The Most Remarkable Investor that You’ve Never Heard Of

Last weekend, I took an extended drive through the Great Lakes region to drop my kids off at their respective camps.

We stayed in Michigan the first two nights – first in Holland and then Munising, right on Lake Superior in the Upper Peninsula.  After a drop off in Minocqua, Wisconsin, we stayed in downtown Madison.  All told, we traveled about 2,300 miles.

While my wife and kids were hooked up to their iPads, I enjoyed listening to a book on tape, A Man for All Markets, a memoir by legendary investor, Ed Thorpe.  Unless you’re a serious blackjack player, you probably haven’t heard of Thorpe even though he’s contributed more to modern finance than he has to the game of 21.

After earning his PhD in mathematics from the University of California, Thorpe used probability theory to prove that blackjack players could beat the house with a simple card counting system.  After applying his technique in Reno and Las Vegas, he literally wrote the book on the subject called Beat the Dealer in 1962.

Although most reviewers thought that he was another crackpot offering a ‘system’ to unsophisticated players, the casinos knew that he was onto something because they consistently lost to Thorpe over the years.  The casinos changed their house rules to remove the edge that Thorpe identified and he was barred from casinos across Nevada.

After beating the dealer, Thorpe worked as a math professor but wanted to figure out how to invest some of his earnings.  He tried his hand at stock picking, but was largely unsuccessful.

After two years of research, Thorpe stumbled on a special security type called a warrant, which is similar to a stock option.  Thorpe realized that, at that time, warrants were systematically mispriced, which allowed him to earn consistent profits.

Thorpe created a hedge fund that earned 20 percent per year for decades, net of his fees, which was one percent of the assets under management and 20 percent of the profits.  Amazingly, the fund only had three down months over that time and they were all relatively small.

His success was based on an option pricing model that he developed, which was nearly identical to the Black-Sholes option pricing model that earned Fischer Black and Myron Sholes the Nobel Prize in 1997.  In other words, Thorpe was using the Black-Sholes model before Black and Sholes figured it out.

Fischer Black actually sent Thorpe an early version of their paper because he was a fan of Beat the Dealer (and Beat the Market, which he wrote in 1967).

Unless you’re in finance, you may not realize what an accomplishment it is to have figured out Black-Sholes before the namesake founders did. What’s truly amazing, though, is that this kind of thing happened to Thorpe over and over throughout his career.

Here are a few highlights:

  • Thorpe had dinner and played bridge with Warren Buffett in the 1970s after Buffett was winding down his hedge fund and forming Berkshire Hathaway.  Although Thorpe didn’t buy Berkshire stock until 1983, he still got in at $982.50 (the stock closed Friday at $257,644.98.
  • Thorpe realized that Bernie Madoff was a fraud in 1992, almost 15 years before the Ponzi scheme was revealed before the rest of the world.  Thorpe saw the returns, realized they were too good to be true, partly because Thorpe understood the strategy that Madoff was claiming to trade (the split strike conversion).
  • Thorpe had a run in with the law thanks to his firm’s association with Michael Milken in the 1980s.  Although Thorpe was not accused of wrong-doing himself, his firm was nearly prosecuted by Rudy Giuliani (Thorpe is not a fan).
  • Thorpe was the first investor in Ken Griffin’s Citadel LLC, one of the most famous and well respected hedge funds around today.  One of Thorpe’s friends discovered Griffin, who was trading convertible bonds in his dorm room at Harvard.  Today, Griffin is the wealthiest citizen in Illinois with an estimated net worth of $8 billion.

I could go on, but my gushing is probably a little too much already.  Unlike a lot of books on tape, Thorpe read the book, which was also a treat.

Most finance books are read by actors with a British accent and don’t know how to pronounce finance terms (one book drove me crazy because the reader spelled out C-A-P-M when referring to the Capital Asset Pricing Model.  Anyone who has spent a day in finance knows that it’s pronounced Cap-M).

I thought that the book was fascinating because his story is so remarkable.  I whole heartedly recommend the book (well, the book on tape, which I think counts!).