As I began this book, I was disappointed. I had picked it up after reading The Idea Factory, the fascinating history of Bell Labs: Fortune’s Formula was mentioned glowingly in the acknowledgements. Bell Labs employees — including my favorite, Claude Shannon — taking a road trip to Vegas to use their reality-bending powers of analysis to defeat the casinos? Sign me up.
Digging in, the danger signs began accumulating. Poundstone’s prose is workmanlike at best. There are endless asides about the backgrounds of various mobsters tied to the gambling industry. And while Shannon’s trips to Vegas (to beat blackjack and roulette, it turns out) are exciting and ingenious, the man was smart enough to quit once his intellectual curiosity had been satisfied. This is no Bringing Down the House. Vegas fades from the scene by the book’s halfway point.
But this is where Poundstone’s project becomes clear. His language loosens, his transitions from explanation to narrative become more fluid, and he starts calling people dopes. He enters his element, and embarks on the effort that excites him. Poundstone is not just fleshing out a fun Bell Labs footnote; he’s telling a story about arbitrage and the modern finance industry.
In particular, he’s telling the history of the Kelly Criterion, an asset allocation formula — aka betting system — mathematically proven to maximize returns over the long run, given reinvestment of winnings and quantified odds. The story of the Kelly Criterion is interesting enough. Its foundations are rooted in Information Theory, the field Shannon singlehandedly invented, in part through the revelation that information works by reducing uncertainty — and what is a gambler’s edge if not a reduction in uncertainty? It’s also fascinating to learn that despite its mathematical soundness, the Kelly Criterion apparently remains a subject of fierce debate, largely rejected by economists, finance experts and business schools thanks to a combination of practical, intellectual and cultural reasons (that it was invented by information theorists, not economists, doesn’t help its cause).
But this book is about more than that. Poundstone mounts an implicit but still quite damning case against the modern finance industry. It’s not just the slight seediness of mathematical concepts invented for roulette translating smoothly to Wall Street; it’s the gangsters we were introduced to in the book’s opening chapters make the trip, too, swept along by a conscious legal strategy (going legit) into a new form of gambling. By the time a young prosecutor named Rudolph Giuliani discovers he can use RICO, a law designed for the mob, to go after titans of finance, the story has become a fascinating moebius strip of money and risk. Is it a coincidence that Ed Thorp, the man who taught the world how to count cards, is also the analytic mind behind one of the first and most successful hedge funds in history?
Thorp comes out of this book looking like a singular genius, and a probably-ethical one, to boot. I’m convinced, but some suspicion is warranted — Poundstone seems to have gotten a lot of help from him in putting this book together. Still, the man’s record of returns and lack of indictments speak for themselves.
Aside from the Kelly Criterion and Wall Street’s strange bedfellows, there are two important takeaways to be had here:
First, Poundstone does a number on the Efficient Market Hypothesis. I think he treats it fairly, explaining the views of its proponents, its intellectual heritage and the debates surrounding it with nuance — like Thorp, Paul Samuelson is portrayed as a brilliant and towering figure (I’m going to have to remember this trick of his — what an amazing dick move). The random walk is explained, as are investment strategies that can succeed despite the market’s unpredictability. Fees and common investor mistakes are acknowledged, and he allows no confusion about what a typical investor should do: buy an index fund and ignore anyone who tells you they can beat the market.
Still, by the end of the book it’s very hard not to conclude that a few ubermenschen walk among us — people like Thorp — who can consistently identify systemic pricing errors and develop ingenious ways to profit from them. The history of hedge fund tactics is explained, and of course it turns out to be built on these manipulations, from the warrant-based delta hedge to junk bonds to leveraged buyouts.
Before you ask: yes, Poundstone considers the survivor-bias argument at length. But I was still convinced that these techniques have worked — at least until they’re disclosed and the market begins pricing them in. EMH proponents tend to hand-wave toward this pricing-in happening with calculus-like instantaneity, but the actual history makes it clear that the process has sometimes taken months or years.
Second, and following from this, it’s hard to read Fortune’s Formula and not conclude that finance has evolved toward (and probably past) a point of uselessness — perhaps even destructiveness. Why does our society reward this kind of work? To provide better prices, they say, so that capital can be allocated more efficiently. The problem is that the process has no finish line. Arbitrage opportunities are discovered, profited from, and cease to exist; but Manhattan remains steadily expensive. So new arbitrage opportunities must be discovered or invented, via the sorts of exotic financial instruments that we’ve heard so much about these past years. But the low-hanging fruit is gone — the margins on these deals are tiny, so they have to be amplified through incredible amounts of leverage. The complexity of the system inevitably sometimes reaches a point where interdependencies aren’t fully realized — Poundstone makes this point by narrating the epic destruction of LTCM — and things blow up.
Fortune’s Formula was published in 2006. Poundstone doesn’t even need the Great Recession to make his point.
A few caveats. I’m not a great consumer of books about finance. I haven’t even read The Big Short. It’s very possible that these insights are less novel than they seemed to me.
But this book taught me quite a bit of history, more than a few financial concepts, and changed the way I think about investing/gambling/risk. I’m tempted to reread it, even if just to make sure I got the thrust of the early chapters right (if I’d known who Ed Thorp would become, I would’ve paid a bit more attention — I had heard the name before, but didn’t make the connection).