Book Review: A Man for All Markets

I first learned about Edward O. Thorp while reading "Fortune's Formula" (Poundstone 2006).  In FF, Thorp is portrayed as a brilliant mathematician who decided to focus his attention on games of chance (roulette) and games of probability (blackjack) to gamble against Las Vegas casinos with an edge.  Poundstone wrote a fine book, but much of Ed's humanity, personality and research approach are not well explained. Published just a few months ago, Ed tells his life story from growing up poor during the great depression, to becoming a gambler, mathematics professor, investor and ultimately a philanthropist. 

Thorp's story begins in the 1930s, his family felt the ravages of the depression and they were often short on money.  From an early age, a number of unusual personality traits and mental abilities became clear. He enjoyed reading and had an outstanding memory.  For example, he was once challenged by a passerby who noticed that Ed was holding a tome on British history that looked much too complicated for him, and asked Ed if he knew anything about the British monarchy.  To his adversary's surprise, Thorp went on to name all British monarchs from Alfred the Great to George VI.  In addition to reading comprehension, Thorp's interest in experimentation was evident from his younger years as well. He enjoyed building radios, model airplanes and using tools to improve his surroundings. This theme would become a defining characteristic of Thorp's life.

From an investment perspective, Thorp's book contains a wealth of wisdom. Common consensus on roulette was that it was a game of pure probability, and given the house's slight edge, unbeatable.  Thorp, knew full well that in theory roulette might be unbeatable, but he wanted to explore it for himself to see if the path of the ball was random as theory suggests or if there might be some patterns/path dependency present on the table.  Thorp decided to tackle the roulette wheel by approaching the problem as an experimentalist.

Thorp bought a few old roulette wheels and began exploring for patterns recording where the ball ended up after a normal spin.  He then learned Fortran to run computer simulations on the data he obtained.  These experiments implied that there were patterns to the balls, but he'd need a computer to help him identify them.  This finding resulted in Thorp inventing the world's first known wearable computer which helped him make real-time calculations and gave him an edge betting at the roulette table.  Thorp developed new techniques and equipment as needed to recognize patterns in data and used theory to codify his results into a betting strategy that could be carried out in real casino conditions.  This involved practicing with his friends and in casinos with small amounts of money to see if he could execute his strategy in a risk controlled manner.  Once satisfied with his results, he slowly increased his bet size. 

Later, Thorp would apply an open minded experimentalist approach to investing in securities, commodities and other financial products on Wall Street.  The prevailing wisdom among academic economists and financial theorists at the time was that market prices were efficient, that is to say, that all prices were right.  One of the implications of this theory of securities prices was that there are no patterns in securities prices which could lead to sustained arbitrage profit. As Thorp admits, this is a fine theory, but to test it you need to examine the data and see if there are in fact any patterns.  Thorp shows again and again throughout his story that this theory is false.  From investing in closed-end funds trading at a discount, statistical and fundamental arbitrage techniques and other well-known techniques in the vein of Benjamin Graham are tradable and produce a positive return.  Thorp's several decades of success should give any proponent of the efficient market hypothesis pause.  Thorp's success inspired many other mathematician run investment partnerships that were able to invest in systematically mispriced securities.  Several of these groups were likely trading on the so-called "Black-Scholes" model for more than a decade before Black and Scholes published their result.

In addition to investing on his own, he was one of the first to run a fund of funds.  He invested with many others including Warren Buffett (early in Buffett's career), believing that detecting skill in pricing securities is ex-ante observable, but requires extensive due diligence.  When contemplating an investment in another investor's partnership, Thorp would visit the fund's office and in some cases ask the investor to work from his office for several months.  His process for reviewing an investment manager included reviewing trade ideas in detail and assessing their thinking for rigor and creativity.  This kind of due diligence approach led him to recognize Bernie Madoff as a Ponzi scheme decades prior to the scheme's collapse.

Thorp's book ends with some thoughts on the importance of science.  One of Thorp's central concerns is that the US may be losing its future edge in science, mathematics, and technology because of a pattern he's observed in labor markets. Thorp notes that America which during the 20th century was viewed as the place which caused brain-drain in other parts of the world, such that brilliant people would leave their home countries and go to America to seek their fortune.  Thorp notes that today, the opportunities for brilliant scientists (given the US-visa system and lack of funding) may be better in China than the US.  He's observed a concerning pattern where many top talents are being educated in the US and then returning to their home countries.  Ultimately, this lost potential could result in the decline of America's role in the economy as a leading innovator.  Thorp notes that while Rome was not built in a day and did not fall in a day, a slow decline due to reverse brain-drain is deeply concerning.

In summary, I'd strongly recommend Ed's book if you are interested in games of chance, strategy, investing, seeing applications of the scientific method to human problems and spend time with a man who cares deeply about education and acting morally.  Thank you for taking the time to write "A Man For All Markets" Ed, your experimental approach rooted in your tendency to not believe what others tell you unless you check it for yourself is inspiring to me. Perhaps this is why Seth Klarman named his horse "Read the Footnotes."

Please pick up a copy of Ed's book today.

Learning through video games

When I was growing up, many of my friends had TVs in their room but I had an encyclopedia. My grandparents gave me an old copy of an encyclopedia from the 1970s as a gift. The encyclopedia sat next to my bed in a large wooden case about three feet long. There were 22 volumes (rather than 26) because some letters shared a volume. At night prior to going to sleep I’d read and re-read the encyclopedia. It introduced many ideas that 12 year olds typically didn’t get to learn about including poverty, plate tectonics, Julius Caesar, communism, sexual reproduction, genocide, Charles Darwin and Sweden.

The challenging part about these books was that the ideas were displayed alphabetically rather than chronologically. Reading about the Boer War followed by Neils Bohr made it difficult to associate related concepts because related concepts rarely follow alphabetical order.

Fortunately, I had other possessions besides the encyclopedia. Beside my bedroom was my dad’s office and he had a computer. When I was seven years old we got our first computer. My dad introduced me to the internet (remember the AOL dial up sound?) and computer games. We enjoyed playing games like King’s Quest V, VI and VII together and if I was well behaved he’d let me kill Nazi’s in Wolfenstein (perhaps that inspired Inglorious Bastards?).

Image from Wikipedia

Aside from adventure games, he also bought me learning games. These games were chronological and considerately ordered to be both entertaining and educational. One game might take you to Rome, and introduce you to a variety of aspects of ancient life from aqueducts, gladiatorial combat, slavery, emancipation, republic, dictatorship and crop rotation. These games could be played again and again without cost, for a slow learner this was a helpful (asking teachers to repeat information in class carries costs). When I tired of ancient Rome, I’d transition to a science game and learn about a 1 sided object like a Mobius Band.

Today, Salman Kahn at Kahn Academy has made great progress creating an online learning environment where students can begin with counting and end with linear algebra. Rather than having to wait years if they want to learn at a faster rate than their teacher or having to ask the teacher to repeat material and irk their classmates that don’t need or want to hear the material again, they can rewind. Once you watch a few of Sal’s lessons you’ll realize he is in the top 1% of all teachers. The notion that we have any teacher outside of the top 1% of lecturers lecturing to students when they could be spending their time with Sal will likely be seen by future generations as child abuse.

One day I expect our schools to look something like this, but until then at least we have Sal.  

Storage costs and home size

When I was small, I’d often sit beside my small table in my room and work my imagination playing with Legos. Beside my Legos, my book shelves were stacked with my favorite stories. As I got older my room remained the same size, but I wanted to fit more stuff inside it. Many of my friends had CD collections, video collections, stamp collections, baseball cards, musical instruments and TVs with video games. I used to imagine what it would be like if I had all this stuff until I realized that it wouldn’t fit in my room.

Long ago, storage costs were high. Suppose you had obtained a large CD collection after years of buying, trading and searching and wanted to keep it safe. You could store your collection in a bank vault (expensive and more difficult to casually admire) or store the collection in your home. If you chose to store them at home, then the desired size of your collection is related to the desired size of your home.

In the last 50 years, storage costs have declined dramatically. Komorowski (2014) assembled some data on the subject described it in the chart below.

A single gigabyte can hold roughly 250 songs or 12 CDs worth of music. Suppose you were a die hard music fan and owned 650 albums. To store 650 albums, you’d need 55 gigabytes of storage. In 1995, that collection would have cost $55,000 to store digitally, today it cost a mere $5.00.

Keep in mind that storing 650 albums requires a shelf this large. 

As the cost of storing a large variety of our property has collapsed (both in terms of size costs and dollar costs), I would have guessed that newer homes might be smaller, but this does not seem to be the case.

The data suggest that new homes seem to be getting larger, family size continues to shrink and the cost of space adjusted for inflation seems stable. If people are having fewer kids and need less space to store their stuff (much can be digitized), it is not clear why they would want to purchase larger homes?

The data above begs the question, why do people continue to buy larger homes? A Reddit thread on the subject provides some hints.

From Reddit user PRguyHere:

My wife and I recently bought a house. We only NEED two bedrooms (us plus our toddler), but the house we bought has four bedrooms. Why?

• Guest bedroom. We live hours from our families, and we want them to be able to visit their granddaughter without paying for a hotel.
• The possibility that we'll have additional kids in the future. We're buying a house because we're done moving. I don't want to have to turn around and buy another house if we decide to have another kid in a year or two.
• Storage.

Starting from the top, this user wants to secure guest bedroom space and is willing to pay for two extra bedrooms to allow his family to stay in his home rather than a hotel. Depending on the frequency with which this occurs it might be a good trade. However, the rise of Airbnb is likely to drive down the cost of renting space to a very low level.  Outlaying a large amount of capital to secure something that is going to be much cheaper in the future sounds like a bad trade.

He’s also thinking about his home size as a way to raise additional children because the costs of moving are too high. In this sense, people may end up overconsuming space should the couple not have additional children. This statement also highlights the costs of moving. Given the high switching costs, people may be unwilling to trade and continue to live in suboptimal situations.

His last comment is the weakest. As storage costs continue to fall, this argument will continue to get weaker.

Another user ShutUpHeExplained:

It's a value store. You invest your money in a large house and you get to write off the interest. You can often sell it later for 50% over initial cost and adjusted for inflation and costs over time, you still make good money.

I agree that size is one component of price but it is not the most important or even third most important.  There are three rules of real estate which take precedence over size, namely:

Rule 1. Location

Rule 2: Location

Rule 3: Location

I suspect that over the next 30 years, housing demand in the US will shift towards smaller homes in urban areas, given further reductions in family size, lower storage costs and reduced price of short term rental (through Airbnb) in desirable locations. I suspect those paying large prices for large homes in non-core areas are going to be disappointed when they go to the market as home sellers because their grandchildren will be playing with Lego in virtual reality.

How I became an investor

Two months after graduating from the University of Rochester, I moved to Shenzhen, China. This decision was unusual in so far as I knew almost nothing about Chinese culture or history and had never studied Chinese. Moving to and working in a new country as an adult when you neither speak the local language nor understand the culture is a real challenge.

I moved there with a group of roughly 120 Americans, Brits, and Canadians. Expats often cope with the challenges of life in China in two ways: by “banding together” or “going native.” I observed that the vast majority of these folks adapted to the challenges of Chinese life (illiteracy, inability to communicate, cultural complexity, etc.) by banding together. Banding together meant hanging out in Western restaurants and bars to avoid the isolation and confusion that you’ll feel dining at a Chinese restaurant alone or with Chinese colleagues who cannot speak English. While I occasionally spent time with other expats, I largely chose to go native.

Life as an expat trying to assimilate into Chinese society is a process of continuous failure and learning. Ordering food begins with pointing randomly at a menu and hoping for a favorable outcome. After several weeks of disappointment, you'll finally ask to take the menu home, study the words and come back with a strategy to try to mitigate disappointment. This process was further complicated by the fact that at the time I didn't own a smartphone. Remember, this process doesn’t just apply to ordering food at a restaurant, but rather almost every aspect of your life.

After the first eight to nine months of confusion, study, further confusion and further study, I achieved basic understanding on a variety of subjects that enriched my life. I liked that I could ask people about their businesses, ask them if they needed help or give people directions if they were lost all in Chinese. I began feeling like I was contributing to society. I renewed my teaching contract to stay another year. There was still so much I didn’t understand and so many opportunities to learn that the decision was a no-brainer.

While I enjoyed both teaching grade 2, grade 5 and grade 6 students English and running my small education consulting practice, I knew that neither business was my passion. I was introduced at a young age to economic concepts by my father, who worked as a currency trader for nearly two decades at several large banks. I still remember him explaining the mechanics of a carry trade to me while I was in middle school. I was an avid student of economics and philosophy and finished degrees in both subjects at Rochester. While an undergraduate, I explored the intersection of law and economics and took several courses in commercial law, constitutional law, criminal procedure and law and economics. Given my interest in law, I researched the market structure for legal services in the US.

I did some market research to better understand supply and demand dynamics for lawyers. After a few days of research, I began to suspect that there was a bubble in the market for lawyers (too much supply of lawyers and not enough demand) in the US such that I expected the marginal product of labor (wage) to fall. The market in the US was further complicated by the presence of internet based services like LegalZoom which made whole sub-specialties of law unprofitable.

Thinking more about my comparative advantages I realized that perhaps I’d be best suited to practice law in Hong Kong. Hong Kong is a common-law jurisdiction, meaning the legal system is based on English case law. The system is quite like the legal system in the other former British colonies as well as the US and is highly respected for being fair and efficient. Given that I’d be one of the few non-Chinese lawyers in a region where foreign firms were looking to expand, I thought my ethnicity and language ability might be comparative advantages.  I applied to law school in Hong Kong and was admitted to the Chinese University of Hong Kong (“CUHK”) Juris Doctor (J.D.) program. I was thrilled. But my family was not.

After much discussion with my family, I realized that I loved them too much to choose a career that would permanently position me on the far side of the world. My desire for a connection with family wasn’t the only reason for choosing to pass on law school. I realized that lawyers were more of a conduit for facilitating and advising business transactions rather than those that were making the determination to transact (the part of doing business that I found most fascinating). Moreover, after additional research on the practice of law, I became more certain that the practice of being a lawyer is nothing like the experience of studying law academically. After careful consideration of the trade-offs, I decided to pass on law school.

Once I passed on law school, I returned to the US. What to learn next? I researched my options again focusing on my comparative advantages. I was interested broadly in the applications of microeconomics and knew a bit about running a business and wanted to apply those skills to investing. There is no obvious way for former English teachers in China to go into investing in the US, so I needed to think creatively. I reached out to the people I knew in the field and asked anyone I could for a job, even offering to work for free. Finally, I got a break and found a job on a multi-family office investment team doing analyst-grunt work. My favorite part of the job was my supervisor, an analyst around my age who encouraged me to learn by reading the annual and quarterly letters of the 20th centuries' great investors.

At the same time, I was searching for a spot on an investment team, I also considered becoming an economist. Several of my economics professors at Rochester encouraged me to consider becoming a professor of economics, but I had much self-doubt. I’ve never been the strongest math student because I have some skill gaps in algebra and calculus. None the less, I applied to do my Ph.D. in economics at George Mason University (“GMU”).  GMU’s department has a strong capitalistic spirit and an awesome group of senior and junior faculty including, Tyler Cowen, Bryan Caplan, Russ Roberts, Peter Leeson, Robin Hanson and James Buchanan.  Having spent two years in Shenzhen, the first and largest special economic zone in China, I had an intuition that the field of economic development ought to focus on special economic zones. The opportunity to study development economics as it pertained to special economic zones with someone like Tyler Cowen sounded so cool!  Much to my surprise in early 2013, I was admitted to the Ph.D. program in economics at GMU. There was only one problem, I loved investing and didn’t want to stop.

As it turned out, I liked investing much more than I originally anticipated. So many of the concepts I came across from arbitrage to venture capital were fascinating to me.  It became apparent to me how many of my passions could, over time, be honed to become competitive advantages at investing. Investing requires abstract reasoning, a love of reading, general curiosity, patience and the wiliness to act differently than your peers. After about five years in the investment business, I now have a much better sense of how little I know about what I thought I understood.  My objective over the next 50 years of my investment career is to reduce my ignorance through study, trial, and error.

On Coffee

I enjoy very few things more than waking up at 6:00am on Sunday and brewing a pot of coffee.  Coffee helps me to think abstractly, yet focus on the task at hand.  Going without it carries risks. 

A few Sundays ago at the Capital One Cafe

A lack of coffee is an unsettling experience.  Earlier this year, I went my first morning without coffee in over ten years.  I woke up in Bariloche, Argentina in an Airnbnb after a full day of traveling.  My working assumption was that all homes have coffee in the pantry.  My assumption was wrong.  My friends, who don't wake up at 6:00am, were still asleep, the car in the driveway was manual and I don't know how to drive stick.  Over the course of that morning, I felt the disturbing power of addiction.  This feeling got me thinking, how is something this addictive so widespread?

Last week, I mentioned that while commuting I like to observe other commuters to see what they’re holding.  I often see other commuters with one or two things in their hand a smart phone or a coffee.  Each morning while I pass Dunkin Donuts on State Street, I see a line of people waiting for their fix.  Down the street at Starbucks, it is the same story.  According to a recent Gallup Poll, ~64% of American adults drink coffee each day.  This is significantly greater than the percent of American adults that eat breakfast everyday (34%).

Coffee consumption has several properties which make it unique among consumer products; coffee is:

• Highly Addictive
• Unregulated
• Socially Acceptible 

Very few substances are as addictive as coffee and all of the substances that are more addictive than coffee are regulated.  There are even substances that are less addictive than coffee that are regulated as well. A highly addictive yet unregulated product means that it can be legally consumed at any age, marketed widely (even to children) and should exhibit low elasticity of demand (see 2007-8-9-10 revenue).

On top of its addictive properties, coffee sellers have an unfettered right to market their product to anyone. Coffee drinking is one of the most socially acceptable of all human practices.  It can be consumed alone, with someone you barely know, with a loved one, a colleague/s, in a business context, in a large group, in public or private all of the above is socially acceptable.  In fact, I don’t know of any other product that is as broadly socially acceptable, highly addictive and unregulated as coffee.

Can you think of one?

Ten Years of iPhone

As we approach the tenth anniversary of the iPhone release, it's worth reflecting on how life has changed since that time. 

How do you feel when you misplace it?

When the iPhone was released, I didn't see it for what it was.  I still saw it as a telephone with a larger screen, worse battery life and a challenging on-screen keyboard.  

It took me to four more years to realize that the development of the iPhone was a fundamental turning point in human history.  We can now hold our computer in our hands and carry it with us just like we've done with other core human innovations in the past: the pen, purse, sword, gun, compass and flask.

Today, a smart phone is a fully functional computer.  Having it in your pocket gives you on-the-go access to:

• The bulk of all human knowledge.  (Wow!) 
• Access to all personal information including but not limited to finance, tax, health, location, communication and images. 
• Near infinite supply of creative content including but not limited to, music, short and long films, books, articles, blogs in almost all active languages. 

In just ten years we've made significant strides eliminating the concepts of:

• Getting lost
• Boredom
• Language confusion
• Loneliness
• Indecision
• Mobility
• Profligacy
• Disagreement
• Bad teachers

All new pleasures can lead to addiction.  As I commute to work each morning I like to look at what people hold in their hands.  Looking at what (or who) people hold in their hands gives you a good sense of what people value.  The two most common objects in our hands these days seem to be our smartphone (mostly iPhones) or a coffee.  

The iPhone often outcompetes for hand time with a highly addictive drug like caffeine or the hand of our loved ones. We should be wary of addiction. 

Dutch electro house duo, Blasterjaxx masterfully captured both my concern and optimism.

While the internet is captivating, the world is beautiful. 

On Running

千里之行，始於足下 - 老子

A journey of 1,000 miles begins with a single step.  -Laozi

When I first moved to Boston during the winter of 2015 I began to regret my decision.  It was brutally cold, the snow banks were taller than me (I'm 5'8'') and my commute doubled in length.  

After my first week at work, I looked out my livingroom window at the tundra below me and saw something I didn't expect. Runners.  Along the path that circles the Charles River, runners were everywhere.  The flow of runners continued throughout the winter, into spring and summer.  Once the weather warmed up after a bit of cajoling from girlfriend I decided to give running a try.  

On my first run, I decided to set my expectations low so that I might succeed.  I guessed that the 1/4 mile to the grocery store should be within my ability. I guessed wrong.  Two days later I tried again.  While I got slightly further than my first attempt, I still couldn't complete the 1/4m without stopping.  On my third attempt I made it!  I was really happy. 

My two Japanese friends.

About nine months later, I found myself in Philadelphia on a Sunday.  I was standing at the starting line, in the rain, alongside a few of my colleagues with 30,000 other runners about to experience my first race.  A year earlier, if you had told me that I'd be running a 10 mile race, I would have been incredulous. A lot can change within a year. 

Over the course of running, I've learned a lot about myself.  Running gives you the opportunity to think abstractly as your runners high takes hold.  While I run, I explore podcasts from music, comedy to economics and think about what is troubling me.  My runs have a variety of psychological and physical benefits, improved my commute and foster my love for Boston.

Rather than walking in the cold to the train, I run to the train.  Running warms your body and if you dress appropriately you won't notice the cold.  You'll arrive at work faster and get home faster, reducing commute time.  When you do arrive at work less psychologically stressed you'll increase your productivity and when you arrive at home less psychologically stressed you'll have a more pleasant home life. 

The benefits to running are enormous and costs to running are low.  

The journey begins with a single step. 

My Grandpa's Stories

When ever my Grandpa Jerry came over, I'd always get excited for story time.  Grandpa was a gregarious serial entrepreneur; therefore, many of his stories were animated tales of profit, loss and deals made along the way.  He'd always find a way to surreptitiously include a lesson or two into these stories. But because I'm a slow learner, it took me many years to notice. 

One of grandpa's businesses was called Friedland Shipping International.  As the name suggests, his firm engaged in international shipping.  Particularly, heavy machinery and white goods between the US and Iran during the reign of the Pahlavi dynasty as well as with customers in Saudi Arabia and to a lesser extent the UAE. His firm employed a few dozen people and was based in the New York City's World Trade Center. 

During the 1960s and 1970s Iran was growing rapidly and required bulldozers, cranes and other equipment that my grandpa was able to source and ship to his customers.  As part of his business, my grandpa traveled to the Middle East to monitor shipments, build relationships with customers and learn about their culture.  Many of the stories he'd tell regarding Iranian and Saudi culture fascinated me, from drinking strong coffee, the heat of the desert, the challenges of being a Jewish trader in the Middle East and polygamy. 

Jerry Friedland with his customers.

At one point in the mid 1970s while his business was going really well, my grandpa explained that he was contacted by some Hong Kong based merchants that wanted to trade with China and they asked him if he'd like to trade with them.  At the time, China was impoverished and closed to direct trade.  He also felt that he lacked Chinese language skills and requisite cultural understanding.  Moreover, his business with the Iranians was going so well that he didn't think it was a good return on time. He declined the Hong Kong merchants' offer.  

A few years later in 1979, the Iranian revolution occurred and his business was mortally wounded.  During one of the last conversations I had with him, he told me that one of his biggest regrets regarding Friedland International Shipping was his decision to pass on trading with the Chinese.  

While I didn't understand it at the time as such, my grandpa taught me about two deeply related business concepts:

 Political Risk and Diversification

Political risk can be thought of as a situation where theft and breach of contract by your trading partner both become legal - the rules of the game no longer apply.  In this instance, the Iranian revolutionary government confiscated private property and refused to pay outstanding debts.  Accounts receivable become write-offs.  

Diversification is best thought of as putting your eggs in many baskets located in different countries with a range of political regimes.  

Diversification is the only way to reduce the pain of adverse political risk.  

If you're ever concerned with government policy or leadership, I strongly suggest you consider this lesson too.

Thank you grandpa. 

Consumption or Creation?

I love reading because there is so much I don't understand and because it is easier than writing.  Each morning, I like to read newspapers from East Asia, South Asia, Africa, Europe and the Americas.  After newspapers, I like to explore my favorite blogs.  Later in the day, I'll hop on Twitter.  Sometimes I'll dig into long-form articles or academic research. In the evenings or during my commute, I'll even indulge in fiction.  

I spend much of my waking life consuming information. 

My relationship with creation is much more complicated.  Creating ideas isn't as easy as consuming them. When you want to spend time reading, you can do so at your discretion.  Creation, on the other hand, requires inspiration, execution and coffee.

My objective is to create ideas worth consuming.

Here we go!