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(More customer reviews)This is an excellent book about the discovery of the Kelly formula that is unknown outside gambling. This story has three protagonists. Two of them were scientists working at Bell Labs: Claude Shannon, a genius polymath who developed information theory; and 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.
Ed Thorp tested the Kelly formula in both gambling and investing. Also, he came up with an options formula before Fischer Black and Myron Scholes. His formula missed a risk-free rate component due to the structure of the market at the time. As a result, Ed Thorp remained in obscurity while Black and Scholes became famous.
Ed Thorp succeeded in deriving superior returns in both gambling and investing. But, it was not so much because of Kelly's formula. He developed other tools to achieve superior returns. In gambling, Ed Thorp succeeded at Black Jack by developing the card counting method. He just used intuitively Kelly's formula to increase his bets whenever the odds were in his favor. Later, he ran a hedge fund for 20 years until the late 80s and earned a rate of return of 14% handily beating the market's 8% during the period. Also, his hedge fund hardly lost any value on black Monday in October 1987, when the market crashed by 22%. The volatility of his returns was far lower than the market. He did this by exploiting market inefficiencies using warrants, options, and convertible bonds. The Kelly formula was for him a risk management discipline and not a direct source of excess return.
Ed Thorp's career as a hedge fund manager was temporarily cut short. This was due to his fund being involved in a tax-avoiding securities scheme with Drexel Burnham. Thorp was not guilty; but, the fund had to be liquidated. The author stated many of Milken wrongdoings. One included getting large equity positions attached to the junk bonds he issued. The companies thought they were issuing convertible bonds. However, the equity component went straight into Milken's pocket as he sold the bonds to investors as high yield debt with no equity attached.
Ed Thorp rebounded from this mishap and started a second hedge fund in 1994. Thorp continued reaping above market return. As the author states, Ed Thorp's genius consists in "...his continuous ability to discover new market inefficiencies ... as old ones played out." Ed Thorp closed this second fund in 2002. He is now independently exploring inefficiencies in gambling.
Claude Shannon amassed large wealth by recording one of the best investment records. His performance had little to do with Kelly's formula. Between 1966 and 1986, his record beat even Warren Buffet (28% to 27% respectively). Shannon 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.
John Kelly was a chain smoking, gun collecting brilliant physicist. He died young at 41 of an aneurysm. He worked closely with Shannon at Bell Labs. Besides being a charismatic character the author does not write much about his life compared to the other two (Shannon and Thorp).
The Kelly formula is Edge/Odds (as explained on page 72). In investment circles, this formula is not always useful because it is hard to quantify your Edge (value of proprietary information). However, Kelly's formula has intuitive practical implications. It entails you should focus on an investment internal rate of return (IRR) instead of its average yearly return. The IRR is always less. Another implication is that higher risk is not always compensated by higher return. There is an optimal risk level beyond which risk taking becomes destructive. The author mentions the Long Term Capital Management as a case in point.
I recommend other excellent similar books: "Fischer Black and the Revolutionary Idea of Finance" by Perry Mehrling, and "When Genius Failed. The Rise and Fall of Long Term Capital Management" by Roger Lowenstein. Both these books describe luminaries in finance and investment fields who were often in contact with Ed Thorp and Claude Shannon. Another excellent book is Sylvia Nasar's "A Beautiful Mind" about John Nash, the Game Theorist.
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