Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street [Hardcover]

William Poundstone (Author)

Book Description

Publication Date: August 25, 2005

In 1956 two Bell Labs scientists discovered the scientific formula for getting rich. One was mathematician Claude Shannon, neurotic father of our digital age, whose genius is ranked with Einstein’s. The other was John L. Kelly Jr., a Texas-born, gun-toting physicist. Together they applied the science of information theory—the basis of computers and the Internet—to the problem of making as much money as possible, as fast as possible.

Shannon and MIT mathematician Edward O. Thorp took the “Kelly formula” to Las Vegas. It worked. They realized that there was even more money to be made in the stock market. Thorp used the Kelly system with his phenomenonally successful hedge fund, Princeton-Newport Partners. Shannon became a successful investor, too, topping even Warren Buffett’s rate of return. Fortune’s Formula traces how the Kelly formula sparked controversy even as it made fortunes at racetracks, casinos, and trading desks. It reveals the dark side of this alluring scheme, which is founded on exploiting an insider’s edge.

Shannon believed it was possible for a smart investor to beat the market—and Fortune’s Formula will convince you that he was right.

William Poundstone is the bestselling author of nine nonfiction books, including Labyrinths of Reason and The Recursive Universe.

In 1956 two Bell Labs scientists discovered the scientific formula for getting rich. One was mathematician Claude Shannon, neurotic father of our digital age, whose genius is ranked with Einstein's. The other was John L. Kelly Jr., a Texas-born, gun-toting physicist. Together they applied the science of information theory—the basis of computers and the Internet—to the problem of making as much money as possible, as fast as possible.

Shannon and MIT mathematician Edward O. Thorp took the "Kelly formula" to Las Vegas. It worked. They realized that there was even more money to be made in the stock market. Thorp used the Kelly system with his phenomenonally successful hedge fund, Princeton-Newport Partners. Shannon became a successful investor, too, topping even Warren Buffett's rate of return. Fortune's Formula traces how the Kelly formula sparked controversy even as it made fortunes at racetracks, casinos, and trading desks. It reveals the dark side of this alluring scheme, which is founded on exploiting an insider's edge.

Shannon believed it was possible for a smart investor to beat the market—and Fortune's Formula will convince you that he was right.

"Fortune's Formula may be the world's first history book, gambling primer, mathematics text, economics manual, personal finance guide and joke book in a single volume. Poundstone comes across as the best college professor you ever hand, someone who can turn almost any technical topic into an entertaining and zesty lecture."—The New York Times Book Review

"Fortune's Formula may be the world's first history book, gambling primer, mathematics text, economics manual, personal finance guide and joke book in a single volume. Poundstone comes across as the best college professor you ever hand, someone who can turn almost any technical topic into an entertaining and zesty lecture."—The New York Times Book Review

 

"Seldom have true crime and smart math been blended together so engagingly"—The Wall Street Journal

"An amazing story that gives a big idea the needed star treatment . . . Fortune's Formula will appeal to readers of such books as Peter L. Bernstein's Against the Gods, Nassim Nicholas Taleb's Fooled by Randomness, and Roger Lowenstein's When Genius Failed. All try to explain why smart people take stupid risks. Poundstone goes them one better by showing how hedge fund Long-Term Capital Management, for one, could have avoided disaster by following the Kelly method."—Business Week

 

"Poundstone, a two-time Pulitzer Prize nominee, takes us from chalkboard to stock market and back as he explains the 'Kelly formula' for gambling through the lives of those who developed and exploited the system. It is a rollicking tale about money, mathematics and greed."—Bloomberg

 

"A dazzling array of math geniuses, rogues, swindlers, Nobel Prize winners, gun-toting physicists—all massaging the formulas that give them an edge in creating fortunes."—George J. W. Goodman (aka "Adam Smith"), author of The Money Game and Supermoney

 

"This is a wonderful tale of how mathematics got married to gambling and went off to honeymoon in Las Vegas, before finding ultimate happiness in the biggest casino of all—the world financial markets. Poundstone has produced a rogues' gallery of mobsters and mathematicians, kneecappers and handicappers, card sharps, professors, systems players, numbers runners, and number crunchers—the best 'investment advisers' you can find. Anyone interested in playing the markets should buy this book and read it immediately."—Thomas A. Bass, author of The Eudaemonic Pie and The Predictors

 

"The true story of the intertwining lives of financial legends, mathematical geniuses and crooked mobsters. Who would you expect to win an intellectual battle between professional gamblers and Nobel Prize winners? This book confirms what I'd long suspected, that the successful gambler knows more about managing money than the most PhD-laden investment banker. Poundstone's book explains that knowledge, and you'll be surprised by its elegance and simplicity. A fascinating book, both a cracking good yarn and a practical guide for investment success."—Paul Wilmott, mathematician, bestselling author, and editor of Wilmott magazine

 

"From bookies to billionaires, you'll meet a motley cast of characters in this highly original, 'outside the box' look at gambling and investing. Read it for the stories alone, and you'll be surprised at how much else you can learn without even trying." —Edward O. Thorp, author of Beat the Dealer and Beat the Market

 

"What a fantabulous book! Fortune's Formula provides a deep but crystal-clear understanding of information theory, card-counting schemes, plunging necklines, mean-variance mapping, junk bonds sold short and gambler's ruin, all part of an epic suspense tale crowded with eccentric geniuses and cold-blooded killers. You'll never follow a horse race, push forward a casino chip or enter a market the same way again. Read this and weep for the edge you only thought that you had, then read it again for a real one."—James McManus, author of Positively Fifth Street

Editorial Reviews

Amazon.com Review

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

From Publishers Weekly

In 1961, MIT mathematics professor Ed Thorp made a small Vegas fortune by "counting cards"; his 1962 bestseller, Beat the Dealer, made the phrase a household word. With Claude Shannon, the father of information theory, Thorp next conquered the roulette tables. In this prosaic but fascinating cultural history, Poundstone (How Would You Move Mt. Fuji?) tells not only what they did but how they did it. For roulette, Poundstone shows, Thorp and Shannon used a betting scheme invented by Shannon's Bell Labs colleague John Kelly, eventually applying Kelly's technique to investing, resulting in long-term records of extraordinary return with low risk. (Thorp revealed the secret in 1966's Beat the Market, but investors proved harder to persuade than blackjack players.) Many other characters figure into Poundstone's entertaining saga: a forgotten French mathematician, two Nobel Prize–winning economists who declared war on the Kelly criterion, Rudy Giuliani, assorted mobsters, and winners and losers in all types of investing and gambling games. The subtitle is not a tease: the book explains and analyzes Kelly's system for turning small advantages into great wealth. The system works, but requires unusual amounts of patience, discipline and courage. The book is good fun for the rest of us.
Copyright © Reed Business Information, a division of Reed Elsevier Inc. All rights reserved.

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Product Details

• Hardcover: 400 pages
• Publisher: Hill and Wang; 1st edition (August 25, 2005)
• Language: English
• ISBN-10: 0809046377
• ISBN-13: 978-0809046379
• Product Dimensions: 9.4 x 6.3 x 1.2 inches
• Shipping Weight: 1.5 pounds
• Average Customer Review: 4.2 out of 5 stars  See all reviews (67 customer reviews)
• Amazon Best Sellers Rank: #529,170 in Books (See Top 100 in Books)

More About the Author

William Poundstone is the author of two previous Hill and Wang books: Fortune's Formula and Gaming the Vote.

Customer Reviews

Most Helpful Customer Reviews

298 of 311 people found the following review helpful:

5.0 out of 5 stars Ed Thorp is a true investment and math genius., September 8, 2005

By 

Gaetan Lion - See all my reviews
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This review is from: Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (Hardcover)

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.

43 of 45 people found the following review helpful:

4.0 out of 5 stars The Ongoing Epic of the Kelly Criterion for Risk Management., July 8, 2006

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mirasreviews (McLean, VA USA) - See all my reviews
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This review is from: Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (Hardcover)

"Fortune's Formula" tells the story of the Kelly Criterion -through the experiments, ideas, wins, and losses of those who have espoused it and who have derided it, at race tracks, black jack tables, sports books, and, finally, on Wall Street. The Kelly Criterion is a risk management formula published in 1956 by Bell Labs information theorist John Kelly, Jr. that dictates how much of your bankroll you should bet based on your edge divided by the odds so that you will have zero risk of ruin no matter how bad your luck is, while increasing wealth faster than any other betting system. It does not address what bets you should make, which is another matter entirely. Instead of writing a simple analysis of the Kelly Criterion, author William Poundstone brings this story alive by relating the histories of key figures who have used, promoted, or criticized the Kelly Criterion: information theorists, economists, traders, gamblers, and gangsters. Some readers may find this approach unfocused and unnecessary. But I think the personalities lend "Fortune's Formula" an epic quality and place the Kelly Criterion firmly in the context of real life, with real consequences, as opposed to the realm of abstruse theories that never leave the halls of academe.

The men whom "Fortune's Formula" casts as protagonists are Claude Shannon, the MIT scholar who invented information science and who amassed a small fortune as a buy-and-hold investor, typically making 28% per year on a small portfolio, and Ed Thorpe, author of 1962's gambling classic "Beat the Dealer", 1967's "Beat the Market", co-founder of Princeton-Newport Partners fund (1969-1988) and founder of Ridgeline Partners (1994-2002) quant fund. Ed Thorpe's transformation from MIT egghead to black jack sharp to Wall Street wizard in an ongoing theme, as Thorpe is an immensely successful advocate of the Kelly Criterion -and he is still alive. There is unfortunately little information on John Kelly, because he died in 1965 at the age of 41. The key Kelly challenger is 1970 Nobel Laureate economist Paul Samuelson, who probably overstates his case in calling the Kelly Criterion a "complete swindle" when the point of disagreement seems to be the concept of "utility" in long-tern outcome. Whatever one thinks of Samuelson's outspoken arrogance, he is certainly entertaining. Mobster Manny Kimmel makes an appearance, as do traders Ivan Boesky, Michael Milken, and John Meriwether, as well as numerous information theorists.

William Poundstone obviously has a point of view. He is an advocate of the Kelly Criterion, believing that it produces better results than any other betting system over the long haul while withstanding even the most unlikely confluences of catastrophe that have a way of manifesting themselves periodically. He doesn't support efficient market hypothesis. He thinks people can, and have, made money consistently on the stock market. -But that you need a darned good method of managing risk to do it, a better method than Value at Risk reports. "Fortune's Formula"'s fascination is not only in its history of the Kelly Criterion, but in the realization that a risk management formula has so many seemingly disparate applications. As Poundstone says, "The idea pops up in the strangest places."

27 of 29 people found the following review helpful:

4.0 out of 5 stars Mobsters, mathematicians and economists, October 25, 2005

By 

Grouchy Smurf (New York, USA) - See all my reviews

This review is from: Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (Hardcover)

I found this to be a very exciting and informative book. Once I started, I was hooked: I couldn't put it down because I wanted to learn more -- not just about the formula but all the intellectual controversy surrounding it and the cast of characters involved. This book tells the story of the 'Kelly criterion' and how certain people used it to beat the casinos and earn consistently above-average returns in the stock market. The cast of characters extend from famous organized crime figures (Bugsy, Longy Zwillman, etc.) to Claude Shannon, father of information theory, to Milken, the junk bond king, and many more.

You can view this book as a study on the history of an idea, as a study of the financial markets, or as a social study of gambling and investing. There are many faces to it. I wouldn't say it is a book on finance, or a book on history, but a bit of everyhting really. It definitely is not a book on 'how to beat the market', don't look for that here. The book does give a good explanation of the Kelly formula, in my opinion, but the whole controversy surrounding it, as well as the story of Ed Thorpe, was much more interesting for me.

If you are interested in finance or financial history, math, or gambling, or how ideas evolve and why certain ideas are better known than others, you should read this book. I think that mathematically sophisticated readers can be a bit disappointed because there is no rigorous treatment of Kelly criterion. But the basic ideas of CAPM, efficient markets hypothesis, the essence of Kelly formula, and random walk, are explained quite succintly and clearly, in my opinion.

The only problem I had with the book was that the author went off in tangents quite a bit, which sometimes distracted from the main story. For instance, right after the description of Kelly formula, there is a discussion of Edgar Hoover's horseracing bets. It seems that the author had a lot of material, may be too much, that he did not want to cut, but also did not know where to put. That detracted from coherence somewhat, which is why I am giving this 4 stars. But at the end of the day, I am feeling better for having read the book -- I learned a lot, and it was an easy and interesting read. Definitely worth the money and time.