Column: Beating the odds: Ed Thorp tells how he invented card counting and made a fortune on Wall Street
Edward O. Thorp doesn’t look like an outlaw.
The man greeting me in his Newport Beach business office stands ramrod straight with the studied mien of a mathematics professor — which he was at UC Irvine for nearly two decades. He’s as trim at 84 as he must have been at 30, when he first won fame as a gambling casino nemesis; or 37, when he founded a pioneering hedge fund; or 58, when he exposed Bernie Madoff’s fraud to an investment client (17 years before the fraud was exposed to the world).
“When there’s money and not full accountability, whether it’s in casinos or on Wall Street,” he says, “there’s going to be stealing and cheating.” His career as a card player and Wall Street investor has been devoted to using mathematics to push back.
Most stock-picking stories, advice and recommendations are completely worthless.
— Edward O. Thorp
The casino industry certainly viewed Thorp as an outlaw after his book “Beat the Dealer” appeared in 1962. The first book to codify and popularize blackjack card counting, “Beat the Dealer” inspired generations of professional gamblers and millions of amateurs. It has never gone out of print and still sells a few thousand copies a year. Among its early adherents was bond guru Bill Gross, the co-founder of Newport Beach-based Pimco, who financed his graduate education at UCLA with $10,000 he won following its precepts at the Las Vegas blackjack tables.
Thorp’s blackjack technique and a related system for baccarat got him run out of dozens of casinos, targeted at others by professional card sharks working for the bosses, and even drugged at one Vegas casino where his car also was tampered with to cause a potentially fatal accident. Or so he believes: “I can’t say for sure that anyone did this, but it was inexplicable.”
Thorp’s new book, “A Man for All Markets,” recapitulates the gambling and investment techniques he outlined in four previous works while looking back on a full life as a mathematician, inventor, academic and investor. It’s a life that has brought him into contact and even friendship with a diverse cast of personalities, including the mathematician Claude Shannon, renowned physicist Richard Feynman and Warren Buffett, in whose Berkshire Hathaway Inc. Thorp was an early — and still active — investor.
In a foreword to the book, statistician Nassim Nicholas Taleb (“The Black Swan”) boils down Thorp’s technique to the search for and capture of a “clear edge.”
That’s the quest that first got Thorp interested in blackjack. Living on a teaching assistant’s stipend from UCLA and following a cheap newlyweds’ vacation in Las Vegas with his wife, Vivian, he pondered the traditional assumption that in gambling, the house always has the edge.
“I had heard that winning systems were supposed to be impossible,” he writes. “I didn’t know why.” What he discovered was that the odds in blackjack change based on which cards remain in the deck after the others are played. Tracking the remaining cards would enable a player to determine when the odds are most favorable and exploit the advantage by raising the bet. Following a series of computer simulations, Thorp codified his findings into a paper on blackjack strategy for an American Mathematical Society conference in Washington.
He expected to be addressing a meager audience of academics. Instead, he found himself in front of a standing-room-only crowd in which “scattered among the mathematicians were others sporting sunglasses, gaudy oversized pinkie rings and cigars, as well as reporters with cameras and notepads.”
Thorp was bankrolled by a couple of millionaires to use his system at the casinos, which originally welcomed anyone with a “system” on the assumption that those players were destined to lose. He wore disguises as his fame spread, but casinos took countermeasures once it became clear that blackjack card counting could hurt them. These sometimes involved violence or, as Thorp maintains, druggings.
Once the mobsters were gone and public corporations took over the industry, the countermeasures became more dignified, and more effective. The new owners altered table rules to discourage professionals by eliminating counting opportunities, though these also created a more boring game of “21.”
“Before they ruined the game, there was a huge boom in blackjack,” Thorp told me. “Now it’s been overtaken by baccarat, which is three times as profitable per table.” That’s an understatement: Last year the casino win from baccarat in Nevada’s Clark County, which includes Vegas and Laughlin, was nearly eight times per table that of blackjack.
Thorp presently turned his attention to roulette. Working with the mathematician and information theorist Claude Shannon, he developed a computer that could predict roulette outcomes based on the speed of the wheel and the bouncing ball. Small enough to hide in a pocket, the 1966 device is labeled by MIT as the first “wearable” computer; versions are still in use by teams who say they use it to exploit roulette games around the world. (In Nevada, where systems such as card counting that depend on brainpower are lawful, electronic devices are not.)
Using his blackjack winnings as seed capital, Thorp began to dabble in stock investing. Gamblers and investors share the same psychological makeup, he reckoned, so after immersing himself in books about securities analysis and market trends, he plunged … and lost. The lesson, he says, was that “most stock-picking stories, advice, and recommendations are completely worthless.”
The market, however, was amenable to careful mathematical analysis. Thorp developed a system based on arbitraging the price differences between two correlated securities, such as a company’s shares and the warrants it issued to purchase those shares. He explained his technique in a second book, “Beat the Market,” which appeared in 1967, and put his formula to work in 1969 by founding what may have been the first hedge fund, eventually called Princeton Newport Partners. The fund consistently beat stock averages in down markets and up, and soon was turning away investors unless they could put up at least $10 million.
By 1975, Thorp was a millionaire with a hilltop home in Newport and a new red Porsche. He developed a formula for trading stock options that prefigured the work of Fischer Black and Myron Scholes, which became the foundation of the public options markets. In 1987, Thorp’s Princeton, N.J.-based partners were indicted on fraud charges by then-U.S. Atty. Rudolph Giuliani and convicted, though their convictions were later overturned. Thorp’s end of the business wasn’t implicated, but he broke up the firm anyway; he and Vivian, he reflected, had made enough money to be comfortable for the rest of their lives.
Fast-forward to 1991. Thorp was working as a consultant for hedge funds when a New York client asked him to review his portfolio. “I approved the portfolio, with one exception,” he recalls. “The story from Bernard Madoff didn’t add up.” Madoff was issuing confirmation statements showing trades “on options which never traded,” Thorp says, “or on options whose volumes were so small that my client alone seemed to be trading way more than that volume. So he was lying.” Adding to his suspicions, the Madoff firm barred him from its building when he came for a look at the operation.
Thorp says he didn’t publicly blow the whistle on Madoff because he owed a duty of confidentiality to his own client. It wasn’t until 2008, some 17 years later, that Madoff’s scam was exposed, at which point Thorp discovered that his client hadn’t taken his advice to dump his Madoff investments.
Thorp hasn’t played blackjack for years. “It’s not interesting to me — the stakes are very small compared to what I’ve gotten used to on Wall Street,” he says. But he still attends the Blackjack Ball, an annual invitation-only event, as a revered figure. And he still contemplates Wall Street with dismay. “What the crash of 2008 taught us was that profits are privatized and risk is socialized — it’s ‘Heads they win, tails the taxpayers lose.’”
Despite his gilt-edged record on Wall Street, he counsels the average small investor to stick with low-cost index funds. It’s possible for determined investors to learn the best investment methods, he acknowledges, but warns: “You’ll be paying for your education.”
And he knows that for the average player, whether at the tables or on the Street, the edge is hard to find. “The first thing people who have control do is tilt the playing field,” he told me. “Maybe the majority of wealth is accumulated because of tilted playing fields. Not because of merit.”