Book: Man for all Market

Edward O. Thorp -- A Genius -- Professor, Mathematician, Inventor, & A Successful Investor

In his autobiography, A Man For All Markets, Thorp shares everything about his life, his achievements, his failures and most importantly he has deconstructed the way he thinks. And in the end, Thorp shares his views on how individuals should try to think.

Below are some of the sections and the most interesting statements, observations, learnings, views of Thorp. The words in Italics are my words to give additional clarity where required.

Preface

• I found a resource that made all the difference: I learned how to think.
• I do all of these, but I also think using models. A model is a simplified version of reality, like a street map that shows you how to travel from one part of a city to another or the vision of gas as a swarm of tiny elastic balls ceaselessly bouncing against one another.
• Because of circumstances, I was largely self- taught and that led me to think differently.
• First, rather than subscribing to widely accepted views— such as you can’t beat the casinos— I checked for myself. Second, since I tested theories by inventing new experiments, I formed the habit of taking the result of pure thought— such as a formula for valuing warrants— and using it profitably. Third, when I set a worthwhile goal for myself, I made a realistic plan and persisted until I succeeded. Fourth, I strove to be consistently rational, not just in a specialized area of science, but in dealing with all aspects of the world. I also learned the value of withholding judgement until I could make a decision based on evidence.

Foreword

• True success is exiting some rat race to modulate one’s activities for peace of mind. Thorp certainly learned a lesson: The most stressful job he ever had was running the math department of the University of California, Irvine. You can detect that the man is in control of his life. This explains why he looked younger the second time I saw him, in 2016, than he did the first time, in 2005.

Chapter 1: LOVING TO LEARN

• From the beginning, I loved learning through experimentation and exploration of how my world worked.
• The books helped establish lifelong values of fair play, a level playing field for everyone, and treating others as I myself wish to be treated.
• The Great Depression’s twelve years of persistent widespread unemployment, peaking at 25 percent, were suddenly ended by the greatest government jobs program ever, World War II.

Chapter 2: SCIENCE IS MY PLAYGROUND

• Read through the list of 60 great novels, mostly American literature, by authors such as Thomas Wolfe, John Steinbeck, Theodore Dreiser, John Dos Passos, Upton Sinclair, Sinclair Lewis, Ernest Hemingway, and F. Scott Fitzgerald.
• Among foreign authors were Dostoyevski and Stendhal.
• I punctuated by hours of reading with body surfing and with thoughts about who I was and where I was going

Chapter 3: PHYSICS AND MATHEMATICS

• If you do this, what do you want to happen? and If you do this, what do you think will happen?
• Understanding and dealing correctly with the trade- off between risk and return is a fundamental, but poorly understood, challenge faced by all gamblers and investors.

Chapter 4: LAS VEGAS

• I also believed then, as I do now after more than fifty years as a money manager, that the surest way to get rich is to play only those gambling games or make those investments where I have an edge.

Chapter 5: CONQUERING BLACKJACK

• It is also common in science for the time to be right for a discovery, in which case it is made independently by two or more researchers at nearly the same time.
• Famous examples include calculus by Newton and Leibniz, and the theory of evolution by Darwin and Wallace.
• Proceedings of the National Academy of Sciences,
• On the other hand, students of plane geometry learn a simple method for bisecting an angle this way. A small change in the problem, from dividing an angle into two equal parts, to splitting it into three equal parts, transforms an easy problem into an impossible one.

Chapter 6: THE DAY OF THE LAMB

• In the abstract, life is a mixture of chance and choice. Chance can be thought of as the cards you are dealt in life. Choice is how you play them.
• Claude asked me at dinner if I thought anything would ever top this in my life. My thoughts then were much like I expected his to have been: that acknowledgment, applause, and honor are welcome and add zest to life but they are not ends to be pursued. I felt then, as I do now, that what matters is what you do and how you do it, the quality of the time you spend, and the people you share it with.
• This plan, of betting only at a level at which I was emotionally comfortable and not advancing until I was ready, enabled me to play my system with a calm and disciplined accuracy. This lesson from the blackjack tables would prove invaluable throughout my investment lifetime as the stakes grew ever larger.
• For the second time, the Ten- Count System had shown moderately heavy losses mixed with “lucky” streaks of the most dazzling brilliance. I learned later that this was a characteristic of a random series of favorable bets. And I would see it again and again in real life in both the gambling and the investment worlds.

Chapter 7: CARD COUNTING FOR EVERYONE

• He studied the theory of card shuffling, and the popular press widely reported his conclusion that seven fairly thorough shuffles was enough for practical purposes to randomize any deck of cards.

Chapter 9: A COMPUTER THAT PREDICTS ROULETTE

• In 1998 a New York Times Science Times article said that mathematicians had discovered how networks might “make a big world small” using the equivalent of the famous person idea, and attributed the concept of six degrees of separation to a sociologist in 1967. Yet all this was known to Claude Shannon in 1960.

Chapter 10: AN EDGE AT OTHER GAMBLING GAMES

• I am often asked what it takes to be a successful card counter. I’ve found that an academic understanding is not enough. You need to think quickly, be disciplined enough to follow the system, and have a suitable temperament, including the ability to switch your mind into the here and now and stay focused on the cards, the people, and your surroundings.

Chapter 11: WALL STREET: THE GREATEST CASINO ON EARTH

• I read stock market classics like Graham and Dodd’s Security Analysis, Edwards and Magee’s work on technical analysis, and scores of other books and periodicals ranging from fundamental to technical, theoretical to practical, and simple to abstruse.
• Behavioral finance theorists, who have in recent decades begun to analyze the psychological errors in thinking that persistently bedevil most investors, call this anchoring (of yourself to a price that has meaning to you but not to the market).
• Like my first mistake, this error was in the way I thought about the problem of when to sell, choosing an irrelevant criterion— the price I paid— rather than focusing on economic fundamentals like whether cash or alternative investments would serve better.
• Lesson: Do not assume that what investors call momentum, a long streak of either rising or falling prices, will continue unless you can make a sound case that it will.
• I also learned from my losing silver investment that when the interests of the salesmen and promoters differ from those of the client, the client had better look out for himself. This is the well- known agency problem in economics, where the interest of the agents or managers don’t coincide with those of the principals, or owners.

Chapter 12: BRIDGE WITH BUFFETT

• Afterward, when I was thinking about Buffett, his favorite game— bridge— and the nontransitive dice, I wondered whether bidding systems at bridge might be like those dice. Could it be that no matter which bidding system you use, there will always be another system that beats it, so there’s no best system? If so, the inventors of new “better” bidding systems could be chasing their tails forever, only to have their systems beaten by still newer systems, which in turn might then lose to old previously discarded systems.

Chapter 13: GOING INTO PARTNERSHIP

• Unknown to Einstein, his equations describing the Brownian motion of pollen particles were essentially the same as the equations that Bachelier had used for his thesis five years earlier to describe a very different phenomenon, the ceaseless, irregular motion of stock prices. Bachelier employed the equations to deduce the “fair” prices for options on the underlying stocks.
• Bachelier’s paper appeared in 1964 in The Random Character of Stock Market Prices, edited by Paul Cootner and published by the MIT Press.
• Bachelier had assumed that changes in stock prices followed a bell-shaped curve, known as a normal or Gaussian distribution.
• Moreover, PNP made money every month in its first six years except for one in early 1974, when it declined less than 1 percent. From the peak on January 11, 1973, to the bottom on October 3, 1974, the drop in the stock market was a savage 48.2 percent, the worst since the Great Depression. Even Warren Buffett said then that it was a good thing for his partners he’d closed down when he had.
• Perverse incentive by giving everyone a single pool of paid leave days that accumulated based on the number of hours worked and covered paid holidays, vacations, days off, and illness. Employees could use this time in any of these ways, subject only to the limitation that time off not interfere with essential job responsibilities.
• In fifty-five and a half years of marriage I don’t ever remember her bragging. The closest she came was when I would admire the way she matched the hues of her outfits or furnished our household with a designer’s eye. She would look at me and matter- of- factly explain, “I have a good eye for color.”
• Initially, I transferred to UCI’s Graduate School of Management, where I enjoyed teaching courses in mathematical finance. But I found factionalism and backstabbing as bad there as it had been in the Math Department.

Chapter 14: FRONT-RUNNING THE QUANTITATIVE REVOLUTION

• We analyzed and incorporated tail risk, and considered extreme questions such as, “What if the market fell 25 percent in one day?” More than a decade later it did exactly that and our portfolio was barely affected.
• The next big test of PNP’s investment approach came soon afterwards. From 1979 through 1982 there were extreme distortions in the markets.

Chapter 15: RISE . . .

• The prototype was Value Line, an investment service that launched a program in 1965 using information such as surprise earnings announcements, price- to- earnings ratios, and momentum to rank stocks into groups from I (best) to V (worst).
• stock is said to have positive momentum if its price has recently been trending strongly up, and negative momentum if strongly down.
• other data were marketed by CRSP, the University of Chicago’s Center for Research in Security Prices.
• The Compustat database provided historical balance sheet and income information.
• When the historical patterns persisted as prices unfolded into the future, we created a trading system called MIDAS (multiple indicator diversified asset system) and used it to run a separate long/ short hedge fund (long the “good” stocks, short the “bad” ones). The power of MIDAS was that it applied to the entire multitrillion-dollar stock market, with the possibility of investing very large sums.

Chapter 17: PERIOD OF ADJUSTMENT

• What the hagglers and the traders do reminds me of the behavioral psychology distinction between two extremes on a continuum of types: satisficers and maximizers. When a maximizer goes shopping, looks for a handyman, buys gas, or plans a trip, he searches for the best (maximum) possible deal. Time and effort don’t matter much. Missing the very best deal leads to regret and stress. On the other hand, the satisficer, so-called because he is satisfied with a result that is close to the best, factors in the costs of searching and decision making, as well as the risk of losing a near- optimal opportunity and perhaps never finding anything as good again.

Chapter 18: SWINDLES AND HAZARDS

• In the early 1980s, a decade before coming across Madoff, I learned of a remarkable investment manager. This foreign exchange trader was racking up returns of 1 percent, 2 percent, 3 percent, and even 4 percent a month. He seemed never to lose. I asked George Shows, an associate in my Newport Beach office, to make an onsite visit to J. David Dominelli in nearby La Jolla. George came back with the amazing track record and “advertising” literature but could find no evidence of any actual trading activity. Our requests for audited financial statements, proof of assets, and proof of trades were smoothly deflected. I suspected a Ponzi scheme, and we didn’t invest. Two years later Dominelli’s scam collapsed in 1984, wiping out $ 200 million and defrauding one thousand investors, including many of the social, political, and financial elite of the San Diego area.
• On HFT -- Some securities industry spokesmen argue that harvesting this wealth from investors somehow makes the markets more efficient and that “markets need liquidity.” Nobel Prize-winning economist Paul Krugman disagrees sharply, arguing that high- frequency trading is simply a way of taking wealth from ordinary investors, serves no useful purpose, and wastes national wealth because the resources consumed create no social good.
• On Silly Reporters & Headlines -- Offering explanations for insignificant price changes is a recurrent event in financial reporting. The reporters often don’t know whether a fluctuation is statistically common or rare. Then again, people tend to make the error of seeing patterns or explanations when there aren’t any, as we’ve seen from the history of gambling systems, the plethora of worthless pattern- based trading methods, and much of story-based investing.

Chapter 19: BUYING LOW, SELLING HIGH

• Market professionals describe stocks with large trading volume as “liquid”; they have the advantage of being easier to trade without moving the price up or down as much in the process. The latest prices from the exchanges flow into our computers and are compared at once with the current fair value according to our model. When the actual price differs enough from the fair price, we buy the underpriced and short the overpriced. To control risk, we limit the dollar value we hold in the stock of any one company. Our caution and our risk- control measures seem to work. Our daily, weekly, and monthly results are “positively skewed,” meaning that we have substantially more large winning days, weeks, and months than losing ones, and the gainers tend to be bigger than the losers.
• Scanning the computer screen, I see the day’s interesting positions, including the biggest gainers and the biggest losers. I can see quickly if any winners or losers seem unusually large. Everything looks normal. I walk down the hall to Steve Mizusawa’s office, where he is watching his Bloomberg terminal, checking for news that might have a big impact on one of the stocks we trade. When he finds events such as the unexpected announcement of a merger, takeover, spin-off, or reorganization, he tells the computer to put the stock on the restricted list: Don’t initiate a new position and close out what we have.
• Why is statistical arbitrage so-called? Arbitrage originally meant a pair of offsetting positions that lock in a sure profit. An example might be selling gold in London at $ 300 an ounce while at the same time buying it at $ 290 in New York for a $ 10 gain. If the total cost to finance the deal and to insure and deliver the New York gold to London were $ 5, it would leave a $ 5 sure profit. That’s an arbitrage in its original usage.
• For instance, in what is called merger arbitrage, company A trading at $ 100 a share may offer to buy company B, trading at $ 70 a share, by exchanging one share of company A for each share of company B.
• The market reacts instantly and company A’s shares drop to, say, $ 88 while company B’s shares jump to $ 83. Merger arbitrageurs now step in, buying a share of B at $ 83 and selling short a share of A at $ 88. If the deal closes in three months, the arbitrageur will make $ 5 on an $ 83 investment or 6 percent. But the deal is not certain until it gets regulatory and shareholder approval, so there is a risk of loss should the negotiations fail and the prices of A and B reverse. If the stocks of A and B returned to their preannouncement prices, the arbitrageur would lose $ 12 = $ 100 − $ 88 on his short sale of A and $ 13 = $ 83 − $ 70 on his purchase of B, for a total loss of $ 25 per $ 83 invested, or 30 percent. The arbitrageur won’t take this lopsided risk unless he believes the chance of failure to be small.
• The idea of the project was to study how the historical returns of securities were related to various characteristics, or indicators. Among the scores of fundamental and technical measures we considered were the ratio of earnings per share to price per share, known as the earnings yield, the liquidation or “book” value of the company compared with its market price, and the total market value of the company (its “size”). 
• The room also had its own safety system. In case of fire, the air was automatically replaced by noncombustible halogen gas within eighty seconds. Once this happened the room had too little oxygen for fire to burn or for people to breathe. We practiced how to get out in time and to trigger the halogen manually, if necessary.
• The Computing Power of PNP Partners -- Our facility was high- tech in the mid- 1980s, but with the enormous increase in computer miniaturization, speed, and cheapness, now even cellphones store many gigabytes. The room was chilled to a constant sixty degrees Fahrenheit by its own cooling system and had sealed doors and dust filters to keep the air clean. 
• To control risk further, I replaced Bamberger’s segregation into industry groups by a statistical procedure called factor analysis. Factors are common tendencies shared by several, many, or all companies. The most important is called the market factor, which measures the tendency of each stock price to move up and down with the market. 
• The daily returns on any stock can be expressed as a part that follows the market plus what’s left over, the so-called residual. Financial theorists and practitioners have identified a large number of such factors that help explain changes in securities prices.
• Some, like participation in a specified industry group or sector (say, oil or finance) mainly affect subgroups of stocks. Other factors, such as the market itself, the levels of short- term and long- term interest rates, and inflation, affect nearly all stocks.
• The portfolio is already market-neutral by constraining the relation between the long and short portfolios so that the tendency of the long side to follow the market is offset by an equal but opposite effect on the short side.
• Of course, there is a trade-off: The reduction in risk is accompanied by limiting the choice of possible portfolios. Only those that are market- neutral, inflation- neutral, oil- price- neutral, et cetera, are now allowed, and so the attempt to reduce risk also tends to reduce return.
• We called the new method STAR, for “STatistical ARbitrage.”
• One reason is that buying undervalued securities tends to raise the price, reducing or eliminating the mispricing, and selling short overpriced securities tends to lower the price, once again shrinking the mispricing. Thus, opportunities for beating the market are limited in size by how trading them affects market prices.

Chapter 22: HEDGING YOUR BETS

• If you have an area of expertise, look for funds that your knowledge can help you evaluate. Hedge fund data services typically list more than a thousand or so funds from the several thousand that currently exist. These services, along with Internet sources like Wikipedia, classify hedge funds by asset types. Another way to sort is by methodology, such as: fundamental, using economic data as opposed to technical, using just price and volume data; or quantitative (using computers and algorithms) compared with non-quantitative; or bottom-up (analyzing individual companies) versus top- down (focusing on broader economic variables). Other important characteristics are the fund’s expected returns, risks, and how the payoffs correlate with those from other asset classes. For instance, the returns from funds that exploit trends in the prices of commodity futures often are not correlated significantly with the market. This can make them useful in reducing the fluctuations in the value of your overall portfolio. There are equity long- only funds, short- only funds, and long/ short funds. Market-neutral funds (like PNP and Ridgeline) attempt to have returns uncorrelated with the market.
• Improperly charging expenses to the partnership is another way that the limited partners get less than they should. The list of issues goes on, the point being that hedge fund investors don’t have much protection and that the most important single thing to check before investing is the honesty, ethics, and character of the operators.

Chapter 23: HOW RICH IS RICH?

• Read up the article -- “Budget Basics: 25 Things You Can Do to Trim Yours Today”
• If you’re uncertain, put in a low value for what you own and a high value for what you owe, leading to a conservative value for what you’re worth.
• Later you will want to make a more accurate balance sheet, which I do about once a year. The difference in balance sheet net worth from one year to the next shows the change in your total wealth after income, expenses, gains and losses.
• In the asset section, for each item list the amount of cash you feel sure it would sell for in a reasonably short time. That car you bought new a year ago for $ 45,000 might have a replacement cost of $ 39,000 now, but you might be able to sell it for only $ 35,000. Put down $ 35,000. Recent sales of houses comparable with yours might range from $ 925,000 to $ 950,000, but after all sales and closing costs, you might net only $ 875,000. Put down $ 875,000. What you owe on the mortgage will be deducted in the liabilities section.
• A. Income, taxable and nontaxable: 1. Earned income such as wages and salaries. 2. Unearned income such as interest and dividends. 3. Realized capital gains and losses. 4. Royalties, honoraria, all other taxable receipts. 5. Tax- free interest, such as municipal bonds. 
• B. Nontaxable gains and losses: 1. Appreciation or depreciation of property such as real estate, art, and autos. 2. Unrealized capital gains or losses in securities. C. Expenses (all money paid out for “costs”— that is, not saved): 1. Living expenses, consumption. 2. Income taxes. 3. Gifts. 4. Any other money earned but not saved.
• As the folly of paying unnecessary taxes dawned on investors, the dividend rate paid by companies in the last part of the twentieth-century dwindled and stock prices soared, shifting returns away from income and toward capital gains.
• Category C is everything you spend or consume that doesn’t contribute to your wealth. Think of your wealth at the start of the year as liquid partly filling a huge measuring cup. The balance sheet tells you how much is there. During the year categories, A and B tell how much you add and category C tells you how much you takeout. The difference, A + B − C, is how much you added or subtracted during the year.

Chapter 24: COMPOUND GROWTH: THE EIGHTH WONDER OF THE WORLD

• “the rule of 72” It says: If money grows at a percentage R in each period then, with all gains reinvested, it will double in 72/ R periods.
• I apply this to the trade-offs among health, wealth, and time. You can trade time and health to accumulate more wealth. Why health? You may be stressed, lose sleep, have a poor diet, or skip exercise. If you are like me and want better health, you can invest time and money on medical care, diagnostic and preventive measures, and exercise and fitness. For decades I have spent six to eight hours a week running, hiking, walking, playing tennis, and working out in a gym. I think of each hour spent on fitness as one day less that I’ll spend in a hospital. Or you can trade money for time by working less and buying goods and services that save time. Hire household help, a personal assistant, and pay other people to do things you don’t want to do. Thousand- dollar- an- hour New York professionals who pay $ 50 an hour for a car and driver so they can work while they commute understand clearly the monetary value of their time.
• To get an idea of what your time is worth, take a moment now to think about how much you work and the income you get from your effort. Once you know your hourly rate you can identify situations where buying back some of your time is a bargain and other situations where you want to be selling more of your time. As you get used to thinking this way, I predict that you will often be surprised at how much you can gain.
• Think of the single worker who spends two hours commuting forty miles from hot and smoggy Riverside, California, to a $ 25- an- hour job in balmy Newport Beach. If the worker moves from his $ 1,200- a- month apartment in Riverside to a comparable $ 2,500- a- month apartment in Newport Beach, his rent increases by $ 1,300 a month but he avoids forty hours of commuting. If his time is worth $ 25 per hour he would save $ 1,000 ($ 25 × 40) each month. Add to that the cost of driving his car an extra sixteen hundred miles. If his economical car costs him 50 cents a mile or $ 800 a month to operate, living in Newport Beach and saving forty hours’ driving time each month makes him $ 500 better off ($ 1,000 + $ 800 − $ 1,300). In effect he earned just $ 12.50 per hour during his commute. Does our worker figure this out? I suspect he does not, because the extra $ 1,300 a month in rent he would pay in Newport Beach is a clearly visible cost that is painfully and regularly inflicted, whereas the cost of his car is less evident and can be put out of mind.
• Spend an average of forty or more hours a week watching television (playing online games, watching movies, snapchat, twitter, etc). Those who do have plenty of “junk time,” which they can use instead for an exercise or fitness program. Five hours a week for this can add five years of healthy life.

Chapter 26: CAN YOU BEAT THE MARKET? SHOULD YOU TRY?

• In 2007-08: In some cases we could even buy SPACs holding US Treasuries at annualized rates of return to us of 10 to 12 per cent, cashing out in a few months. This was at a time when short- term rates on US Treasuries had fallen to approximately zero! For those who still believe that the market always prices securities properly, here’s a profit opportunity that arose because investors couldn’t even do arithmetic.

Chapter 27: ASSET ALLOCATION AND WEALTH MANAGEMENT

• Major Asset Classes and Subdivisions 
  EQUITIES Common Stock Preferred Stock Warrants and Convertibles Private Equity 
  INTEREST RATE SECURITIES Bonds US Government Corporate Municipal Convertibles Cash US Treasury Bills Savings Accounts Certificates of Deposit Mortgage- Backed Securities 
  REAL ESTATE Residential Commercial
  COMMODITIES Agricultural Industrial Currencies Precious metals
  COLLECTIBLES (Art, gems, coins, autos, etc.)
  MISCELLANEOUS (MARKETABLE) PERSONAL PROPERTY Motor vehicles, planes, boats, jewelry, etc.
• Investors who chase returns, buying asset classes on the way up and selling on the way down, have had poor historical results. The tech bubble that ended in 2000, the inflation in real estate prices that peaked in 2006, and the sharp drop in equity prices in 2008– 09 were especially costly for them. On the other hand, the buy- low/ sell- high investors, whom you might think of as “contrarian” or “value” investors, have tended to outperform by switching some funds between asset classes.
• On Real Estates -- For many it is a large part of their wealth. How good an investment has it been? In 1952, one of my uncles and his wife paid $ 12,000 for a small one- story wood- and- stucco home in the working- class community of Torrance, California. In 2006, he sold his house near the peak of the real estate bubble, which was especially extreme in California. Despite the deterioration of his neighborhood into a borderline gang area, and the advanced age of his house, he netted about $ 480,000 after taxes and commissions. His investment multiplied forty times in fifty- four years, for a compound annual return of 7 percent. Also, his expenses of a few percent a year in property taxes and maintenance were less than what he would have paid to rent a similar property.
• To cut taxes, start with a tracking basket and, each time a stock drops, say, 10 percent, sell the loser and reinvest the proceeds in another stock or stocks chosen so the new basket continues to track well. If you want only short- term losses, which is usually best, sell within a year of purchase. I advise anyone considering doing this in a serious way to study it first with simulations using historical databases.
• The lack of liquidity in hedge funds and in real estate would prove costly for investors in the 2008– 09 recession.
• Because you can’t get out in time when trouble is coming, the excess returns you expect from illiquid investments may be offset by the economic impact of unforeseen future events.
• The lesson of leverage is this: Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.
• In his fascinating history of the topic, Fortune’s Formula, William Poundstone points out that for a favorable bet that pays odds of $ A for a bet of $ 1, the optimal Kelly bet is the percent of your capital equal to your edge, divided by the odds, A.
• Kelly’s criterion is not limited to two- value payoffs but applies generally to any gambling or investing situation in which the probabilities are known or can be estimated.
• (1) The investor or bettor generally avoids total loss;
  (2) the bigger the edge, the larger the bet;
  (3) the smaller the risk, the larger the bet.
• (1) The Kelly Criterion may lead to wide swings in the total wealth, so most users choose to bet some lesser fraction, typically one- half Kelly or less;
  (2) for investors with short time horizons or who are averse to risk, other approaches may be better;
  (3) an exact application of Kelly requires exact probabilities of payoffs such as those in most casino games; to the extent these are uncertain, which is generally the case in the investment world, the Kelly bet should be based on a conservative estimate of the outcome.
• Investing heavily in extremely favorable situations is characteristic of a Kelly bettor.

Chapter 28: GIVING BACK

• We wanted at least 90 percent of the amount we gave to be spent directly on our target purpose, rather than on fundraising and administration. You can check this percentage for any nonprofit organization from its annual financial statements by looking at the ratio of money spent on the target to the amount of money spent overall.
• Vivian and I were indebted to the University of California system for giving us a quality education that we could not have afforded otherwise. It was also where we met. We enjoyed saying thank you.

Chapter 29: FINANCIAL CRISES: LESSONS NOT LEARNED

• But the key to the disaster that followed was easy money and leverage. Investors could buy stocks on as little as 10 percent margin, meaning that they could put up only 10 percent of the purchase price and borrow the other 90 percent. It sounds eerily familiar because it is. The 2008 collapse in housing prices had the same cause: unlimited unsound loans to create highly leveraged borrowers.
• Brooksley Born wanted to regulate the derivatives that would later be a major cause of disaster, the PBS program Frontline detailed how she was blocked in 1998 by the triumvirate of Federal Reserve chairman Alan Greenspan, US Treasury Secretary Robert Rubin, and Deputy US Treasury Secretary Lawrence Summers, all of whom would later advise government on the 2008–09 bailout. Nassim Taleb asked why, after a driver crashes his school bus, killing and injuring his passengers, he should be put in charge of another bus and asked to set up new safety rules.
• 2004, five major investment banks persuaded the US Securities and Exchange Commission to increase their allowable leverage. Previously, they could borrow $ 11 for every $ 1 of net worth. This meant they only had $ 1 out of every $ 12, or 8.33 percent, as a cushion against disaster. Under its chairman Christopher Cox, the SEC allowed Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers to expand their leverage to something like 33:1, rivalling the levels that doomed the ill- fated hedge fund Long-Term Capital Management just six years earlier. With, say, $ 33 in assets and $ 32 of liabilities for each $ 1 of net worth, a decline of a little over 3 percent in assets would wipe out their equity. Once this happened and a bank was known to be technically insolvent, creditors would demand payment while they could still get it, triggering a classic run on the bank, just as in the 1930s.
• Programs like the Works Progress Administration (WPA) and the Civilian Conservation Corps (CCC), which I remember from my childhood, built roads, bridges, and public works during the 1930s, and the improvement in our infrastructure benefited us all for decades.
• How can we prevent future financial crises driven by the systemic and scarcely regulated use of extreme leverage?
• Institutions that are “too big to fail,” and have a significant risk of doing so should be broken into pieces that are small enough to fail without jeopardizing the financial system.
• Canada did not see any massive meltdown in 2008. The difference was that Canada had strict standards for mortgages and tighter limits on bank leverage and risk.
• We privatize profit and socialize risk.
• Compared with one of their average workers, CEOs in 1965 took home 24 times as much but “four decades later the ratio was 411 to 1.”
• Another indication of increasing economic inequality is the share of national income captured by the top one- hundredth of 1 percent of all earners. In 1929 they captured 10 percent of national income. This fell to about 5 percent during the Great Depression, gradually rising again beginning in the 1980s. In the last few years the share of national income claimed by these 12,500 households broke its 1929 record of 10 percent and continues to increase. These executives claim that their compensation inspires them to be the creative engines of capitalist society, benefiting all of us. The crisis of 2008 is one of our rewards.
• Studies done both before and after the 2008–09 recession showed that the larger the percentage of corporate profit paid to the top five executives, the poorer the earnings and the stock performance of the company.
• However, as Moshe Adler, in his article “Overthrowing the Overpaid,” points out, economists David Ricardo and Adam Smith, writing more than two hundred years ago, “concluded that what a person earns is determined not by what that person has produced but by that person’s bargaining power. Why? Because production is typically carried out by teams . . . and the contribution of each member cannot be separated from that of the rest.”
• The company rules are deliberately designed to make it difficult or impossible for independent shareholders to nominate directors or place issues on the ballot. Instead, corporations — their legal existence already being permitted and regulated by the state— should be required to conduct democratic elections following the usual voting rules in our American democracy. Moreover, any block of shareholders that together holds some specified percentage of the shares should have the unrestricted right to nominate directors and to put issues on the ballot, including the replacement of board members and top executives.
• Management may, for instance, own A shares with ten votes each and the public may own B shares with one vote each. How would you like to live in a country where any “insider” could cast ten votes and any “outsider” got only one? Abolish this and make it one share, one vote.
• Institutions that hold shares in custody for their owners can cast proxy votes for those shareholders who decline to vote. These proxies usually perpetuate current management and ratify its decisions. Change this so that the only votes that count are those cast directly by the shareholder; so- called proxy votes would not count. These two measures— democratic elections and shareholder rights to put issues to a vote— would allow the owners of the company, namely, the shareholders, to exert control over the compensation of top executives, their so-called agents, and would, in my opinion, be far more effective and accurate than direct government regulation.
• As the philosopher George Santayana famously warned, “Those who cannot remember the past are condemned to repeat it.”

Chapter 30: THOUGHTS

• Education has made all the difference for me. Mathematics taught me to reason logically
• Physics, chemistry, astronomy, and biology revealed wonders of the world and showed me how to build models and theories to describe and to predict. This paid off for me in both gambling and investing.
• One of the major public policy issues today is the trade- off between the costs and the benefits of certain procedures. Some choices are stark. Is it better to spend $ 500,000 to save the life of someone with super-drug-resistant tuberculosis or to use the same amount to save fifty lives by delivering fifty thousand doses of flu vaccine at $ 10 each to schoolchildren? Statistical thinking can help us with choices like these.
• I believe that simple probability and statistics should be taught in grades kindergarten through twelve and that analyzing games of chance such as coin matching, dice, and roulette is one way we can learn enough to think through such issues. Understanding why casinos usually win might help us avoid gambling and teach us to limit our losses to their entertainment value.
• Gambling now is largely a socially corrosive tax on ignorance, draining money from those who cannot afford the losses.
• Most of what I’ve learned from gambling also is true for investing. People mostly don’t understand risk, reward, and uncertainty.
• This well- known strategy, called laddering, generally pays off because longer-term US bonds, with more price fluctuation, before they mature, generally yield more. Five- year bonds have beaten thirty- day T- bills by about 1.8 per cent annually over the last eighty- three years.
• One of my great pleasures from the study of investing, finance and economics is the discovery of insights about people and society. The physical sciences have rules such as the law of gravitation that generally holds true in the world as we know it. But human beings and the way they interact aren’t covered by broad, unchanging theories and may never be. Instead I’ve come across more limited concepts that tie things together and serve as shortcuts to understanding.
• Productivity would be maximized as though guided by an “invisible hand.” The notion is of limited use, because most markets are not as Smith assumed. Take computer chips: 99.8 percent of them, worldwide, are made by just two US companies, and the smaller one is fighting to survive.
• “The tragedy of the commons,” as explained in 1968 by Garrett Hardin. Example of the tragedy of the commons -- On a global scale, we have the example of pollution. Individual humans have freely burned fossil fuels and greatly increased the amount of greenhouse gases such as CO2, leading to a continuing rise in the earth’s temperature over the last century. The tiny particles also emitted have caused lung diseases and deaths. But each polluter gains more individually from his own actions than he loses, so he has no direct pressure to change.
• “Externalities.” In the arcane jargon so beloved by the economic priesthood, an externality is a cost or benefit for society that results from private economic activity. The externality is negative in the case of air pollution. The “fair” solution then becomes obvious: Estimate the damage and tax it by that amount. Externalities also can be positive.
• Berkshire Hathaway’s Charlie Munger presents his list of such thinking tools in the engaging Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger. This multidisciplinary collection of insights includes a favourite of mine for understanding deals and relationships, namely, “Look for the incentives,” which is closely related to finding “Cui bono?” or “Who gains?” Cui bono instantly explains why seven thousand US gun dealers, lining the border with Mexico from Tijuana to Corpus Christi, are allowed freely to provide nearly all the military- level arms used by the Mexican drug cartels.
• More insights come from a much bigger idea of fundamental importance for all investors, the recognition that the group I call the politically connected rich are the dominant economic and political power in the United States. This is a key concept for understanding what happens in our society and why it happens. They are the ones who buy politicians, using campaign contributions, career opportunities, investment profits, and more. As owners of wealth who also control power, they run the country and will continue to do so. We saw how they used the government to bail them out of the financial crisis of 2008– 09. The power in this group resides mostly in those who are in the upper 0.01 per cent of wealth holders, currently worth $ 125 million or more.
• Another theme for dealing with public policy issues is to simplify rules, regulations, and laws.
• The hardest part, more often than not, is passing laws to implement it. This has become harder, as the political clash between the parties in the United States has become extreme. Politics once called the art of the possible, is becoming the art of the impossible. Gridlock between uncompromising factions was one cause of the fall of the Roman Empire.
• History, arguably, has had just two great superpowers, the Roman Empire after the defeat of Carthage, and the United States after the fall of the Soviet Union. Of great importance for long- term investors is whether the US will be the dominant world power in the twenty-first century, or whether we have peaked, dissipating our strength in costly foreign wars, financial mismanagement, and domestic strife. The first scenario could lead to another century of equities returning 7 per cent a year after inflation. The other outcome could be far less pleasant. I reassure the pessimists by noting that we’re still rich, still innovating, and besides, Rome wasn’t destroyed in a day. Nations that were once among the most powerful, such as Britain, France, Italy, Spain, the Netherlands, and Portugal, are still among the most developed and civilized of countries. To the optimists, I mention the obvious: endless deficits, massive wastage of lives and wealth in wars, political subsidies (pork, bailouts, corporate welfare, paying the able-bodied not to work), and destructive partisanship in all three branches of government. Meanwhile, the rise of China is transforming the geopolitical and economic landscape.
• The ten campuses of the University of California, once among the finest public systems of higher education in the world, raised tuition to $ 12,000 a year by 2015. When I was a student in 1949 it was $ 70, which is like $ 700 today, adjusting for inflation. A good education was available to any qualified student. The university’s graduates went on to lead the technological revolution, but by 2014 the state contributed only about 10 per cent of the total cost of all campus operations. If the UC system doubled tuition and fees it could drop state support altogether and go private! Since out- of- state and foreign students are charged three times the tuition paid by California residents, individual deans and administrators are raising more money by replacing the latter by the former. Meanwhile gifted foreign students, many of them Chinese, receive advanced degrees in the United States and return home, rather than struggle for postdoctoral funding and permission to become residents. Talented American- born scientists and engineers are joining them in a reverse brain drain. Economists have found that one factor has explained a nation’s future economic growth and prosperity more than any other: its output of scientists and engineers. To starve education is to eat our seed corn. No tax today, no technology tomorrow.

Epilogue

• Life is like reading a novel or running a marathon. It’s not so much about reaching a goal but rather about the journey itself and the experiences along the way. As Benjamin Franklin famously said, “Time is the stuff life is made of,” and how you spend it makes all the difference.