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

by William Poundstone (Author) "THE STORY STARTS with a corrupt telegraph operator..." (more)
Key Phrases: compound return rate, geometric mean criterion, average compound return, New York, Bell Labs, Las Vegas (more...)

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 (60 customer reviews)
• Amazon.com Sales Rank: #262,537 in Books (See Bestsellers in Books)

Customer Reviews

Most Helpful Customer Reviews

260 of 271 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 (TOP 500 REVIEWER)    (REAL NAME)

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.

32 of 33 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

By	mirasreviews (McLean, VA USA) - See all my reviews (TOP 100 REVIEWER)    (COMMUNITY FORUM 04)

"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."

131 of 163 people found the following review helpful:

3.0 out of 5 stars This book is something of a cheat, October 14, 2005

By	Jamesian "pragma" (Connecticut USA) - See all my reviews

Let's consider the subtitle. "The Untold Story of the scientific betting system that beat the casinos and Wall Street."

Okay ... what's the system that beat the casinos? In two words: card counting. It's the "untold" system that was demonstrated in the movie "Rain Man." If you can keep track of the cards coming out of a particular deck, you recognize at some point that there are "lots of Queens in there. Definitely. Lots and lots of them." Such a realization moves the odds in your favor.

The problem with that system has little to do with science. It is, as those who've seen Rain Man will remember, that if you're obvious about it you get escorted out of the casino by intimidating beefy men. This book provides anecdotal evidence of the same phenomenon.

Moving on ... what is the "scientific system" that has beaten Wall Street? In a word, its arbitrage. Look for opportunities created by the inefficiencies of others, especially such inefficiencies as bifurcate markets, and exploit them, simultaneously selling in one market and buying in the other. This, like any particular card counting expedition, is (a) easier said than done and (b) tends to be self-terminating. One example in this book involves the S&P index. When S&P futures were first listed, some traders hadn't figured out how to value them. This inefficiency bifurcated the market. One could exploit it by selling the index futures contract, while buying the underlying stocks.

How long did that last? Four months! Then, says this book, "the market got the message .... The price anomalies vanished."

Poundstone tries to erect out of such exploitation of bifurcated markets a vast intellectual warfare between efficiency theorists and street-wise systems bettors who know better (no pun intended), a war between Samuelson and Thorpe. But it doesn't wash. Market efficiency theory is a default option, if you wil, a framework of ideas that underlies whatever particular anamolies suspend it from time to time. The fact that an anamoly can last a whole four months doesn't constitute an earth shattering discovery, and since the correction of any such inefficiency by definition moves the market closer to an efficiency model, one might say that Thorpe is helping bring Samuelson's theoretic point of view to completion. Good for him.

There's rebellion as a fact and there's rebellion as a style. Poundstone reminds me a little of a kid dressed rebelliously (baggy pants, untied shoelaces, the baseball cap turned backwards) who nonetheless, in everything important, thinks and acts along with dear old Dad. There is no rebellion against the "random walk cosa nostra" here. Just a baseball cap turned around.