This book is about a bunch of different things. It’s mainly about Ed Thorp and Claude Shannon and that is how I found this book. I’ve read a lot of books that mention Ed Thorp and Claude Shannon. It builds Ed Thorp and Claude Shannon up as two of the best financial geniuses that people have never heard of.
The book title came from the name of a paper that Ed Thorp published.
Ed Thorp is well known for his book about card counting called Beat The Dealer. Many people that take blackjack seriously end up reading this book.
First part of the book is about Ed Thorp and Claude Shannon’s background. I wanted to learn more about Claude Shannon because he is discussed in past books I’ve reviewed such as The Man Who Solved The Market and Life After Google. I went into this book to read more about Claude Shannon, but I ended up learning way more than I thought I would.
Next the book goes into Ed Thorps background in gambling and how Claude Shannon and Ed Thorp got connected. The gambling section discusses methods used by Ed Thorp and then the transitions into the Kelly Criterion. The Kelly Criterion is introduced in the gambling portion of the book.
It’s also about how to maximize wealth primarily through the stock market. This book discusses gambling since this is how most of the people in the book got started in equity trading. Many people get involved in gambling but realize once they get an edge, casinos don’t let them play anymore. We saw this in the book The Man Who Solved The Market. Jim Simons loved gambling as well.
It covers other topics like information theory and the mob’s involvement in markets and gambling.
Information theory is introduced because it deals with the law of large numbers, and you can use the law of large numbers to your advantage. As long as you don’t go broke, then the law of large numbers should eventually start to work in your favor. Most people go 100% into bets at some point and that is the best way to lose all your money.
You have to think of it from this perspective. If you had to bet on something, you have a better chance of making money in the long term if you have a low chance of going to zero. The way you would do this in the stock market is by investing in something like a mutual fund that tracks the most successful companies like the S&P 500. It is highly unlikely that all 500 companies in the S&P500 would go to zero, therefore; it would be hard for your investment to go to zero. In that case, it would be ok for you to put all your money into that fund.
The Kelly Criterion
The most important part of the book is stated as follows:
When faced with a choice of wagers or investments, choose the one with the highest geometric mean of outcomes.
This is the Kelly Criterion.
The Kelly criterion doesn’t apply to certain wagers though. If you are able to replace your money, then you should maximize your arithmetic mean. Arithmetic mean is just the average of numbers. Geometric mean is the mean calculated by multiplying n values of numbers and then taking the nth root which is not a fun and easy calculation.
The primary way to gain wealth according to the book is the kelly criterion. The kelly criterion was developed as a way to measure information. It tells you how to allocate your portfolio. The math in this book gets confusing because there are so many scenarios. There are scenarios where you have insider info like many people in the book. There are also scenarios involving leverage. If you have a strong edge, then you should leverage your position. Ed Thorp actually ended up writing a book about the Kelly Criterion after the publishing of this book. If you want to learn more about the Kelly Criterion, you should most likely just get that book. He also recently wrote a book called A Man For All Markets that is about how he beat wall street and casinos. That’s probably another book to get if you are interested in Ed Thorp.
Essentially my understanding of the Kelly Criterion is you need to assess your past bets and successfulness of those bets. Then you use the formula to understand how much you should place on future bets. These are bets on things that have the potential to go to zero. If you don’t have the potential to go to zero, then you should invest more into that item. That is why index fund investing has become so popular recently.
The remainder of the book goes into other metrics that are important to investing, but the book always comes back to the Kelly Criterion. You can tell that the author believes very deeply in the Kelly Criterion.
The main thing I learned about this book is the math formulas behind the quant traders in today’s market. Though many quant traders no doubt use other formulas, this would be a good start for people to learn how to run a quant fund. You can use the kelly criterion to allocate capital and dig into the other math calculations in this book to learn about the best trades.
Other People & Concepts Mentioned In This Book
H.A. Latane – Choice Among Risky Ventures. Started work in the 1930’s and researched Bernouli. He worked on portfolio theory and came up with the concept that the geometric mean is the best for investors.
Harry Markowitz – worked on mean-variance analysis. Basically that if you spread your risk across a bunch of investments or stocks you will be safer.
D Bernouli – Measurement of Risk
The book also mentions geometric wealth versus logarithmic wealth.
Arithmetic mean – regular mean
Geometric mean – the usual scorecard for wall street. Higher volatility means a lower geometric mean.
Kelly Criterion can tell you which one is better.
This book also discusses Rudy Giuliani and how he started prosecuting RICO cases. Rudy Giuliani is best known for being the Mayor of New York City.
The reason it discusses this is because Thorp got caught up in a RICO case involving a popular bond trader. Ed Thorp had to shut down one of his funds because of this. If he didn’t have to shut down, then the author contends that he would have been one of the most successful traders in history and their would have been a lot more written about him.
How this book is structured. Build up into kelly criterion. Kelly criterion. Expansion of kelly criterion. Alternatives to kelly criterion.