strategy baccarat


please, welcome to the stage

Ron, bacardi ceo of context capital partner and john culbertson cio of context capital partners

Thank you everyone for being here and welcome to our biggest summit yet?

part of this event

John and i are very excited to interview, someone who really is a legend in the industry

it's considered to be the father of quantitative trading and

We're, gonna talk tonight a lot, about a. Book that he's recently published, which is in essence an?

Autobiography titled a man for all markets


Many of you know he also plays a mean hand at poker i'm sorry out of a

Blackjack so before before, we get into the interview, we just want to show? A quick video?

now let's meet our third team of challengers

What is your name please my name is edward thorpe?

My, name is edward thorpe, my name is edward thorpe

Alright, no please take out the next copy if you will and follow along. I edward thorpe i'm an

Associate professor of mathematics i am especially interested in the laws of probability in gambling games i applied, some theories of my

Own and the findings of a computer to the game of blackjack or twenty-one and came up with a preliminary report

Which i delivered before a scientific meeting the results were astonishing

300 copies of my report, was snapped up, by the scientists and i was besieged by people?

Who, wanted to help me profit from my, system - big-time gamblers actually, did backed me in an experiment at

the blackjack table in two hours of play, we broke the bank twice and won

$17,000 the book i wrote expounding my

System is called beat the dealer a winning strategy for the game of 21 it is currently the most requested volume in

The las vegas public library

Signed edward thor

And here we bring you three gentlemen?

Panel all claiming to be edward thor bish you heard author of what is called the most popular book and in las vegas public

library, we'll start with taking cash peggy thank you and number two who's gone

Scarn yeah, do you, mean scar knee, well i don't know. How, to pronounce it i read the book but i wrote a

Book, about gambling, uh number three in blackjack he tells you to stand on a certain number do you know

What number that, is i'm sorry i don't know? You know number one?

Who, tells you this tyranny if when he wasn't in this book, about blackjack he says that you should you can

Even stand on as low. A number as a certain number i don't recall do you know number two no i know

Oh, what is insurance number three, what is insurance in blackjack, when you take insurance

well that, means that if the dealer has an, ace

And you can see the ace then you can put out. A little bit to protect. Your bet against him helping a. Blackjack

Orton and number two you broke the bank twice in two hours of play with other times, where you tried it and failed

There were other times, we broke the bank other times

we did

Did you lose all your money sometimes no never

Number one how much money would you need to go into this would you have to have a certain reserve behind you

Well i started with $10,000 with, my to gambling friends i only dipped into

$1,300 i

See number number three, where these are gambling friends are they still walking free in the face

Do you know them by name i call them x and y in my book

Well having done this extraordinary thing i want to know, why, you're here, why aren't you working

number one

We had a man on this show once who had a computer for i think it was blackjack do you know. His name

Hmm i think i know, who you mean?

but i don't believe you use the same type of computers as i used i used a digital computer i think

Now number two how, long did it take you to work this out the entire theory yeah

Close to a, year number three i'm asking this question seriously, why, don't you just do it all the time

I'm not very popular out there

Oh number one where did you play tom poston

Number one they wouldn't think of keeping you out of las vegas would they are they sure would

What is that what do you mean they, don't want you to be comfortable las vegas gambling is a business i know but it's

Also, supposedly in a free society

There's nothing, free under the sun you start winning you're in trouble, well uh

Thank you number two number two, what is a bank, what determines a bank

Determines the bank it's up to the casino, they will have this much or

That's it there we pause on an ads and we stop and go right to the if and but as?

we please mark our ballots that ones please without, any change of course and without any consultation just vote now for number one

Number two or number three

All ballast marks nope please mark, we haven't much time

There it all right tom for who i voted for number three and i'll tell you if

We better straighten this out right now because i don't think that vegas or any other place that's a public

Place like that is allowed to bar people from their

Calls just, because they

Win maybe i'm wrong but i think it's number three hey

I voted for number two i don't think that they could keep you out of say the flamingo if you wanted to bet

But and also nervously?

Insurances when you have two aces and you doubled them up in bet it it's not that other insurance that you said at least to

Where i played if that was in shirani

If i think it was the nice, we had a chance to hear number one's a story about how

To, after him, before they come from

Number three cuz, they weren't after him aboard a, well but you know

i joined

Kitties, well i think peggy, and plumber, naive i'm sure they, want to keep him out of las vegas

My voted for number two

About that book and if you made up that book i'm gonna tell you no good

I voted for number two pilots even they split, that's more the way you do is rule two economy

Was gone please go now for the truth and find out who's right and who's wrong as you learn?

Which one of these gentlemen actually is the author of the most popular book in las vegas library will the rail dr.

Edward thorpe please stand up

Let's welcome to the stage dr. Edward forages

So i thought it was interesting that

We were talking a minute ago i found out. That was not ed's only, game show

Who actually appeared on a few others correct

Which others were you on?

I've got a secret

Okay, what's my line, and steve allen?

great, well

I'm interested to hear how

You, go from college professor to game show, contestant to hedge fund manager so that's what we're here to talk about

Okay, so but i want to rewind? A little bit and and really go back to your childhood you talk a lot in the book

About your childhood and one of the things that i found really interesting, was from a

Young, age your ability to really focus on whatever it is you were you were doing can you talk a, little bit about that

It was kind of odd when i was?

very young i

didn't talk until i was about three and

people worried, about, me my parents particularly there were trying to get me to say something and then one day i was sitting in

Montgomery ward a big department store in chicago and


Were friends of my mother, who were along and they kept, asking me questions as they always, did hoping i would

Say something so a man got off the elevator and they said

Where's he going and i said something rather like

Going to buy a shirt and they were really startled and then a couple ladies got off they said, where are they

Going and i said, oh?

they're, going to the bathroom to do peepee and

Yeah, all three of the blushed a beet red and i was very surprised? By that and it left quite an impression upon me


Then i started talking and my father

Decided that this kid might be able to learn things and he started trying to teach

Me whatever he could so in rapid succession there, was reading and math and i seemed to gobble up whatever. He showed me

But this was during

Not long after, we moved to southern california

the war broke out and my parents were in

Defense centers industries working

Night and day they were working

One of the swing shift one of them was working on the graveyard shift so i didn't see much of them

And i was pretty much on my, own and?

So i was going to a school that was academically

Rather backward it was 31 out of 32 in the la city school system

So i ended up with, my interest in science having nowhere to go unless i taught myself so i did that and

That was one of the things that helped me?

Focus on things very intensely and it gave me a very good education because i could just move from one subject to another

Fairly, easily and started learning it whether or not i'd had any formal training

So another common theme, was clearly your tenacity it seemed like once you had set your mind on solving a problem

You, would stay pretty committed to finding that solution

I, assume that had to be a

Critical component of your success yes and if i wanted for example to go to college i had to set my mind on that because

Nobody, from this, high school

Went to college and we didn't have the money to send me so i had to go out and earn it myself with

Delivery newspapers that 2:00 or 3:00 a.m.. And

Finding other odd jobs and trying to win?

We're then rather small scholarships here and there and a piece of them all together

so it took a lot of determination at that time because this, was an era, when people are much poorer than they are now, and

in which many fewer people, went to college and from this particular millio they, say nobody went

So you're in college you actually started at berkeley i believe you transferred from berkeley to ucla because berkeley, was too expensive


you, graduate from

ucla and

Eventually get a job at mit where you met claude shannon, yes

so i know you began

talking to shannon about a variety of

Gambling problems that you were interested in and of course everyone knows. You for blackjack but

you, actually started with roulette correct, that's right what happened, was i

changed from chemistry

After my freshman, year at berkeley the physics and moved to ucla and i got a. Bachelor's and a master's in physics and?

Then i ran into a lot of

There was a thesis in quantum mechanics and there were a lot of math problems

That i had to solve and i needed more math in order to do it?

So i went over to the math department and started taking courses

Without a lot of the prep courses that i would have needed had i been a math, major and

i learned that

When i was doing this that i could get out in math sooner than in physics so i did that and

However while i was working on my, master's in physics i have thought, about roulette an idea it had way

Back in high school and thought that it was predictable so i decided i would try to build a machine to actually predict

where the ball would fall and

That's what got me interested in gambling and

That led by chance to getting interested in blackjack because i went out

After i got my phd i was teaching at ucla for years i went out to the

Casinos in las vegas with, my wife for


Specification but my real, goal, was to look at roulette wheels and see if they were as

Well mushy perfect as i believed them to be and if the experiments i'd done were?

Which confirmed that if they were that way the experiments i did suggested that i'd be able to build

A machine to predict, and have a. Huge edge donee how

I, was there to look at roulette wheels and i happened to hear about a way of playing blackjack that was almost even?

so i

Decided to risk ten dollars at the blackjack tables partly to get some experience in the casino

Which were i had never gambled in and yet a feeling for the

environment because i thought i'd be playing roulette there for

substantial stakes that's sometime in the future and what i learned during that blackjack experience convinced

Me that i could beat that game i went back to ucla and read the article very carefully that had given me the little

system for playing almost even and

I saw from reading the article that in fact it was almost certain i could beat it using some of the math i'd learned

So that set me on that track and?

Then when i went to mit i?

they, had a i b m

704 computer that i a faculty member could use i

Shared it with mit faculty and 30 new england universities computers were scarce in those days

this, thing, was refrigerator-sized and

Probably, not anywhere near as powerful as your

Phone that you're carrying around

but i learned to

Type out type holes and punch cards and other in the program and fortran and in about, oh

a, year, i had worked out the theory for blackjack, and


Led me to claude shannon as it happened because i wanted to get

Very rapid publication, my experience had been that if you

Don't publish something really interesting rapidly other people will claim they, did it and maybe published, before you

Did and the way to publish for it quickly

Was to get your article in the proceedings of the national academy of sciences which

Published short unusual articles that they thought were significant and to do that you had to have somebody from the national academy

Approve the article and send it in on your behalf

though, the only person in math in the national academy at mit was claude shannon but i looked him up and i was told if

You have an appointment with him he only

Talks to you for a few minutes at the most unless he gets interested for some reason or another and so

we talked, about black track and he agreed to send the paper in

and then he said, what else say you're working on i

Said, well i have this idea for roulette and?

I've already carried it far enough to know that it's almost certain to work and he was

You, may know that he's the

Founder of information theory, which is a?

Major, underpinning for the whole digital, age and he, also was a great gadget cheer and he was one of the two

Distinguished professors on the mit faculty than the other being norbert wiener and


The fact that we could build a gadget really appealed to him and so, we spent about nine months in his basement

Outside cambridge in his big three-story house working on the computer, while i was busy teaching and also dealing with a

Black, jack and it's fall out, and?

the upshot

Was that we actually built a computer that worked and it turned out to be the first of the wearable computers according to the mit

Timeline on this subject

Although, we weren't thinking about that, we were just thinking about building something that would be amazing and?

Having a lot of fun with it i like that you invented the first wearable computer as just like a side thing yes

Just just as an aside on that i was at a meeting

A couple of decades later it was a biotechnology meeting and somebody said, did you know

You invented the first wearable computer and i said what's a wearable computer?

I had lost track of this subject, never never thought, about it again, until that time

so shannon also

Led you to a critical component of what became your ultimate

Sort of theory of how to beat blackjack that's a really interesting question

shannon was the

Most famous person at bell labs, which was one of the?

great historical think tanks and

The probably the second most interesting person there was a physicist named john kelly

So john kelly learned, about shannon's information theory from shannon, he wrote a paper called a, new

Interpretation of information rate that came out in 1956 and that paper

Had to do with

interpreting a

Communication line that had defects in it interpreting it as a betting scheme and the upshot was that

He devised a method

By, which if you followed it your capital, would grow in the long run, faster than anybody, else's

so i

Said this is the shannon told me about it and i said this is the perfect. Thing for betting at

Blackjack if i won't live anchor role there and the casinos to grow at the maximum possible rate

So anyhow, i that for blackjack and i learned a great deal about it at the time and

over the years i used it in investing very successfully and then i

And two others were?

Editors of a book called came out 2010 it's called be kelly capital growth investment criterion it's a collection of about

700 pages of papers some of which

We the editors wrote and then connective and explanatory material so it it takes the subject. From this early time

When i was basically, using it for about blackjack betty up to the present, where you can

Use it for a very wide range of investing problems

so one of the

my recollection of

Sort of how you came up with

The best way to be blackjacks there were two significant insights one was clearly kelly

To, control your bankroll but another really had to, do with the expectancy that a

Player, had and how, that was actually a moving target unlike it was and all the other

Casino, games yeah, that's exactly right ron the the key initial key insight was

Can you get an edge and what i realized, was that as they, deal down through the deck

Some of the cars are now out of the deck as you get to the second third rounds of dealing

And that will shift the odds one way or another?

And the insight, was that i could see right away the shift in the odds?

Was going to be very large in some instances which meant a winning

system because the edge i had to overcome in the casino initially

Was very small the it was believed to be points minus 0.6

2% for the player and it turned out actually, when i've finished

Analyzing the game i thought it was minus 0.2

One because the computer couldn't, do all the computing but i knew that was a low, number it had to be better and

Just playing flat with, no counting that turned out to be plus 0.1. 3 and then when you start counting you get

Situations, where it's 2 3 4 or 5% in your favor and so the obvious thing is you bet a lot

When it's in your favor you bet a little when it's not in your favor so you can

Keep your seat or not attract attention. If you're always popping up and down and looking for another game it can

Focus the casino on you and they may, ask you to leave

So the kelley, system tells you how, much to bet in each of these favorable situations

Basically the ideas the more favorable the more you bet the more risky the less you bet and so it's a trade-off between

Those two things and it's


easy, trade-off to calculate when you know exact probabilities of things

More difficult when you only have rough probabilities like

You, do in investing situations or even very rough probabilities then you have to sort of cut. Back and not bettis punching

okay, so

All this culminates in the paper that yet that gets submitted

to, the national academy of sciences and

It's obviously a huge hit you know

there's there's huge interest in it and the boston globe runs a big story on it papers around the country are running stories on it

And shortly after that you get a visit from an interesting guy and as i understand it his two nieces

Yeah, what happened was?

Lots of people showed up to my talk before the american, mass society in washington, which i

Explained all this to the audience and the audience was a collection of rather unusual people in addition to many mathematicians


so some of the people there wanted to bankroll a venture showing this actually work i

Was an academic i wasn't particularly interested in doing that but the washington post

Ridiculed me in an editorial saying this is you know

A lot of poppycock, and they, went into, some detail about, why, they thought that and the casinos said

They, would send cabs for people like me and

They loved to have us come


With that i said you know i claim it works but, i haven't actually gone out there

And proved it works and i kind of owe it to the people, who have heard, about this to prove that

What i said is so theoretically actually collects money in the casinos i thought, about it for a while and i was contacted?

persistently, by a

Wealthy, businessman in quotes, who lived in new. York city his name was the emmanuel kimmel i

Didn't know, who he was at the time

Other than that he was a wealthy businessman and?

He, also, had a friend named eddie hand, who

Moved all the cars, and trucks for chrysler


Inc was absorbed by ryder?

in 1974

Got a lot of money for that in any case these two, wanted to put up $100,000 in bankroll a trip to las vegas and

I thought to myself you know i'd never

Really, played with any significant money i don't want them to put up $100,000 in case something

Goes wrong if something goes wrong with the bankroll something might go wrong with me

though, i talking down to $10

$10,000 and they were extremely disappointed but they went anyhow. And we've spent a week out there and i i messed around with

betting $1 to $10 $2 to $20 because i one day get used to playing and handling the money and then i found i

Learned the feeling of scaling up when you knew, what you were doing and?

That there's sort of no limit the scaling up once you

Understand what you're doing and you have a disciplined approach and you know it works


After 20 hours of scaling up i got to what the limits were then 50 to 500 and so we turned their

$10,000 bankroll into a twenty one thousand dollar bankroll, we we'd won a net of eleven thousand

And that was what i forecast i'd forecast a winner of ten thousand b for the trip and?

So i was satisfied that i'd proved in principle that what i did was right

Because he knows weren't terribly, happy with me though

This is a sidebar but can, you tell everyone how. You communicated with

Your wife that was hilarious, well my wife, was much more nervous than i was i was a naive about?

What casinos were like and you probably know. If you've read the book, casino in the seventies

our seeing the movie how, rough it was

Beatings killings and so on the 60s were even worse, but, this, was all unknown to me but

my, wife was more savvy and so she wanted me to call every, day, and

Say, how, we were doing but, we?

Didn't have any significant amount of money and i decided that i would make phone calls that didn't cost anything

though, i would

alter it collect, each, day and

Ask, for edward middle initial thorpe and

If i asked for an a middle initial it meant that, we were had

Between zero and $1,000 a b between 1,000 and 2,000 and so on so that would take us up to

26,000 if we got up to xia

And if we were losing i would just say put the initial first i'd ask for a edward thorpe if we're losing

Between zero and a thousand and so forth

does she say it's not home and

All she got were pluses has it happened because it turned out that between calls even though

We had a dip down of - 1300 we got back up in time then, when i i called at one point said

Ask, for edward m thorpe she was very happy

So last night at dinner you told us some really interesting las vegas stories, which unfortunately, we don't have time for but

I'd love for you to tell the story, about what happened to your car

If he had been playing for a, while, well i got interested in other games as, well as

blackjack and you know, about roulette another one was

Baccarat played nevada, style and i happened to notice at one point that they, had, some side bets that were unusual

so i am a

Phd student of mine at new, mexico state which i was teaching out at that time

Analyzed the side bets i knew that there was a?

Card counting system that would work it was a matter of working out all the details so we figured out, how

To, beat them and then i went off there


It was a spring break at new, mexico state?

with the

chairman of the math department the comptroller of the university and our wives

and we set up shop in one of the hotels and then, we went to the dunes casino

Which i'm happy to say has been destroyed since then


i came up to the baccarat tables the first night and

Nobody noticed me i sat down, and then after i was playing

Somebody the crowd said there's the guy, who wrote the book, and

The pitch got very excited and the pit boss ran over to the phone and called upstairs and one of the wives said

That she overheard the conversation and the upshot, was the fool, thinks he can beat another, game let. Him play

There were all smiles and very pleasant so, we want our?

Projected amount so much per hour

that night and

Then, we came, back the next night and they figured something was up

Somehow the fool seemed to be winning steadily so they had shills on each side of me and

the shills

Monitored my every move they thought maybe i was marking the cards and i helped them, along by

Burning, by, thumb behind, my ear periodically we're with a. Job for marking the cards would be and

The chills were sitting in place

Very upset because i had a kind of a dry throat tickle and i was coughing

they, thought it was something terrible that they, were going to get if they had to sit right, by, me so they were they were

commanded to stay in place

and so, we went again the second night and

The third i say, we because i played two-shoes if the issue has eight decks takes

About 45 minutes then you have to count three things eights nines in total so that was

Fairly hard for people i so i i wanted to be relieved every third shoe so my two companions

The math department head and the comptroller i had trained up to count

Eighths in total for one of them and nines in total for the other so they

Each, did half of the side bets that were available and then i'd come

Back after after a one shoe break and played two more so that's how, we went through the evening?

Well the third evening they, came out i'd been refusing drinks and

They, offered me what i like coffee with cream and sugar

That's it fine and?

After a while i drank some of the coffee and i found that i just couldn't think or count and i felt really terrible?

so i got up, and left the table and

The wife of the comptroller was a nurse at the local hospital and she said you know. Your pupils are gigantic

You, look, just like people, who are drug to have been brought in to avoid lead

They, said we better walk? You so they, walked, me for hours took me like

Five or six hours of walking and coffee to come back to some sort of state of normalcy

So the other two guys played on and then the fourth night i came

Back and they offered me cream and sure with a, big smile, again, and so so i said. No just bring me a

glass of water

so they brought the glass of water in my companions so, oh, no i

decided that i was clever enough not to drink the glass i would just put a drop on my tongue i

Put a drop on and a chase, would like that emptied a, box of baking, soda into the glass and

That drop was enough to, do the same thing with, me again i'll swallow i think and i we wouldn't be having this conversation?

So the four after the fourth night they told, my companions they were a bard so as i and never to bring

Anyone else to that baccarat table again

So i said, well there's one more game in town it's at the sands we'll

Multiply the win rate by ten and see how

Long, we last it won't be very long so i went down and i played two and a half hours and?

Then carol cohen, who was on the floor of the sands

Basically managing the operation and one of the partners came over and said you know

We want you out of here and i said do why and they said?

No reason and he had a gigantic security guard so i said, well okay i'm going

The, kyle cohen became famous, among other things for

Disciplining frank sinatra frank had a. 1% interest in the sands and

He, did something that i guess carl thought was out of line?

So carl i'll back him in the mouth on loosened his teeth and tell him he couldn't be on the floor anymore

He didn't, mess with. Kyle so he was a no-nonsense

Casino manager

Though, anyhow, we were driving home after that the next day and i was on a narrow road neros ona?

Two-lane, road going downhill about 60 miles an hour, and

Suddenly the accelerator locked to the floor and i couldn't

Stop the car i push the brake as hard as i could and we got up to 80

Wasn't slowing down i thought you know it's got to slow, down because there's

No, way to control this car at this speed on this road

So i down shifted to first gear

turned off the key

Press the foot brake, as hard as i could and also use the handbrake

And that slowly brought the car down and we pulled him to a turnout put up, by the hood put a

white flag up on the antenna and

about an hour later because, we don't know, what to do, some good samaritan came, by and

Stopped he knew all about cars and he said i've never seen anything, like, this with, this accelerator linkage

but i i know, how to fix it so he, did and then, we were on our way, again, but, this, was a

Sobering experience i can't say, who was responsible or why, but that's what happened

so my

question to you before i heard the story, was going to be

Why, write the book

When you have figured this out and you can just stay in the casino, making all this money but i think you've already answered

Why, you didn't, want to stay in the casino so

How, did you get from own i guess it was around the same time obviously that you did your appearance you write the book you

Do the appearance on the game shows, and it's all part of the book promotion

Tell us how. You went from

Solving the gambling problems and and promoting a, book to

Experimenting with stocks and bonds, okay i'll just back up one second to pick up a thread that you

Commented on which is i?

Like to do things because they're interesting not because they

Made money and the reason i get interested in gambling

Was because mathematicians had studied gambling since 1520 and tried to work out a theory of?

Whether you could win or not with various schemes and

Systems of betting and they concluded that it was not possible and they proved that for almost all the

Classical gambling games so

What got me interested was i said this is going to be?

Big news in the math world if they realize that there are some games that are exceptions to this

Rock-solid proof that they have and people would send in papers to math meetings saying they

Had methods that would work and they all turned out to be bogus

And they were all fell under the power of these theorems mathematicians have proven, which show

That they couldn't work so anyhow. That, was my motivation rather than trying to get rich you know i was interested in academic life and

When i'd made some money from

playing, blackjack and from book royalties i

Said, well i've got to invest this money, we for the first time in our life

We actually are solvent and we have a small amount of savings

though, i made terrible investments and

Then i said i've got to learn how, to do this properly, because i'm not doing, well at all making these

Awful investments i mean ones that worked out, awfully i listen to stories believe some of them put, some money down terrible

So i sat down in the summer of 64 and

Spent the whole summer in a big bookstore in beverly hills reading every finance book and newspaper they, had in the store


I didn't see where to go i saw there were a lot of ways you could go but i didn't see what would work and

Then i sat down, again, starting the summer of 65

And right away it happened to read a little book, about warrants, which are like, like options only they're

Issued by companies rather than on the exchange and i saw how to?

Make, a theory for those options and i realized that i could set up

very low

risk hedges using that theory and those options hedging against common stock and

So then i decided to

follow through on that and actually try it out and i ran into an economist at uc irvine when i came there in

the fall of 65, when the campus opened and

Turned out he was doing the same thing, and he's written a phd thesis, about it about three years earlier and i said, well?

Well mister well professor kossuth if we get together and?

Put our minds to this, we can, make this much more powerful much more effective so, we sat down

And worked on the ideas for about a

year about once a week and, we wrote it up in a book called beat the market and

Meanwhile, we started investing money for people around campus and all work just fine so that led, me into the financial world

so so ed you developed an option model in

1967 yes the the model now is called black scholes yes

You, developed this five years before fischer black and myron scholes publish their research

Well talk a little bit about that yeah sure i actually

In 67 after

kossuth and i had gone on our separate, ways in the investment world i

worked on the theories, some more and i did something that people at mit had done about three years earlier, which is

i used something called the log normal distribution and

Integrated it and i got an option model and i after i did that i found that it already been done at mit?

There are two missing things in the option model one was the drift rate on the stock and the other is the discount rate

but the uncertainty off in the warmth and

So everybody, was stuck there they didn't know, what to do about those two things which, by the way?

Picture of black and myron scholes figured out, what to do and that of course made them famous


Said i sat down, and thought, about it and i said

what if i lived in a

Risk neutral world

What would the answer be then?

well the drift rate would be

The riskless rate and the discount rate will be the riskless rate

So i popped it into the formula and i got this beautiful formula i said this has to be the right formula and

I'm going to be living in a risk neutral world because i know, how

To, hedge these things so there's virtually, no risk i'm not gonna continuously, adjust, them because it's too costly but if i have a

Whole pot of these option, and warren hedges in my portfolio

the little random

deviations from perfect, hedging are going to wash out and

So, my portfolio will rapidly converge toward a totally riskless portfolio if i have a setup with, quite a few positions

so i had this all up and running in

1967 later when i talked to fischer black i found, that he and scholes had actually figured out their option model in 1969 but

They, didn't believe that they were right and so fisher black and myron scholes had their publication rejected i think more

Than a once they finally managed to get something in print in 1972

with i believe the intervention of

Maybe paul samuelson somebody at mit

So anyhow

So i had this a couple of years earlier and i was looking forward to the opening of the cboe

Figuring i'd be the only guy, who had that

And i was all set up with a, little hewlett. Packard 98 30

Computer, which was wonderful because it drew colored diagrams with ink pens and i could condense huge amounts of information

Into colored pictures so i had diagrams you could just look at

Them plot a point option, stock price option

Price and know what the hedge ratio was and how much overpriced or under priced it was

So i had all this stuff running, when i get this paper

It's mimeograph that's from somebody called fischer black, who i've never heard of because i'm not part of the financial community

I'm not part of the, well academic community that

Well i'm not part of the academic silos in finance and economics i don't know

Any of these people i look at i say this looks a lot like


Formula though i draw i draw a graph from i program it very quickly and draw a graph

From the black a black controls paper and i see oh it's not it's not like

My, formula it but it has to be the same and then i look at it again i say oh i know

why it's not the same it's because i have three formulas not one and i put the wrong one in

So i put the right one in and yes it's the same, why

Do i have three formulas it's because in those days if you shorted the stock or the option

You, did not get to use the short sale proceeds whereas on the exchanges now


get full cash usage of them so i had to write a formula one formula for the case when i

Shorted the stock and bought options

And was deprived with the short sale proceeds a second formula when i got it from

When i was able to use them then a third formula when i was had the hedge the other way, and was to rot derived

Draw deprived with the short sale proceeds

So the chicago is coming out at. Me i'm talking very

So anyhow

That's where that came from and to me it was just a tool for

Investing it i was unaware of any greater importance in the formula not being part of the communities that were aware of how

important it was

that's story there it's great it's great so princeton newport partner starts in

1969 yes correct

What were some of the early strategies that you were you were trading well first, we had warrant hedging and then, we followed it with?

At the same time with convertible, bond hedging and the principle is pretty much the same a convertible, bond looks like a regular

Bond with, some so called latent warrants attached. You can't cut

Him, off but it's a combination of a regular, bond and a bunch of warrants or options attached

So, we had that going and then when, we heard about the options?

Has changed coming up, we were ready for that and then, we kept expanding the things, we could do beyond that?


things like

futures in

Sp 500 came on we began arbitrage in that we were among the first to do that on a large scale


we got into something else in



Became pretty interesting later it led to

A lot of trading and a lot of profits and i think ultimately to - high-speed trading and this thing

We got into it's called statistical arbitrage and

One of our researchers i would charted a project that i called the indicators project and one of our researchers working on this project

By set a random idea out he looked at. Stocks that have been the most up in the last

Two weeks and noticed that they underperformed in the next two weeks and the reverse happened for stocks that were the most down


He said, well why don't, we make a?

Portfolio, that's short the most up stocks and long the most down stocks and i said yes?

well we'll do it with one or two hundred companies on each side and

Diversify away market risk, and maybe we can, do it even better

By, diversifying the other factor risk and so, we were ready to do that but, we didn't at the time because

We had our capital employed in hedges of various kinds fully and so

This didn't look, as good as the hedges it seemed to have a higher

Risk than

The hedges, which seemed almost low. Risk they almost always made money

But he deferred it and then we came across somebody, who was a refugee from morgan stanley, who had discovered

The, same notion and improved it somewhat a, fella named jerry bamberger back in 1982 1983

Had discovered this

We were advertising for people with good quant ideas and so in 1985 he, saw


Ad the left morgan stanley came over and worked for us and so we then did statistical arbitrage

from then on and i only just continued it in

2002 but it was a great profit, center all that time and some of the people

Who, worked for me broke off and did it on a giant scale and made - actually billions of dollars

It's great so princeton newport ran for 19 years yes and you compounded money at 19 percent roughly, yes at that time period

Which is about twice what the sp, was yesterday time period pretty spectacular track record?

However we giuliani, wasn't so impressed with, your track record they, tell us some of the story around that okay, well we?

Were very averse to risk and we tried to?

Avoid, tail risk in any way, we could

Goldman, sachs for example once i owens, asked, them, what happens if a

Freighter with a nuclear, bomb, is set off in new?

York, they said what happens to our capital in our records they said, well we have duplicate records in iron mountain and i said?

well what happens if

There's a giant earthquake in tokyo what will happen to our positions and i checked things like that

What will happen to our positions if the market drops 25% in one day

People everybody said, no i'm not

Gonna happen the worst day were you ever seen is 12 or 13 percent i said

Yep, but we're safe for the 25 percent drop in one day, and we were so?

We made money every year every quarter and all but three months and the three months were all

1% or less in negative territory

But there was one risk that i hadn't foreseen, now i'll call it the rudy giuliani risky

But the way, we operator was we had at our peak about 40 people in newport beach, which, was the research and development area and?

Then, we had about 40 people in our princeton office and that was?

trading back office and

taxes and so on

So rudy giuliani it was making his name on wall street by

prosecuting people who he thought sometimes correctly sometimes not had broken various, securities laws, and

he was after michael milken and

Fella named bob freeman at goldman sachs

Bob friedman happened our bad luck

To, have been the roommate for jay regan, my the partner my co partner

Was managing the princeton office so giuliani, thought he could, squeeze regan for information on freeman, and we've done a lot of trading with

Drexel burnham too so he thought, we could he could, also squeeze him for information on mike milken

so he raided the princeton offices and



3,300 cartons i think of information and

Then went through it all and they happened to find some old trading tapes there were?

Three tapes that had four, days, each on them and they comb through all the tapes they found a couple things on those tapes

It gave him, some leverage one of them was

A stock parking

issue and the other was a stock manipulation issue and

They, were fairly minor as far as numbers, ago

but they were

illegal and so

he decided to use rico on princeton newport, and

Threatened to confiscate everything limited partners money and so forth and

the upshot was that

It wasn't feasible to operate the partnership under these from stances though

We closed it down at the end of 1988 when all the smoke cleared two or three years later

The defendants had spent roughly 20 million dollars defending themselves and the

Whole result, after the government pretty much dropped the case the sole result, was fines for two individuals that

was it

But it did scare

Milken, and freeman into pleading guilty

before they saw the outcome of the princeton newport, case and of course rudy, went on to

Fame and notoriety as you know

Extraordinary really extraordinary so as you were having, some success at princeton newport. You started investing in other hedge funds and

you, stumbled across a manager a trader, who, was trading japanese warrants out of his dorm room yeah and

He tell us a little

about that story yeah i i have a friend frank meyer who sung i think is in the audience here today and

He heard about a fellow at harvard

Undergraduate, who, was trading securities out of his dorm room and doing very, well and he was into

Borned hedging and convertible securities this fellow at harvard

So frank followed up. And saw that he was doing very, well and?

Frank, decided he, would set him up in business

so they came out to talk to me in

California and i told him how, princeton newport work and i turned over a

number of cartons of prospectuses for

Warrants and convertible bonds those were valuable because they, had been around

Some of them for 15 years you couldn't get him anymore if you wanted the trader warrant or a convertible

Bond you were well advised to know exactly what the terms were the prospectuses were the best summary source of information

So after i described how, princeton newport, worked profit centers fee fees and so on?

They, pretty much set up a firm called citadel that became

What it is now starting from a very small amount i think they had

The in or two to start with i was the first regular investor frank, was the

go, managing general partner and

It went on from there i did great, yeah it's amazing track down so anyhow

Citadel is a good example of what princeton report would have evolved into, had, we not encountered the?

Giuliani, yeah yeah

So in 1991. You've stumbled across another extraordinary track record

this one though

Was doing something called split strike trading, yeah that, was sort of interesting i had a little, oh?

Sabbatical between the end of princeton newport and starting another statistical arbitrage hedge fund and

One of my friends, who was a fund of funds manager cool, bob

Well-known and made a lot of money at it

was consulting for a

International consulting firm on the east coast and he said we're reviewing, their portfolio in alternative investments and

They, would like you to come, and have a look at it so i did and everything looked fairly reasonable

There were things like

elliott associates in the portfolio and

I went out, and kicked the tires there everything seemed fine

Now but then i had there was one track record that seemed very strange

The person, who had this track record of the firm that had it was making money every month and

My client had been in the

Investment for a couple of years they, made money every month one or two percent a month

The strategy, was to put a collar on stocks a put

And they would buy a put below, the stock price and sell a call

Above the stock price and the money from the call, would pay for the foot, would pay for the foot so they

Had zero net money up in options so you expected in the long run

That the rate of return, would be zero on the options and it would all be attributable to the stocks

However they did much better than investing in stocks and when

Market, was down the strategy should lose money in a month but it didn't

so i

Wondered why i looked at their monthly statements in the statements there was a magical trade

In a month where this thing would have lost money that was a big short of the sp 500

stock index i

said, oh the only time they, do that is in a month's worth the rest of it loses money i

Held, my nose and i started asking more questions i found out that

The head of information technology, was the operators brother i found out

That his accountant, was i a guy, who lived down the street he'd known for years and years i?

Then found out, that he told everybody that

If you were an investor with him you shouldn't tell anyone else

So then i said i want to go over there and kick the tires and see what's going on?


my client called and said they're gonna send me over to the lipstick building in manhattan where this operation, was going on and

The, head, guy's brother peter said, i will not let him in the front door peter was the guy, who

was printing all the confirms and running the it operation i

Said i've got to look at this more closely for you, this this looks fake to me

so i asked for the two months of their confirms i

checked the con, forms like any of

13,000 other investors could have done and

Checked them against newspapers half the confirms showed trades that never occurred because the conference showed you what the exchange

Was what the bottom was and so on these are often trades had never occurred?

The stock trades could have occurred because there was a big liquid stocks

So then i looked at another

The i looked at the remaining con firms and i found that half of those out of 160 over 160 total after those

At volume that was less than

The volume that my client alone had into accounts of about 25 million each

So i said these trades are fake you need to get out of this they said, yeah but we're making twenty percent a, year


said, well

There are two cases you can move out of this

Fake 20% a year into your next best alternatives, which currently, we're producing 16% a, year

Or you can, stay in your, fake 20% a, year if i'm wrong

It'll be a real 20% and you'll be happy but

If i'm right and you stay in the fake 20%. Your job is maybe history if this thing blows up

They around two months

They, understood, what was important and of course this was 1991?

no, one else had ever heard of this i was i had

Reported to a client it was up to them to say anything further they, did not want to say anything further. They

Wanted their affairs kept quiet

So i sat on my hands for 17

years waiting for something to happen and knowing it was it was getting bigger and bigger and bigger, we identified about half a billion in

Through, them through our grapevine at that time in 1991 that, was invested with this manager bernard madoff and

in of course in

2008 when it blew up there, was something like 65 billion in

Supposed money invested and probably maybe 40 or 50 billion in real money i'm not sure where the number, was and

An amazing side bit

Be at the fund of funds guy, who invited me to consult with the client

He heard all this he knew it was fake or he should have known it was fake

But the weight of everybody, else believing i think, may have convinced him i had to be wrong somehow. And as the years went by

Became more more evident that i must be wrong and so the very week that

madoff confessed

The person, who told me about this

Was listed along with?

family trusts

In the 13 thousand accounts that the sec published as

Been being current, was made and he was actually selling

madoff the week of the blow-up

Though, this is an amazing

exercise in just denial and

Just as a footnote this is the kind of thing that

You need to think about when processing information

And i one of the things that be very helpful to me is having what somebody, else called a very good bullshit detector

And i think that's one of the most valuable things you can possibly have, when

evaluating investments or

investment managers

It's amazing our time is out and i have one last question for you in your book, there's a theme of?

introspection and knowing what is most important to you personally he devoted a couple of chapters to thoughts

And your epilogue in an industry that's not always known for its moral code can you

You, talk a little about that

And some of the some of the thoughts you expressed in that one chapter sure, oh?

I've thought, about life from a number of different perspectives and

some people are so money driven that they never have enough and

So they, won't stop until

The end whenever that is and they will, die with a pile of money and we'll spend all their?

precious, life time chasing it and things and

My view, is that the most important thing in life, is the way you spend

Your time and the people you spend it with, and just how. You

Just how. You experience things as you travel, along

So to me money and things are just auxiliaries that, make things more pleasant but they're, not the main goal in life

excellent thank you oh great


Do, we have time for a few questions any questions from the audience back there, we get a microphone

Being at to find in efficiency an edge i know, that's the trillion dollar question

Where you think there might be opportunity, today that there's some inefficiency left

Well a lot of people, ask, this because they, want to know

what to

Do with their money people with small amounts of meeting amounts and large amounts and so to me it's a it's a

Three-phase thing if you, don't want to spend a lot of time

Then the obvious thing to do is to index and

That gets you a big advantages probably almost everybody here knows

Versus the average investor because you're, not paying

transactions costs on the same scale that the active investors are and

you're, not paying for

Advice which can, be very expensive?

You're, also if your taxable not training generating as much

Taxable income as early

So it's that's a simple solution and just a matter of how

You, want indexed you, want all that goodies do you, want have small stocks the bills big stocks do you!

Want to have bounced in there you, want to already i t's and so forth so there's a discussion of that in my

Book, as to the pros and cons and the historical returns, and what you might expect and the next level is maybe your?

Small to medium investor but you just can't sit still you've got to do something or you, want to learn something

About the markets so sure go in and have fun but, realize, that it's going to cost you


You spend time paying your educational

Tuition to the market you may actually evolve into situations

Where things are really good i mean there's some obvious things that i mentioned in the book one of them is?

Closed-end funds that are discount you

Want to spend some time studying that it's not a very hard problem you can get a few percentage i believe?

another one is that everybody knows, about is

Mutual savings and loans

converting into

Publicly traded companies but that is so heavily done now, that it's hard to make

Significant amounts of money this is good good stuff for small people, who happen to have had accounts in particular mutual savings

alone, when they do offer an ipo those people should, wake up and take advantage of it

then, there's the

bigger level, where

You have a fair amount of money that you can

Bring to bear and that is a complex difficult problem because

So many other smart people are doing the same thing so you have a lot of competition in all these areas and

There are two ways to go you can, try to find somebody who's running a. Successful alternative investment

operation, picking those is

Probably, as hard as picking stocks or close to it it's basically the same problem in another setting

or you can try to go into business for yourself and

What i find, is that if you want to go into business for yourself you need some

Thing that will be a solid base that will make you a profit and then once you have this foothold

You can, begin to expand into whatever else comes along, but it'll give you enough

Profit flow in the beginning so you can build an entity or an organization that then is expandable so those those are the three

Ways that i would look at it

Over on the side

i couldn't understand all that occurred brisk parody any thoughts on on

risk-weighted responsed

Besting, well i'm not sure if i'm talking, about the same thing but there is a notion that has received a

Fair amount of press about how

People pay too much or high-risk securities versus low-risk, securities that, is that

What's behind this?

It's probably more of a generalized question it's an investment strategy at bridgewater

Like strategy, sort of weighting your investments. By their risk, oh i see

Well i'd say?

The way to answer that

Is first to look at data, and see if it supports that methodology and then asked

Whether the extent to which it supports it is statistically significant

and i don't know i don't know the answer because i haven't done that job

Mr. Thorpe i have a question about your investment in berkshire hathaway could you tell us about your meetings with mr.

Buffett, and then how. Long you've held, the stock and and whether you've been able to accumulate a big position early on sure

what happened was when i started setting up the warrant hedges back in



People around campus heard, about it and they wanted to invest and

So i managed, some individual accounts i was limited to 14. By the investment advisors act so i kept it under that

One of the people, who invested, was the dean of the graduate school at uci

His name was ralph waldo girard and turned out that he, was a?

cousin of a fellow named

benjamin graham and

Girard had been an early investor in the partnership called buffett, partners limited and he had a very happy experience

But the market, was manic in 1968 and?

Up pretty far in 67 too as i recall and buffett said you know we're out of good situations i'm shutting down

Though, he, was giving money back to his partners and girard, was looking for another place to invest so he started with me

with a warrant hedge and

He, also introduced me to warren buffett, who warren buffett spent summers out in the newport beach, area, where i lived so

we had some

Dinners with


Warren buffett. A suzy buffett a ralph and his wife frosty, and me and my wife vivian

And then i had some bridge sessions with ralph and warren and i forget, who?

Was the other, who was the fourth

Though, weren't asking a lot of questions and we chatted away and i realized at that time that he?

would be one of the richest people in

the united states because he had been at this game a long, time he already, had 25 million or so in

1968 coming out of buffett partners limited and he

Understood long-term compounding and he was willing to devote his life, to doing just that i personally would not have

Made that choice but everybody makes a different choice that suits them

so any apparently approved of me and

Gerrard gave me a large amount of his money to manage and ended up in princeton newport partners until the end there and actually a

Gerrard and then his wife died during that 19 years, we were running a princeton newport and so their

Estate remain invested in princeton newport

Until, we finally came to the end of princeton newport and made a lot of donations to uc irvine?

That's where he, was leaving a lot of the money in any case

but one day in

1983 i was reading something or other and i came across berkshire hathaway there

Was some article about it and i realized that warren buffett, was running that as his, own over?

in 1982 i not sure the date you know i think it's 83 in the book so i

Realized that warren buffett, had been running this as his, own private mutual fund all these years unknown, to me and the

when berkshire hathaway

When he first invested and it was at something like $12 i don't know act number and then when. He shut it down

it was maybe in the 20s or 30s in

1968 and

he wanted to capture as much stock, as he could at that time that basically take control of the company

so when i saw it it was a nine hundred eighty two dollars and fifty cents so i started buying and


Held it ever since

I've given some of it to uc irvine to endow a chair in mathematics i gave them a little over a million

and i told them

Only take 2% a, year or less out. And it will grow so it's about 2.6

million now even after they, had been spending i think, we endowed it in

2004 and of course it's been a

little over 12 years


It has a lot of advantages to it

There are people the things that people consider disadvantages one of them, is that the rate of return

Hasn't been

Much greater than that in the sp500 pretty close in fact over the last

seven or eight years i

In the book i break it into into phases or periods you can, see how it did in each of those periods

But and then people worried about

keyman risk

Charlie died as warren dies and so forth but

It has a lot of pluses going one is that it doesn't pay dividends

Which many people consider our negative but i consider it a. Huge positive because you pay dividends you're more likely to pay taxes and

so it compounds

Tax-deferred and when you actually?

Cash, some of it in if you need money you can

Always spend a little bit here and there you will pay long-term capital, gains tax under current law

As opposed to some higher rate of tax so it has a lot, going for it and then

Also i'm stuck in it because i have a low

A low

Basis and so i take it a

20 or 25 percent yet when i sell it and so i've got to have something really good in order to take that hit and

Change from it so warren's strapped me

Well thank you ed we have to leave it there

Ed's book is a man for all markets. He will be

At the event tomorrow with

A sweet and plenty of books if anyone's interested in buying and getting a signature and chatting with ted so

Thank, you again for for being here with us

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