At Symmetry we have a library of investment books, once in a while I take out a book and read it. Last time it was the 2017 autobiography of Edward O. Thorp, A Man for All Markets. In this book Thorp reflects on his childhood in the 1930s, his lifelong passion for learning, and how he developed a system to gain an edge in blackjack. Later he would go on to apply these analytical skills to the financial world, founding a hedge fund, which was one of the first to specialize in hedging convertible securities, such as warrants, options, convertible bonds, and preferred stocks, using mathematical models and computers extensively. His investment career spans over half a century, so while the book is autobiographical in nature it also offers insights into market history.

Thorp, demonstrating high intelligence from a young age, applied his intellect across various domains. Parallel to his academic role as a mathematics professor, he published Beat the Dealer in 1962. This book presented the system he had developed and tested with real money in Las Vegas for winning at blackjack. The system's basic tenets involve tracking the remaining cards and adjusting bets according to the odds—betting more when the odds are significantly in your favor and less when they aren't. Beat the Dealer was a success, but Thorp would soon venture into a much larger market, where odds were more non-deterministic and much more capital were at stake.

In 1969, he co-founded Convertible Hedge Associates which in 1974 was renamed Princeton Newport Partners (PNP), a pioneer in hedging convertible securities using mathematical models and computers. The fund's primary strategy was to identify pairs of closely related securities with inconsistent pricing. For example, warrants and options might be mispriced if they don't align with their theoretical value as per models like Black-Scholes, based on price and time to expiry. Convertible bonds could be mispriced if their market price doesn't accurately reflect the combined value of the bond and conversion option. Preferred stocks, or hybrids, might be mispriced if their market price doesn’t reflect their value as preferred stock plus the conversion rate's value. If an opportunity arose, such as an overpriced convertible, the fund would short the convertible and buy the stock; if underpriced, it would do the opposite. Unlike blackjack, where you must bet before cards are dealt, the stock market allows waiting for the right opportunity, so this would give the fund the opportunity to only bet when the odds where in its favor. PNP returned + 20% annualized return after fees across two decades.

This method, targeting mispriced derivatives, suited Thorp's mathematical investment approach. Derivative prices can be understood as outputs of a function based on their properties, with the underlying security's price as input. Accurate modeling allows for a well-defined target price for the derivative relative to the underlying security. However, capitalizing on perceived pricing inaccuracies assumes the market will eventually adjust. Most strategies targeting market inefficiencies rely on this expectation for correction. But as financial analyst Gary Shilling noted in 1983, "The stock market can remain irrational a lot longer than you can remain solvent". Hence, hedging must be paired with strict risk control. It’s vital not to overcommit to slightly favorable investments and to allocate more capital to investments with odds significantly skewed in your favor. The challenge lies in accurately determining these odds. In blackjack, odds are derived from a set scheme and card tracking, as the rules and available cards are well-defined. In contrast, financial markets are more complex and open-ended.

Thorp's strategies at PNP were an evolution of his blackjack techniques. His experience taught him that understanding the odds necessitated dedication and a clear strategy. Similarly, in investing, despite the complexity and the constant emergence of new asset classes and millions of actively trading market participants, the key to success remains the same: Know the odds and bet accordingly.