Lessons From Ed Thorp’s Interview With Tim Ferriss

Moontower Munchies #50

Friends,

Episode link:

This is not a summary but just a selection of excerpts I want to preserve.

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You’re teaching a class of the neophytes how to invest? And some are, say mathematically inclined, and some are not. It’s a very mixed group. What types of tools or thinking frameworks, heuristics, mental models? Anything would would you focus on in the first handful of of lectures?

The first thing I tell them is, the answer is really easy for almost everybody. But you’re not going to believe me until you work through it yourself and understand it. I’ll tell you the answer to start with, and then I’ll try to convince you that it’s the right answer.

So, the answer is, if you’re a long-term investor, you should just buy and hold equities. The best place to have equities has been the US for the last couple of 100 years. Overall, equities here have compounded about 10, or 10 and a half percent for 200 years. The data for the first hundred years is not as good as the data for the last 100. But the data for the last century is quite good and very well documented.

How does that do against everybody else? Well, you can prove by logical mathematical arguments. I won’t go into all the details here. Some of it’s in my book, it’s also in other places, you can prove that if a person simply buys the index and holds it, they will outperform most all other players. The people who buy and hold the index will beat the whole collection of people who don’t do that. They do way better, on average, the ones who don’t do that pay trading costs. They have more volatility from lack of diversification. They often pay investment advisors, and all this and they also pay taxes when they trade. So the upshot is that you might make 10 and a half percent. If you don’t pay all these people, you might make eight, or seven or 6% to pay the crowd of people waiting to, quote, help you unquote. So that’s the simple answer for people who don’t know anything about investing.

Now, you might say, Well, yeah, but I’m pretty smart. I hear all these stories. I listen to Cramer on TV who jumps around, makes loud noise, and sounds good. So why can’t I do better?

Well, the academics have something called the efficient market theory in which they claim that you can’t do better. Now, I’ve already explained that that’s wrong, you can find instances where you can do better. Warren Buffett’s company did much better. I found with my hedge fund, I could do much better. But the kind of work you have to put in to do much better is substantial. It doesn’t seem like it at first. But when you get into it, there are all kinds of details and follow-ups and things to be checked out. And you end up spending a substantial amount of time and energy, figuring out how to do it better. And for everybody who finds out how to do better, the rest of the crowd who isn’t buying the index is doing a little bit worse, because you can show that the whole collection of people who don’t buy the index, or themselves as a group, is like the index. You subtract the index part out, and the rest is like the index too. So the people who aren’t buying the index that are like the index, as a group, are busy paying all these costs, taxes, investment advisors, and so forth. So on average, that whole group does worse. So you’re starting, you’re paying basically, casino vigorish, or whatever, if you’re not indexing, and you got to beat that, in order to do better than the indexes. And obviously, the group can’t beat that. So it’s only a small collection of people, some by luck, and some by skill will end up doing better. So you’re basically betting against the odds if you just invest by stories, and invest in various mutual funds that are actively managed, and so forth. So that’s what I would tell people.

Now, on the other side of the coin, if you really are interested in investing, it’s worth educating yourself and trying to do it, because you will learn a lot about investing, you might actually find a way to win. And you’ll learn about how the world works and a lot about life too. The things you learn from what seems like a narrow, specialized field, generalize very widely to all kinds of things. If you’re the kind of person who can take a lesson in one part of life and transport it to another part of life.

What are some of those transferable lessons in your mind?

Let’s take investment risk as a good example. You learn about how you minimize great risks. This is because significant investment risks can remove you from the game altogether. You might have an opportunity where you multiply your money by ten times, but you might also lose it all. Highly volatile things, like buying cryptocurrency, fall into this category. You may have the chance for a large gain, but also the risk of a significant loss. If you lose most of your capital, it’s challenging to recover. For instance, if you lose 90% of your capital, you’ve got to multiply what’s left by ten to break even, which means you’ve got to make a 900% return to offset that 90% loss. It’s not easy and takes a long time. So, you want to avoid really bad outcomes.

I applied this, for example, to COVID. I thought about what to do and how to deal with it. The early 2020 stats showed that people 85 and up, particularly males, had an 18% death rate if they contracted it. Even now, the death rate is very high for those who get it. If they’re unvaccinated, it’s probably close to that, and if they’re vaccinated, it’s maybe a tenth of that. So, I consider that a risk that could take me out of the game. It was a fairly high probability, so I’m going to avoid getting COVID if I possibly can. I’m going to mask up, avoid crowds, and think about the risks of various activities that I do and decide whether it’s worth it. So, I did my own analysis of COVID and its risks and tried to be very careful from then on. I think it’s paid off for me and my family. I’ve passed this information on to people around me.

On thinking for yourself

You won’t adhere to something unless you understand it yourself. There’s an old saying, “Give a person a fish, and they eat for a day, teach a person to fish and they eat for a lifetime.” The same applies to thinking. If you give somebody advice about a problem, they might solve that one problem. If you teach them how to think about problems, they can solve problems for the rest of their life. Also, if you give them advice, and they don’t understand what the advice is, or how to think about it, there’s a good chance they won’t take the advice.

A brutal example of someone not thinking for themselves

Back in 1991, I was invited to review the portfolio of McKinsey and Company in New York. They had a profit-sharing and a pension plan. I looked at all the things they had and they were quite good. But there was one very strange investment that yielded one or 2% a month, every month, for years. I asked, “How do they do this?” They said they didn’t know exactly, but they showed me their accounts.

I saw that this account had stock and put option positions with calls. Collars. They had a put option a little below the stock price, and they bought a call option a little bit above. The two things paid for themselves, so it seemed like they didn’t have a lot of risk. But I could show that in a down market, they would lose and in an up month, they would win. They won every month because a mysterious trade was put on involving S&P index options, and it was always in the right direction.

So, I said this is not possible. I wanted to go over and look at this place. They called the person in charge, Peter Madoff, the brother of Bernie Madoff. Bernie was off in Europe raising money. This was 1991. When Peter Madoff heard I was coming, he said, “No, I won’t let him in the front door.”

I decided to take a better look at all their trades. I saw that half the trades never happened when I researched them. That is, there were no trades occurred on any exchange at the prices they were making them out for these options. Another quarter of the trades had so much volume, that the volume couldn’t have happened because there wasn’t that much volume on the exchanges where they traded. The last quarter of the trades didn’t happen anywhere. There was no explanation.

So, I decided to look at some of the trades that actually could have happened. I went to a vice president of Bear Stearns and asked him to research 10 options trades. I wanted to know who was on the other side of these trades. In particular, was Madoff and Company on the other side of any of them. They researched the trades and said they couldn’t find any trace of Madoff and Company.

So, I said to McKinsey, “This is a fraud.” They said, “But we’re making 20% a year.” I said, “Well, you’re making 16% on your other investments. If I’m right, this 20% is not real, and the roof’s gonna fall in someday, and you might lose your jobs. On the other hand, if I am right, and you move, you’ve solved this problem. If I’m wrong, and you move, you’re only going from 20% to 16%. So it makes a lot of sense to just exit.”

So they exited in two months. We inquired of everyone we knew on my network, they through their network, to find out who had investments with Madoff and how much they had. We could only cover a small part of the territory because our network was not comprehensive. We were able to identify about half a billion. That means that there was a lot more than half a billion out there. How much more we couldn’t say.

But how could you challenge Madoff? He was a pillar of the National Association of Securities. He’d been a past president, even on committees there. He was the biggest third market, that is off the exchange maker, in the country. He was a respected person, well known to everybody, and he had thousands of investors. Because he had so many investors, everybody knew it had to be right, because surely those people had checked it all out.

The finale of the story is that when I was doing this, the person who invited me, who was a hedge fund manager himself and had been an advisor to McKinsey, believed in Madoff and continued to raise money for him. In 2008, when the news came out that Madoff was a fraud, my son called me up and said, “You know, Dad, the stuff you’ve been telling me about for 17 years, it finally happened. It blew up.”

This fellow who had been running a fund of funds, and included Madoff in that fund of funds, that’s a special type of hedge fund that invests in other hedge funds. He had been doing this and had a very big fund of funds. He was raising money for Madoff the same week that the bad news came out. He had his own personal money, his family’s money, and trusts where money was with Madoff. But I had explained everything to him in great detail. I knew him quite well, at the time back in 1991, that McKinsey and Company had this analysis explained to them and decided to pull out.

The whole point of this is, here’s a person who had all the information, it was explained very clearly, and he just didn’t believe it. He himself was in the investment business and was very successful. But he was swayed by popular opinion. He would poll people and then go by the poll. So just imagine that you asked 10,000 people whether they thought you could travel faster than light. 9,999 said, “Yep, you can do it. I saw it on TV.” And only one guy said, “No, you can’t do it, Albert Einstein.” So a guy like him would overwhelmingly reject Einstein and believe the 9,999 average people who just said, “Yeah, you could do it,” because the poll was 9,999 to one on one side.

He doesn’t think for himself. He lets the crowd think for him. And that, I think, is a fundamental mistake that many people make. They let the crowd do their thinking. They don’t figure it out for themselves.

[Kris: This is an incredibly difficult topic — the tension between first principles and consensus in truth-finding. In this example, Thorp uses the consensus finding method know as a poll aka democracy. In Dinosaur Markets, I explain a a very similar metaphor I learned from Jeff Yass at SIG. Yass and Thorp would probably agree that if there was a futures market traded on the speed of light question the contract would trade for a much smarter price than what the poll would indicate — Einstein would have raised money to short the proposition from a small but rich group of investors who are in the business of finding wedges between fair value and consensus price.

But even markets can suffer from the madness of crowds. Markets and democratic means of finding truth can both fail. And that is where the first principle people shine. It’s the scientist, entrepreneur, or Billy Beane whose independent thinking coincides with everyone laughing at them. 

But I say the tension is difficult because well-functioning markets have a good track record of being hard to beat, so if every problem is a nail to be hit with a first-principles hammer your gonna waste a lot of energy tearing down Chesterton’s fences only to discover that your predecessors deserved more credit. Also see  Snowflakes vs Lemmings]

Which investors, other than Warren Buffett, impress you? They could be people who are no longer actively investing, or they could be current investors. Are there any who come to mind who have particularly impressed you, aside from Buffett?

There are people in the hedge fund world who have done remarkable jobs at various times, but they’re not accessible to your listeners, or to most people. For example, let’s take Jim Simons of Renaissance. Renaissance Partners is basically a private operation at this point. But it’s been extraordinarily successful, using PhDs, computers, math, and codebreaking, and so forth. And it has, from around 1989 or 1990, been spectacular in its performance, probably having the best risk-adjusted record in the world from that time forward.

Any other names who come to mind?

Well, I’m trying to think of whom I would give money to invest. I don’t have anybody now to whom I’d give money to invest. There are a few good hedge funds around, but they take too much for the general partner and leave too little for a limited partner. They also generate income that is highly taxed if you’re a taxable investor. So, they’re only good for nonprofits or tax-exempt investors.

You could have simply become a full-time capital accumulator. How did you decide to wind it down? And how do you determine what is ‘enough’? This doesn’t strike me as a common sentiment among people who are really good at investing.

The way I entered the investment world was as an academic. I was curious and found things interesting. I wasn’t really there to get rich; I was there to solve interesting math problems that kept coming up. Blackjack and Roulette were math/physics problems. Investing was, for me, lots and lots of math. So, I enjoyed that. I just do things I like, and I don’t worry about money. As my former sister-in-law once said, “Do what you love, and the money will follow.” She wrote a book with that title. And I thought, that’s right. Do what you love, and the money may follow. If it does, that’s fine. If it doesn’t, you’re still doing what you love. What’s important in life, I think, is the journey, the people you spend your time with, and how you spend your time.

I started out as a child of the Great Depression, so I knew what it was like to have basically no money. I used to sleep four or five hours a night in high school and get up at two or three in the morning to deliver newspapers. I made $25 a month, which seemed like a lot of money. I saved part of that for college and invested part of it in science equipment, chemistry, telescopes, electronics, and so forth, just because I liked playing with those things and learning about them. So my goal wasn’t to make money; it was to have a good life, enjoy myself, and have fun. It just so happened that I also made a lot of money.

What I found in the investment world is that lots of people go into it for the money. And when they do, they keep going and going. It’s a validation for them that they can’t stop. They end up with five or ten villas, a yacht, a jet. But imagine having five houses. How much of your time is spent in each house? You can’t be in your house all the time. You’ll be vacationing, traveling, meeting, and so on. So maybe it’s a sixth or seventh of the time, on average. Now, some houses you’re going to spend more time in, some less. You may spend a tenth or fifteenth of your time in one of those houses. So you end up with a lot of stuff to manage and take care of. You end up hiring people to do that, then you have to manage those people. Then you have to hire people to manage the people who manage the people, and so on. It’s like running a business. You don’t get to enjoy the important part of your life, which is time.

[Kris: You don’t have to be a centimillionaire to relate. If you live in a nice suburb town near a coastal city (ahem the working rich) you can learn from this too. Personally, I feel that many high-earners who still feel money insecurity just spend too much time looking over their neighbor’s fence. But Thorp endorses a book by Ian Shapiro that proposes another possibility that I think makes more sense. It’s not envy. It’s a fear grounded in what our eyes see — communal breakdowns. The book is called The Wolf at the Door: The Menace of Economic Insecurity and How to Fight It.

Thorp describes the book:

The book is fairly recent, explaining the concepts I learned in a political science course a few months ago. It discusses how to form coalitions that can win and how to pass measures that will endure. For instance, Social Security has remained intact because it immediately established a strong constituency that would perpetually defend it. Politically, despite attempts by some politicians and occasional political parties to dismantle it, they have not been successful due to the deeply embedded and robust constituency. He provides a clear description of how to effectively accomplish goals. He believes that incremental progress can be made, as discouraging as it may seem these days, by correctly forming and defending against blocking coalitions. I highly recommend his book to anyone looking to make evolutionary progress.

In my opinion, we are currently in a democracy crisis. Simplistically, we have three paths: devolution, which we are currently undergoing; evolution, which I hope will occur where we fix things and improve; and revolution, which is extremely unpleasant.

One of your previous interviewees, Ray Dalio, has a book that I believe is worth reading, despite being a challenging read. It contributes significantly to the discussion about the crisis we are currently facing, discussing the changing world order, the rise of China as an empire, and the decline of the United States. As an empire, we need to do some serious thinking. We cannot rest on our laurels, claiming our past greatness and hoping it will continue. We need to do things differently.]

Did you have a specific point at which you knew you were going to exit the business, so to speak, or was there a particular day or experience that prompted you to say enough is enough?

I wasn’t having fun anymore. It was turning into work. And I thought, “Well, I don’t need to do this. I have enough wealth. I’m never going to spend it all. Why keep doing this?” So, I decided to wind it down. It was fun for a long time because they were challenging problems. It was challenging to try to figure out new things and to deal with all the issues that came up. But when it became bureaucratic and paperwork, and a grind where I had to do things I didn’t want to do, that was enough. It was time to go. And it was the same thing in academia. I loved academia, but there were aspects of it that became burdensome: committee meetings, endless reviews, grant proposals. What I liked was research and teaching, and the people that I met there, the students and the faculty who were smart and challenging. If it was only that, I’d still be there. But it wasn’t only that, and I found other things that were equally or more fulfilling. So, anyhow, I just migrate to where I want to be. I don’t have a set thing that I have to keep doing. Let’s explore that.

I spend my time reading, traveling, exercising, enjoying my family and friends, and learning things I can. It’s also entertaining to casually manage my investments. I might interject here that one thing that makes you independent is accumulating capital. Then, the capital can grow on its own if it’s simply invested, as I described before, in an index fund. Once you have capital, you have the chance for independence. If you have enough capital, it can support you indefinitely. When you’ve achieved that goal, there’s no point in spending time doing anything you don’t enjoy if you can avoid it. There are some things you don’t like but have to do, like gathering your tax information every year or going for routine medical appointments.

Is there anything that you are particularly interested in learning more about, currently in the process of learning about, or looking forward to learning about?

What I’ve focused on for the last year or so is reading about what’s going on in American society. What may happen? I don’t think we can predict for sure what’s going to happen. But we can map out scenarios, we can map out possibilities. We won’t get them all, but we can map out quite a few of them. And ask ourselves, what will we do if scenario A, scenario B, or scenario C materializes, and have some sort of preparation and readiness for that.

I won’t go into a list of extreme scenarios except maybe a few:

• You could have an autocratic country where a minority pretty much rules everything and dictates everybody else.

• You could have a turbulent country where a large part of the country, maybe a majority, is badly upset and just wants to bust everything up and start over somehow.

So you could have the choices that describe a devolution, evolution, or revolution. I don’t know how it’s going to play out. But it’s worth thinking about what might happen. And whether there’s anything any of us can do about it.

I don’t think there’s much that an individual can do on a grand scale, unless he happens to be in a position of great importance, or manages to get himself in a position of great importance. But I think there’s a lot that an individual can do on a small scale. And I think the best thing we can do is teach everybody to think for themselves. So they don’t just take what they’re told, in the press, for example, or in the other forms of the media, the internet, Twitter, and so on. They don’t just take that and blindly believe it, but they question it. And they ask whether, in fact, it might not be true. What the motives are of the people who are putting these things out and so forth. When you begin to think for yourself, the whole world changes and becomes much clearer, in my opinion. And you can manage your life much better. 

[Kris: This is an area which I would partially disagree with Thorp. While I think it’s a noble goal to want to teach everyone to think for themselves…I think this fundamentally unscalable. I am not optimistic about the capacity of individuals to elevate their ability to cognitively reflect by large jumps. Which means we are locked into the distribution of this ability as it is. And even if we could, it’s not clear that it is adaptive or even possible at the group level. I don’t feel that the group level is just a scaled up version of the sum of individual gains — I think it’s a phase shift into which those gains would either be lost or sublimated into another dumb mob mentality, hacked by the same forces that infiltrate every group movement draining them of the purity of their initial energy. At a society level, progress requires the carrying capacity to bring our dumb caveman selves along with it.

If progress is contingent on us escaping our tribalism, it’s doomed from the outset. I think Dan Carlin has the framing best — our unraveling will come from failing to seriously confront an existential coordination problem. And we are going to need to do that without counting on a collective mental upgrade.]

☮️

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