Fortune's Formula: The Untold Story Of The Scientific Betting System That Beat The Casinos And Wall Street
by William Poundstone
Dec 2005
Top notch theory, storytelling just okay
The story lines in Fortune's Formula are strong, but the telling is somewhat disjointed. The book offers a rich tableau of venues -- Bell Labs, MIT, Nevada, Beverly Hills, Hong Kong -- but much of the material has a lightly dusted, surface-level feel, leaving this reader vaguely dissatisfied. Fortune's Formula is not a hodgepodge of anecdotes, but nor is the connecting thread especially taut. (For an example of tight storytelling woven expertly into the subject matter, check out `Complexity' by Mitchell Waldrop, `The Predictors' by Thomas Bass, or 'Moneyball' by Michael Lewis.)
Shannon and Thorp were reticent men, and Kelly died all too young -- getting inside their heads is understandably a tall order. Perhaps this is why colorful side characters take so much of the spotlight. There is something of a gangster fixation going on; the book leads off with the story of the underground wire service, a gambler's boon steeped in organized crime. (This cycles back to Bell Labs, you see, because AT&T was involved with the wires and did a nice bookie business sotto voce.)
The mob angle also touches blackjack pioneer Ed Thorp. Seeking financial help to test his theories in the real world, Thorp wound up in Reno with two mafia backers at his side. His source of funds was a complete accident, of course; Thorp clarifies he would not have taken `mustache money' had he known its origins. While true that Shannon's Information Theory was based on data transmission (i.e. wires), that the Kelly formula was originally inspired by gambling insights, and that Thorp had an amusing run-in with Soprano types, the wise guy focus seemed tangential. Why so much emphasis and material on Longy Zwillman, Manny Kimmel and their ilk? I suspect the heavy hand of marketing; organized crime skews interesting for Joe Reader in a way that mathematical formulas do not.
With their own separate methods, Thorp and Shannon trounced the market averages over a period of decades. The retelling of how they did so exposes another kink in the book's implicit premise: the actual formula in Fortune's Formula is not a money-making recipe, but rather a fatality-avoidance recipe. The Kelly criterion was not truly central to Thorp's or Shannon's financial success; it merely facilitated that success via proper understanding of bet size.
Think of it this way: In order to succeed as a trader or investor, you must practice effective money management. But effective money management guarantees nothing on its own. It is a necessary, but not sufficient, condition... ensuring survival is not the same as ensuring profits.
Ed Thorp made a pile of money exploiting early market inefficiencies. He also had a knack for finding new inefficiencies when the old ones went away. In other words, Princeton-Newport Partners (Thorp's flagship fund) was a pioneer in statistical arbitrage. Shannon's method was even further removed from the Kelly criterion; his market-beating 28% returns came from a buy and hold portfolio more than 90% weighted towards just three stocks! He was an astute observer of technology and consumer trends, smart enough (and wise enough) to stake and hold long term positions in huge winners like Teledyne and Hewlett Packard.
As Poundstone recounts, Claude and Betty Shannon were the type of investors who ate a bucket of Kentucky Fried Chicken before buying stock in it. Shannnon's returns are more an inspiration to concentrated value investors than arcane formula followers. His risk management techniques were apparently limited to taking reasonable losses when an idea didn't work out.
In practice, the Shannon investing method can be boiled down to three truisms: "invest for the long term," "know your area of expertise," and "diversification is a hedge against ignorance." (Plus, buy Teledyne for 88 cents and Hewlett Packard for less than 2 cents, then hold to $300 and $45 respectively.)
For all the criticism in this review, the straightforward explanation of theory is where Fortune's Formula shines. Poundstone does a superb job in distilling the essence of Information Theory and the Kelly criterion. He communicates the gist of both in a way that the non-mathematically inclined can grasp, and successfully highlights the subtle points of controversy and real-world application that make both theories so interesting.
In regards to thinking about risk, better understanding risk, and applying risk-related concepts to trading / investing / money management, light bulbs will click on for experienced practitioners and novices alike. (Less pragmatic readers may find these explanations dry, but enlightening nonetheless.)
Last but not least, the academic crowd, aka "the Random Walk Cosa Nostra," takes the worst of it in Fortune's Formula... and very much deservedly so. Poundstone does not have to intentionally skewer these economic leading lights, for their own words expose them as arrogant, egotistical jerks.
For example: Paul Samuelson, the MIT godfather of neo-classical economics, chose to trash the Kelly criterion based on a minor league point of disagreement. He ferociously argued it to be a `fallacy,' though the actual objection voiced was little more than a straw man. This distinguished economic statesman apparently enjoyed belittling his opponents and treating them like simpletons; Samuelson's masterstroke was a flaming critique written entirely in one-syllable words.
Examples starring Eugene Fama, Myron 'fools like you' Scholes and others are even more pompous, if possible. It is eye opening to get a collective picture of these Nobel laureates in action -- burning heretics at the stake on dubiously nitpicky grounds, crushing dissent by means fair or foul, and blind to their own myopic hubris all the while. These are supposed to be our wise men? The mind boggles.
