John Authers talks to the ‘godfather’ of investing about Madoff, moneymaking and madcap inventions Lunch with the FT
As far as Ed Thorp is concerned, Wall Street is no better than a casino — not because it is a gamble, but because it is fixed. “The invisible hand has become the invisible middle finger. It’s a controlled and manipulated marketplace. As Donald Trump would say, ‘It’s rigged’.”
Thorp, a sprightly 84-year-old, is uniquely placed to judge. A mathematical prodigy, he worked out how to “beat the dealer” at blackjack while a postdoctoral student at MIT. After he published a book in 1962 revealing how to count cards, he became so famous that casinos banned him from playing — he says one even resorted to drugging him. Many changed their rules to thwart people using his counting system.
Next came an attempt to beat roulette, using a contraption tied to his foot that is now described as the world’s first wearable computer; after that, an expedition into Wall Street that netted hundreds of millions of dollars. His Princeton Newport Partners fund, set up in 1969, is recognised as the first quant hedge fund (one that uses algorithms). Over 18 years it turned $1.4m into $273m, compounding at more than double the rate of the S&P 500 without suffering so much as one quarter with a loss. Thorp’s then revolutionary use of mathematics, options-pricing and computers gave him a huge advantage.
His escapades, as well as his moneymaking abilities, have made Thorp the “godfather” of many of today’s greatest investors. Warren Buffett, a bridge partner, advised investors in his first hedge fund to move to Thorp; Bill Gross, who founded Pimco and built it into the world’s largest bond fund manager, spent time at blackjack tables, then set up as an investor using Thorp’s 1967 book Beat the Market; Ken Griffin, now the world’s highest-paid hedge fund manager, set up his fund Citadel in 1990 using documents that Thorp gave him from Princeton Newport.
It’s an intimidating CV and I am nervous as I meet Thorp at his office in a modern block in Newport Beach, a spectacularly situated town in Orange County to the south of Los Angeles. But in person Thorp, who is wearing a tracksuit and still works out regularly, is not intimidating. A tall man with immaculately clipped designer stubble, he could easily pass for someone 30 years his junior and his face wears a seemingly permanent puckish smile.
After admiring his glorious view of the Pacific, we descend to the ground floor, and he bids me to get into the passenger seat of his red Tesla (“I used to have a Porsche, but this is so much better”). It is a gloriously smooth, and quiet ride down the highway to Rothschild’s restaurant in Corona del Mar, a family-run Italian place where they are delighted to meet him. It is also, he points out, not too expensive.
This is a key to understanding Thorp, whose success stems in part from the habits he learnt as a child growing up in restricted circumstances in Chicago and then Southern California during the Great Depression and the war. His parents worked and he had to educate himself. He also learnt not to be greedy.
He no longer gambles. “I enjoyed the process of learning something new and being in a new milieu. Once it became a routine grind, I wasn’t interested,” he says. “Blackjack isn’t very interesting because the stakes are so small. If you are used to betting millions in the market, betting a few thousand in the blackjack tables doesn’t mean anything.”
These days, quants and hedge fund managers are notorious for their love of poker. “That’s because they can compete with each other. They like doing that a lot,” he says, with tongue in cheek.
We both order specials; he has the salmon and I have the swordfish, which he recommends. We also discover, to our mutual relief, that neither of us drinks at lunch, so this will be washed down by sparkling water and iced tea. I have the minestrone soup, but he abstains as he will need to keep talking.
So, why is he so negative about Wall Street? Without raising his voice, he launches an indictment. “Adam Smith’s market is a whole lot different from our markets. He imagined a market with lots of buyers and sellers of things, nobody had market dominance or could impose things on the market, and there was a lot of competition. The market we have now is nothing like that. The players are so big that they control the levers of financial policy.” There are still plenty of Ponzi schemes on Wall Street too, he says, and not just Bernard Madoff, whose epic fraud he claims to have spotted more than a decade before it collapsed. In 1991, Thorp did some due diligence for a consultancy that asked him to look through their hedge fund investments. Madoff’s returns instantly looked too good to be true, he says.
He tried checking the trades that Madoff had reported making against those reported in the official record. Half of them could not have happened because there was zero volume (the number of shares traded) in those options on the day the trades were supposed to have been made. “Once you know half of them are fakes, it’s pretty hard to believe the other half are real.”
A more detailed check revealed that in half of the remaining trades, “my client alone had more trading volume than was reported for the entire exchange. This was absolute proof. You didn’t need financial theory, no nothing. It was as if I had a video of him pulling a trigger.”
Nobody took any action. “I waited year after year after year for it all to blow up. One reason it didn’t was that he was a pillar of the establishment. And he had all these people steering money to him, charging fees. He wasn’t charging fees himself, which was another big red flag.”
As for hedge funds, he says they are now “a mature asset class, and the risk-adjusted returns for hedge funds are inferior to other asset classes”. So many people are now using quant methods that they are no longer so profitable.
I have had many conversations like this in the 10 years since the financial crisis. So, as we begin to tuck into the fish, lovingly wrapped in home-made pasta, I ask what he suggests we do about it? “The banks who are too big to fail should have been allowed to fail. Their shareholders should have had to pay the price. Big companies go through organised bankruptcies. Why is it that we couldn’t afford for the banks to go bankrupt? It’s that they are so influential. They can persuade the government not to let them go bankrupt.”
If I could go back and trade places with Warren Buffett, would I do it? No. I never even thought about finance until I was 32
He also holds that banks’ speculative arms should be broken off — essentially a return to the Depression-era Glass-Steagall law that was controversially repealed by President Clinton in 1999. The newly elected President Trump — we are lunching on the first Monday of his presidency — was elected on a platform of bringing back Glass-Steagall, but now appears intent on deregulation. Thorp winces at the mention of Trump’s name, saying he is as negative about him as it is possible to be.
I need to ask Thorp about his own most awkward professional moment. In 1987 his hedge fund’s New Jersey office was raided by agents working for the then New York district attorney, Rudy Giuliani. They had had dealings with Michael Milken, the king of junk bonds, and Giuliani was looking at every possible avenue to bring Milken down. Thorp, based in Southern California, was never charged or implicated, but several of his New Jersey colleagues were dragged through years of legal proceedings before establishing their innocence. Rather than fight on, Thorp decided to fold up his fund.
On Milken, who brought bond finance to many smaller companies, he is sympathetic. “Milken’s crime was far greater than any other person on Wall Street because he began unhorsing the old-line white shoe establishment and driving the companies they were running into the ground. He had to be stopped. And unfortunately he gave them some ammunition.”
As for Giuliani, Thorp resists my bait to criticise. “I don’t know how to install an ideal system. First, is there such a thing as an ideal system? And, second, is it politically possible to achieve it? I’m not sure about the first; to the second I’d say absolutely not, because the people with power don’t want it to happen.”
By now we have both completed our fish (truly excellent), and are on to postprandial caffeine. I ask about the roulette computer idea he cooked up in 1960 with Claude Shannon, the father of information theory. Thorp had gone to Shannon for advice on his academic paper on blackjack. Shannon asked if he had any other ideas, and leapt with excitement at Thorp’s ideas on roulette. That led to experiments in Shannon’s basement, full of half-invented contraptions, with strobe lights and tilted roulette wheels.
The idea, Thorp says, was to press a button on the gadget (with his toe) as the ball whizzed around the upper ring of the roulette wheel (or “rotor”). Pressing again would gauge its speed and rate of deceleration. I can see how this would help predict where it would fall. But what about the separate problem of where the wheel would be? It spins in the opposite direction. Knowing where the ball will drop does not help unless you know the wheel number that will be underneath when it does so.
Thorp explains by whirring his finger around a tea saucer. A roulette wheel has one (or, in the US, two) green pockets. These give the house its advantage, as everyone loses when the ball lands in green. But they also enabled him and Shannon to break the game. By clicking on the contraption when the green passed a certain point, it was possible (by programming the machine with phenomenal mathematics) to work out where the ball would drop and roughly which number would be underneath. Total precision was out of reach, but they could narrow the range to six numbers — good enough odds to give them a crushing edge over the house.
The system worked, but the hardware suffered a fatal weakness. The machine needed an earpiece. They bought the thinnest wire available, and went to elaborate lengths to hide it behind their hair, which they grew longer, but the wire often broke and could not be trusted. These days, they could probably use a Bluetooth earpiece.
Thorp’s childhood, lovingly described in his new autobiography A Man for All Markets, was filled with homemade experiments. He loved making things go bang, and built a succession of explosive devices. At school, and university, he specialised in physics and chemistry. In Shannon, he found another overgrown schoolboy who happened to be a maths genius. So why did Thorp become a financier? Should he not have been an engineer up the coast in Silicon Valley?
He grins. “There are certain times in an industry when something is ready to happen. If you are there at the time, there’s a much higher chance that you will be involved.” His roulette gadget came more than a decade before the first Apple computer, and almost four decades before the iPod — wearable computing was not ready to happen.
Instead, he put his insights from blackjack to work on investments, using advanced mathematics to develop strategies based on buying stocks in large numbers, where the odds were in his favour, just like counting cards. Having turned investment into a mathematical problem, he solved it, and programmed computers to help him.
Why was he able to make so much money from this when others do not? “People aren’t good processors of information. Not collectively. Witness the recent political campaign in America. They can be fooled by fake news easily.”
And there’s another point. “One of the things that’s served me very well in life is having an extraordinary bullshit detector.”
Thorp says that whenever he hears a surprising statistic, he tries to test it. Over coffee, I am scribbling fast in shorthand. He is intrigued. How fast can you write with that? I tell him I passed at 120 words per minute. “And people talk at about 80 words a minute, right?” No, I reply, they generally talk a lot faster — more like 150, but the tendency to be more considered when talking to a journalist probably saves us. Thorp’s eyes narrow as he listens to the conversations at other tables. “Actually there’s a way I can test that. I recorded an audiobook. So I can listen to that and time it . . . ”
As his mind calculates how fast people speak, I tell him FT Weekend readers might want some investment advice. Why not copy his friend Buffett and try value investing as advocated by the investment theorist Benjamin Graham — analysing balance sheets to find underpriced companies?
That never appealed, says Thorp. “The way I sized up the Ben Graham approach was that it would be a total lifetime of effort. It was all I would be doing. Warren demonstrated that. He’s the champion of champions. But if I could go back and trade places with Warren, would I do it? No. I didn’t find visiting companies something I wanted to do. I never even thought about finance until I was 32.” Buffett was trading bonds aged 11.
Thorp’s advice: “If you aren’t going to be a professional investor, just index.” He conducts some more quick calculations in the air. Collectively, those who try to beat the market do 2 per cent worse than those who just buy an index fund, each year, by the time they have paid all their fees. That means that you make “twice as much money if you index as the average guy who doesn’t index, after 35 years”. Meanwhile, you can get on with what matters.
This also explains why he did not make more of an effort to keep his hedge fund. “I realised Princeton would have taken over my life. I would have spent my life just accumulating money.” His secret was to realise that he had enough.
Instead he and Vivian, his wife of more than 50 years, travelled the world and enjoyed their grandchildren. Three of them — triplets — are now at MIT. His book, long in the writing as it was sadly interrupted by Vivian’s year-long battle with terminal brain cancer, describes life as an adventure, and ends with advice about work and life balance.
That adventure continues. As I pay the bill — a very reasonable $80 — and we head back along the coast, he tells me about his latest hobby. He has taken up scuba diving with his new girlfriend, a molecular biologist. The Maldives are great. As for what comes next, when he passes on his body will be cryogenically frozen. “I feel that I have more to contribute and more things to do and enjoy in life than an ordinary lifetime allows.”
He estimates his chances of resurrection at about 2 per cent.
John Authers is the FT’s chief investment commentator
Illustration by James Ferguson