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Sunday, February 14, 2010

Review: Fortune's Formula

Fortune's Formula is William Poundstone's exploration of gambling and the stock market.

He starts with an exposition of the various scientists who've worked on it. These included the usual suspects of any finance book: Claude Shannon, Black & Scholes, Robert Merton. However, the lessor known ones include Ed Thorp and John Kelly.

In many ways, Poundstone's book is about the conflicting ideas behind the efficient market hypothesis academics and the gambling hypothesis. The gamblers were largely governed by the Kelly Criterion, while the efficient market guys focused on making leveraged bets and made headlines mostly by blowing themselves up (as LTCM did). The Kelly criterion folks noted that the LTCM-type betters were betting so heavily that their expected return over the long term was effectively zero.

What is notable was that none of the Kelly criterion people in the book blown up, though Thorp's fund was shut down over tax shenanigans, indicating perhaps that his 28% return was at least partially due to cheating. In any case, the statistical arbitrage folks seem to have had unusual success in the market, though at the end of the book Poundstone indicates that since 2002, they've not been all that successful, probably because too many people entered the statistical arbitrage field after Thorp's success. Another interesting note about the apparently success was that all the portfolios were relatively small. Thorp's operation never exceeded several hundred million dollars, and Claude Shannon's portfolio at the time of this death was approximately half a million dollars. This suggests that the efficient market guys were partly correct: you can't scale up the kind of statistical arbitrage operation that Thorp was running without also eliminating the kind of opportunities that would make such operations successful. Of course, as an individual investor, several hundred million bucks is enough real money that a really smart person with access to a lot of data could probably execute large enough bets often enough to make himself wealthy for life. Thorp, by the way, was the first person to discover how to win at blackjack, the inspiration for the MIT folks in Bringing Down The House.

In any case, this book is very well written, covering all the basic theories and math without even a single equation (though there are plenty of graphs). It does take sides, and like many journalists, I'm not sure the entire story was told. However, if you have an interest in statistical arbitrage, this is a great book with a lot of fascinating stories in it. In particular, you might be surprised at the number of crooks involved in this type of operation. Highly recommended.

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