michigan in 1916. [...] The ability to see clean and elegant solutions to complex problems distinguished Shannon throughout his life."

This quote describes Shannon's background and his innate talent for solving problems, which played a role in his later success.

Claude Shannon's Academic Journey and Information Theory

  • Shannon's career took a significant turn when he took a job at MIT to maintain the differential analyzer.
  • He envisioned an electrical digital computer and applied Boolean algebra to electrical circuits, proving that such a computer could compute anything.
  • Shannon's work laid the groundwork for modern computing and his investment strategies.

"Shannon envisioned an ideal computer in which numbers would be represented by states of electrical circuits."

The quote highlights Shannon's foresight in imagining modern computing, which became the reality we live in today.

Project X and Shannon's Work with Alan Turing

  • Shannon worked on Project X at Bell Labs, a classified project involving digital communication encryption during World War II.
  • Alan Turing, known for cracking the German Enigma cipher, also worked on Project X.
  • Shannon's work on concealing messages with random noise contributed to his insights in information theory.

"A secrecy system is almost identical with a noisy communication system."

This quote links Shannon's work on encryption to the principles of information theory, showing how diverse experiences can inform future innovations.

Shannon's Shift in Interests and Contribution to Artificial Intelligence

  • Shannon shifted away from information theory to explore other interests, including artificial intelligence.
  • He organized the first major academic conference on artificial intelligence in 1956, showing his broad intellectual curiosity.

"I just developed different interests. As life goes on, you change your direction."

Shannon's words explain his decision to move away from the field he created, emphasizing the fluidity of intellectual pursuits.

Introduction to Edward Thorpe

  • Ed Thorpe is described as precise and had a zeal for measurement from a young age.
  • Thorpe's intellectual capabilities were evident early on, and he had a penchant for making money through bets and experiments.
  • As a physics undergraduate at UCLA, Thorpe sought ways to optimize learning and earning.

"One friend described Ed Thorpe as the most precise man I've ever met."

This quote introduces Thorpe's character, setting the stage for his meticulous approach to gambling and investments.

Edward Thorpe's Path to Beating Roulette and Blackjack

  • Thorpe discussed the possibility of beating roulette through physics at a party, leading to his interest in gambling systems.
  • He considered the imperfections of roulette wheels as an opportunity to predict outcomes.
  • Thorpe's studies in blackjack led him to intersect with Claude Shannon, as the computations were too complex to solve by hand.

"If the wheels have flaws, some of the numbers ought to be favored."

The quote captures Thorpe's rationale for believing that roulette could be beaten, either through perfect physics or by exploiting wheel imperfections.

Early Computing and Programming Efforts

  • William Poundstone describes MIT's mainframe computer, the IBM 704, which had available time during the summer.
  • Edward Thorpe decided to use the computer but needed to learn programming first.
  • Thorpe taught himself Fortran and programmed the computer to test his blackjack system.

"Thorpe taught himself the Fortran programming language and programmed the computer himself."

This quote explains that Thorpe was self-taught in programming, highlighting his determination and resourcefulness in pursuing his blackjack system.

Academic Publishing and Collaboration

  • Thorpe wanted to publish his blackjack system but faced a hurdle: only National Academy members could submit articles.
  • Claude Shannon, a famous mathematician and the inventor of information theory, was the only academy member at MIT who could help.
  • Thorpe met with Shannon, who agreed to submit Thorpe's paper on blackjack.

"Articles had to be submitted by a national academy member. And there was only one academy member at MIT who was a mathematician. That was the famous Claude Shannon."

This quote underscores the academic protocol that Thorpe had to navigate to publish his work, as well as Shannon's pivotal role as the gatekeeper for Thorpe's academic dissemination.

The Roulette Prediction Machine

  • Claude Shannon showed interest in Thorpe's roulette prediction idea because it involved building a gadget.
  • Shannon and Thorpe collaborated to create a roulette prediction device the size of a cigarette pack with twelve transistors.
  • The device required the user to click a toe-operated switch to predict where the roulette ball would land.

"Shannon was riveted. He was possibly more interested in the roulette scheme than the blackjack system because there was a gadget to build."

This quote captures Shannon's fascination with the practical application of theory, particularly when it involved creating a tangible device.

Testing and Challenges in Las Vegas

  • Shannon and Thorpe's roulette computer predicted betting outcomes with musical notes transmitted to an earphone.
  • They encountered technical issues with thin wires breaking, which hampered their ability to gamble seriously in Las Vegas.
  • The collaboration ended when Thorpe accepted a job offer, and he refocused on his blackjack theory.

"These problems prevented any serious gambling, so it was actually unsuccessful."

The quote reflects the practical challenges faced by Shannon and Thorpe, demonstrating that even brilliant ideas can stumble upon real-world obstacles.

Thorpe's Blackjack Theory and Financial Backing

  • Thorpe presented his paper titled "Fortune's formula: a winning strategy for blackjack" at a conference, attracting gamblers' attention.
  • Gamblers from across the country contacted Thorpe, some offering to finance him to test his blackjack system in casinos.
  • Claude Shannon advised Thorpe to use John Kelly's formula to decide how much to bet, emphasizing risk management.

"Thorpe decided that the best offer was the biggest one. A syndicate of two wealthy New Yorkers was offering $100,000."

The quote highlights the interest and financial potential behind Thorpe's blackjack system, as well as the significant backing he received to test it in a real-world setting.

The Kelly Criterion and Risk Management

  • The Kelly formula, created by John Kelly of Bell Labs, is a mathematical equation for risk management.
  • The Kelly criterion is based on the principle that accepting even small risks of losing everything will eventually lead to ruin.
  • Thorpe and other successful investors like Warren Buffett and Charlie Munger reportedly used the Kelly formula.

"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."

This quote from the transcript encapsulates the core philosophy of the Kelly criterion, which prioritizes survival and controlled risk in betting and investing.

Thorpe's Success with the Blackjack System

  • Thorpe and his financier, Manny Kimmel, successfully used the blackjack system in Vegas, but faced pushback from casinos.
  • Thorpe estimated a profit of $11,000 in 30 hours of play, validating the effectiveness of his system and the Kelly criterion.

"By Thorpe's estimation, they had built $10,000 into $21,000, 30 hours of play."

This quote confirms the financial success of Thorpe's blackjack system, demonstrating its practical application and profitability.

Importance of Having an Edge

  • The fundamental principle for investors and entrepreneurs is to have an edge.
  • An edge ensures that in the long run, more wins than losses will occur.
  • William Poundstone emphasizes that without an edge, one should neither bet nor compete.

"Assuming you have an edge in the long run, you will win more than you lose."

This quote underlines the importance of having a competitive advantage in any venture, which will likely lead to success over time.

Kelly System for Wealth Growth

  • The Kelly system is highlighted as the fastest method to grow wealth.
  • The system was developed by John Kelly, a Bell Labs research scientist.
  • It is a mathematical theory for the management of capital.

"The Kelly system grows wealth faster than any other."

The quote succinctly states the superiority of the Kelly system over other wealth growth strategies.

Ed Thorpe's Life and Career

  • Ed Thorpe's journey from poverty to wealth is a testament to the power of knowledge and an edge.
  • Thorpe's move to New Mexico State for financial reasons is a strategic life decision.
  • His book "Beat the Dealer" and the subsequent application of the Kelly system in gambling and investing are milestones in his career.

"Thorpe writes a bestselling book called Beat the Dealer."

This quote indicates the significance of Thorpe's book in his career, which also introduced the Kelly system to a broader audience.

Risks and Dangers in Gambling

  • Ed Thorpe faced physical dangers in casinos due to his successful gambling strategies.
  • Casinos do not always play by the rules, posing a threat to those who win consistently.

"Ed Thorpe almost died doing so."

The quote highlights the life-threatening risks Thorpe encountered in the gambling world due to his winning strategies.

Application of Gambling Strategies to the Stock Market

  • Shannon and Thorpe applied their gambling insights to the stock market.
  • They, along with Buffett and Munger, reject the efficient market hypothesis.
  • Paul Samuelson's advocacy for the efficient market hypothesis is criticized for being contradictory to his actions.

"I'd be a bum in the street with a tin cup if the markets were efficient."

Buffett's quote, as relayed by Poundstone, challenges the efficient market hypothesis by suggesting that his success is due to market inefficiencies.

Claude Shannon's Stock Market Analysis

  • Shannon conducted an extensive study of the stock market out of curiosity and profit motive.
  • He explored various investment strategies and questioned the efficient market theory.
  • Shannon's success with stocks like HP and Teledyne illustrates his practical rejection of market efficiency.

"Shannon once said, I don't believe that's true at all."

Shannon's quote expresses his disbelief in the efficient market hypothesis, aligning with his profitable investment practices.

Henry Singleton's Capital Allocation

  • Henry Singleton is praised by Buffett as an exceptional capital allocator.
  • Singleton's company, Teledyne, exemplifies successful investment and acquisition strategies.

"Buffett, he says something like, singleton is the single best allocator of capital in history."

Poundstone references Buffett's high regard for Singleton, emphasizing his investment acumen.

Ed Thorpe's Shift to Stock Investing

  • Ed Thorpe transitions from gambling to stock investing to avoid physical harm.
  • He learns from his initial losses in silver trading and seeks areas where he has an edge.
  • Thorpe's work on options and warrants leads to significant financial success.

"I learned an expensive lesson regarding all the money you lost in silver."

Thorpe's quote reflects on his costly mistake in silver trading, which taught him to focus on areas where he holds a competitive advantage.

Thorpe's Partnership with Sheen Kasoff

  • Thorpe collaborates with Kasoff on warrants, but they part ways due to philosophical differences.
  • Thorpe's hedge fund, Princeton Newport, becomes one of the most successful of its time.

"Kasov believed that he could sometimes predict in which direction certain stocks were going to move. Thorpe wasn't."

This quote explains the fundamental difference in investment philosophy between Thorpe and Kasoff, leading to their professional separation.

Remote Work and Business Partnership

  • Thorpe and his business partner, Reagan, successfully run a bicoastal hedge fund.
  • Their partnership is unique for its time, with Thorpe focusing on the mathematical models and Reagan on the business side.

"We were actually happy being separate because we had different styles and very different personalities."

The quote from Poundstone demonstrates the effective division of labor and mutual satisfaction in Thorpe and Reagan's remote partnership.

Meeting with Warren Buffett

  • Ed Thorpe meets Warren Buffett through a mutual acquaintance.
  • Both Thorpe and Buffett share a belief in exploiting market inefficiencies.

"Thorpe says the question wasn't, is the market efficient, but rather how inefficient is the market and how can we exploit this?"

The quote captures Thorpe's investment philosophy, which focuses on leveraging market inefficiencies rather than accepting market efficiency.

Criticism and Success of Princeton Newport

  • Princeton Newport faces skepticism for its computer-based investment approach.
  • Despite criticism, the hedge fund outperforms most mutual funds and proves the efficacy of Thorpe's methods.

"The journal writer was amazed at Thorpe's disregard of fundamental analysis and his reliance on computers."

This quote reflects the disbelief and criticism from the traditional investment community towards Thorpe's innovative approach to investing.

Princeton Newport's Durability and Wealth Growth

  • Princeton Newport demonstrates resilience during market crashes, such as Black Monday.
  • The hedge fund's consistent performance challenges the efficient market hypothesis.

"Princeton Newport's 600 million dollar portfolio shed only about $2 million in the crash."

The quote illustrates the hedge fund's stability and success, even during one of the stock market's most turbulent times.

Princeton Newport's Unexpected End

  • The hedge fund's closure is abrupt and dramatic, involving a federal raid.

"Vans pull up in front of Princeton Newport building. They contained 50 federal agents of the FBI, Treasury Department and ATF."

Poundstone's description of the raid on Princeton Newport underscores the sudden and shocking end to Thorpe's first company.

Arrests on Wall Street and Thorpe's Business Partners

  • Rudy Giuliani, as the prosecutor of the Southern District of New York, conducted raids for publicity ahead of his political ambitions.
  • Edward Thorpe faced issues with his business partners during the Wall Street arrests.
  • East coast partners of Thorpe's fund withdrew $15 million and re-deposited it under their wives' names, indicating potential misconduct.
  • Stock parking, a tax evasion strategy, was performed by traders in Thorpe's East coast office without his knowledge.
  • Thorpe chose to take the Fifth Amendment when called to testify, to avoid potential downside despite being unaware of the misconduct.
  • The use of the RICO Act by Giuliani led to the dissolution of Thorpe's hedge fund, Princeton Newport Partners.

"Actions spoke louder than words. Some of the east coast partners took about $15 million out of the fund and replaced it under the names of their wives." This quote explains the dubious actions taken by Thorpe's business partners, which cast a shadow over the fund's operations.

"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 going to take the fifth." Thorpe's decision to potentially invoke the Fifth Amendment highlights his strategy to protect himself from the legal turmoil surrounding his partners' actions.

Princeton Newport Partners' Performance and Closure

  • Princeton Newport Partners had an impressive 19-year record with a 15.1% compound return rate, outperforming the S&P's 8%.
  • Despite not engaging in wrongdoing, the fund was affected by the legal charges and the public's perception of guilt.
  • The partnership was dissolved in 1988, with the positions liquidated and money returned to investors.
  • Thorpe blamed the dysfunctional partnership and the partners' bold actions for the fund's downfall.
  • The closure of the fund was particularly frustrating for Thorpe as it interrupted the power of compounding wealth.

"The financial results of our partnership. To many portfolio managers today, the 19-year record of Princeton Newport Partners is the definitive home run." This quote emphasizes the exceptional performance of Thorpe's fund over its operational years.

"With RICO's charges looming, the fund's investors wanted out. In 1988, Thorpe and Reagan dissolved." The RICO charges and the subsequent investor panic led to the dissolution of the fund, as noted in this quote.

Thorpe's Post-Hedge Fund Career and Longevity

  • After the hedge fund's end, Thorpe ran Edward Thorpe and Associates, achieving high returns, primarily managing his own money.
  • Thorpe, at 87 years old, wrote his memoirs and remained sharp both physically and mentally.
  • The podcast host recommends watching interviews with Thorpe to appreciate his continued acuity.

"From there on in, he runs this thing called Edward Thorpe and Associates, like a series of hedge funds." This quote describes Thorpe's career trajectory following the closure of his hedge fund, where he continued to be successful in finance.

"I've never seen an 85-year-old person look as good as him. And then not only that, still be so on point mentally, it's remarkable." The host expresses admiration for Thorpe's well-being and mental sharpness at an advanced age, underscoring the rarity of such vitality.

LTCM's Failure and the Kelly Criterion

  • Ed Thorpe declined to invest in LTCM, which later infamously collapsed.
  • LTCM's founders, including Merton and Scholes, believed in exploiting market inefficiencies with massive leverage.
  • Thorpe's avoidance of LTCM was due to concerns about Merton and Scholes' lack of investment experience and criticism of the Kelly criterion.
  • LTCM's collapse was attributed to excessive leverage and poor risk management, which is a cautionary tale against risking survival in investments.

"For every dollar of investor money, the fund borrowed, $29 more." This quote illustrates the extreme leverage employed by LTCM, which significantly contributed to its downfall.

"You want to put yourself in a position you cannot be successful, you don't survive, so therefore never risk your survival, ever." The podcast host discusses the importance of risk management and survival in investment, reflecting on LTCM's critical mistake.

Claude Shannon's Investment Strategy

  • Claude Shannon achieved remarkable investment returns, outperforming professional money managers and mutual funds.
  • Shannon applied his communication theory background to investing, focusing on fundamental analysis rather than technical indicators.
  • He emphasized the growth of earnings and the quality of company management over stock price movements.
  • Shannon's investment approach was to invest only where he had an edge, which aligns with advice from Buffett and Munger.

"Claude Shannon, though not mentioned in the article, had done better than all but three of the pros." This quote highlights Shannon's exceptional investment performance, even when compared to professional money managers.

"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." Shannon's quote underscores his focus on long-term earnings growth as the most crucial factor for investment decisions.

Diverse Investment Philosophies and Practices

  • The podcast covers various investment philosophies, including those of Warren Buffett, Harry Markowitz, and Andrew Carnegie.
  • The host criticizes Markowitz's Modern Portfolio Theory, aligning more with Buffett and Munger's focused investment approach.
  • The discussion emphasizes the importance of understanding and leveraging one's unique edge in investing.

"We have not at any time in the past 30 years attempted to balance our portfolio." Claude Shannon's quote reflects his concentrated investment strategy, which contradicts the diversification principle of Modern Portfolio Theory.

"Andrew Carnegie told us, study how the great fortunes are wealth, great fortunes are made. It's not a scattershot approach." This quote illustrates Carnegie's philosophy of concentrating investments in areas of expertise, which is echoed in Shannon's approach.

Thorpe's Investment Success

  • Ed Thorpe's investment record showed a 20% annual return over 28 years, suggesting skill rather than luck.
  • Thorpe's extensive number of transactions and positions indicates a systematic and successful investment strategy.
  • The podcast host concludes with the importance of achieving a high probability of success in one's endeavors, beyond mere chance.

"Overall, it would seem to be a moderately long run, with a high probability that the excess performance is more than chance." Thorpe's quote reflects on his successful investment career and the likelihood that his returns were due to skill.

"I estimate that I have made $80 billion worth of purchases and sales for my investors." Thorpe provides a sense of the scale and success of his investment activities in this quote.

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