| Fortune's Formula is a fascinating study of the connections between such seemingly unrelated topics as gambling, information theory, stock investing, and applied mathematics. The story involves the stunning brainpower of men such as MIT professor Claude Shannon, who single-handedly invented information theory, the science behind the Internet and all digital media; Ed Thorpe; and John Kelly of Bell Laboratories, who developed the "Kelly criterion," a now-legendary investment strategy for maximizing growth while controlling risk. Initially, Shannon and Thorpe took Kelly's theory to Las Vegas and applied it to roulette and blackjack. Later, they took it to Wall Street and cleaned up--Shannon made a personal fortune while Thorpe created the highly successful hedge firm Princeton-Newport Partners. They both discovered that Kelly's system was particularly effective when applied to arbitrage (minute price differences that result from market inefficiencies). As Poundstone ably demonstrates, the merits of Kelly's criterion are still hotly debated today. Poundstone has a tendency to meander in his writing, but his asides are so revealing and interesting that they add, rather than detract, from the narrative. The book also includes a cast of fascinating and colorful characters as varied as Ivan Boesky, Warren Buffet, Rudolph Giuliani, and notorious mobsters such as Bugsy Siegel and Meyer Lansky. In explaining the lasting impact of the work done by Shannon, Thorpe, and Kelly, Poundstone even explains Kelly's system for those wishing to follow his formula, offering readers both theoretical and practical lessons. Whether viewed as a how-to guide or straight scientific and financial history, Fortune's Formula proves an entertaining and illuminating analysis of "the most successful gambling system of all time." --Shawn Carkonen |
|
 Ed Thorp is a true investment and math genius. |
| Review Date: September 8, 2005 |
| Reviewer: Gaetan Lion, |
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.
|
Should be on the 'must read' list for every trader
|
| Review Date: March 6, 2006 |
| Reviewer: Paul M. King, Vermont, USA |
If you have ever heard of the Kelly Criteria for position-sizing, or wondered if Optimal F is a good way to manage risk, this book is for you. In a narrative, story-telling style that is much easier reading than a mathematical, economic, or statistical textbook, the author covers a whole range of interesting and informative theories that are relevant to trading and investing.
Knowing that a trader who uses the Kelly Formula to maximize return always has a 50% chance of losing 50% (or X% chance of losing (100-X)% generally) of their capital may be an eye-opener for many traders. Although this book will not tell you how to make money trading, it will generate more than a handful of useful areas of research, and get you thinking about risk management rather than entry signals.
Covering a multitude of financial, economic, and mathematical geniuses, this book has many interesting side-stories and anecdotes that are amusing, interesting and thought-provoking. The majority of this book is not strictly about trading, but all of the ideas have some application to trading and investing if you think hard and long enough. |
Useful and Interesting
|
| Review Date: January 20, 2007 |
| Reviewer: Z. Fang, |
Very interesting to read and very useful to know. The Kelly Criterion applies to all variants of investments (gambling, stock market, horse racing, etc). This book explains the history of the Kelly Criterion and academic misunderstanding of it.
The only problem with the book is that it did not explore the daily applications of the Kelly formula. Many readers would finish the book and ask: So how do I use this? The book also fail to explain how to adapt the Kelly concept to situations with multiple outcome states rather than only Win or Lose. Support for multiple outcome states is essential in real-life applications of Kelly Criterion [...]
Overall, the book is great as an introduction to money management. |
Against James Pragma's review
|
| Review Date: June 11, 2007 |
| Reviewer: DasMaN, |
James pragma's review below is so bad that i felt the need to write my own review. let me clarify some of what James gets wrong, and also clarify what the book is actually about.
James obviously misunderstood the book (and that is not the writer's fault in this case). Poundstone clarifies the Kelly betting system which was originally applied to card-counting but has uses beyond it. the central example and climax of the book is how the kelly betting system and the controversy surrounding it in light of efficient markets theory can help us explain the tragic blow up of a powerhouse hedge fund. the book is about risk, how to manage risk and avoid ruin. that has nothing to do with card counting as a system to get an advantage over the house (Which everybody knows about), the point is that Kelly invented a way to maximize long-term reward and minimize risk. but did he? that's the question.
James Pragma's review is nonsense. he failed to understand the book. in addition to what i say about, Poundstone gives us the history of math, information theory and gambling as it relates to the core story i mention above. it was a fun, informative book. |
Fun and Informative
|
| Review Date: July 19, 2007 |
| Reviewer: gregory dwyer, houston, tx |
Yes, perhaps the book's title is a bit misleading. Those who gave bad reviews to the book may have been looking for a get rich quick formula to beat the market or the casinos. The book focuses on the Kelly criterion and also gives quite a bit of attention to the efficient market hypothesis. The strength of the book is in its portrayals of the characters involved in the stories behind the Kelly Criterion and Efficient Market Theory.
Admittedly, at times it was a stretch to connect some of the players in this drama to the Kelly Criterion or the Efficient Market Hypothesis. Rudy Guiliani is one of several people in the book who are quite tangential to the main story line. However, I found this not to be a weakness of the book. Indeed, it enhanced my enjoyment of the story.
Those who are looking for a hard core mathematical examination of some of the topics of the book will be disappointed. As will those who are looking for a quick how-to in applying some of the theories. However, the vast majority of people will enjoy getting an inside look at some of the personalities involved in the development of these concepts and will love seeing how some of the theories held up in the "real world".
|
Great story with a point
|
| Review Date: September 27, 2005 |
| Reviewer: MaddMark, Chicago, IL |
| This is a human story about a big idea, the Kelly criterion. The Kelly formula has been dissed by economists (Paul Samuelson and the folks who brought us Long Term Capital are the "villains" here). I can understand Jim Curry's position but it takes a book like this to get people's attention. It had better be entertaining. The book really does hit the nail on the head in term of laying out the basic issues. You have to take risks to make money. How do you know how much risk is too much? That's what the book asks, and ultimately answers. |
It takes exceptionally smart people to make truly massive blunders
|
| Review Date: June 25, 2008 |
| Reviewer: Dave Snell, Chesterfield, Missouri USA |
This book is a concise look at the evolution of formal investment theory, with continual contextual references to its ties to gambling and to organized crime. It also is a hilarious and insightful history of gambling from the Bernoulli's in the 1700s through the hedge fund traders of the late 1990's.
The author devotes over 50 pages to notes and the index. This was appreciated since I wanted to look up more about so many of the anecdotes he included.
Mr. Poundstone poignantly describes the downfall of high-flying firms such as LTCM, where the investment wizards went from the darlings of Wall Street to the dredges of the investment community in large part because they were so clever; and they started to believe they were infallible.
One LTCM road-show presentation was held at the insurance company Conseco in Indianapolis. Andrew Chow, a Conseco derivatives trader, interrupted Scholes. "There aren't that many opportunities," Chow objected. "You can't make that kind of money in Treasury markets."
Scholes snapped: "You're the reason - because of fools like you we can." (Page 281)
Warren Buffett marveled at how "ten or 15 guys with an average IQ of maybe 170" could get themselves "into a position where they can lose all their money." That was much the sentiment of Daniel Bernoulli, way back in 1738, when he wrote: "A man who risks his entire fortune acts like a simpleton, however great may be the possible gain." (Page 291)
He also points out the real world flaws in some theoretically appealing scams. The St. Petersburg Wager seems mathematically correct; yet it overlooks a vitally important constraint (pages 182-184). Another is the unfounded weight we unconsciously give to historical returns, as evidenced by his retelling of another Warren Buffett story:
In a 1984 speech, Buffett asked his listeners to imagine that all 215 million Americans pair off and bet a dollar on the outcome of a coin toss. The one who calls the toss incorrectly is eliminated and pays his dollar to the one who was correct.
The next day, the winners pair off and play the same game with each other, each now betting $2. Losers are eliminated and that day's winners end up with $4. The game continues with a new toss at doubled stakes each day. After twenty tosses, 215 people will be left in the game. Each will have over a million dollars.
According to Buffett, some of these people will write books on their methods: "How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning." Some will badger ivory-tower economists who say it can't be done: "If it can't be done, why are there 215 us?" "Then some business school professor will probably be rude enough to bring up the fact that if 215 million orangutans had engaged in a similar exercise, the result would be the same - 215 egotistical orangutans with 20 straight winning flips." (Page 314)
The author follows the lives of a few major contributors to investment theory, information theory, and betting theory: Claude Shannon, who invented Information Theory and paved the way for the digital computer age; John Kelly, who developed the formula for gains with no possibility of ruin; and Edward Thorpe, who built upon these findings and beat the roulette wheels, the blackjack tables and the investment fund managers.
It's a fast read - only 329 pages before the notes and index. I highly recommend it!
|
|
Gambling News and Tips
Leave a Reply