Podcast Summary
Claude Shannon's Connection to Investing: Claude Shannon, a pioneer in information theory, applied his academic knowledge to investing, using unconventional strategies inspired by gambling, achieving exceptional results.
Claude Shannon, a pioneering scientist in information theory, applied his academic knowledge to investing and achieved exceptional results. Shannon, who is considered a "sure thing" due to his invention of information theory, which is the foundation of our digital economy, saw the connection between gambling and investing. Fortune's Formula, a book that explores this idea, highlights Shannon's and Edward Thorpe's unconventional approaches to achieving above-average returns. Shannon's early life and personality, marked by a strong inclination towards inventing and a family history of innovation, set the stage for his groundbreaking scientific achievements and his successful investment strategies. Shannon's work, which includes the creation of information theory, has had profound impacts on our world, making him a figure of significant influence and intrigue.
Shannon's deep thinking and focus led to groundbreaking discoveries in computing and information theory: Deep thinking and focus, even in solitude, can lead to significant discoveries and innovations in today's fast-paced world.
Shannon's unique ability to think deeply and focus on complex problems, often in solitude, led him to groundbreaking discoveries in information theory and computing. This quality, which was also evident in Thomas Watson, the founder of IBM, highlights the importance of dedicating time for uninterrupted thought and self-reflection in today's fast-paced world. Shannon's personal passions ranged from chess to genealogy, and he applied this same focus to his work. His realization that the MIT differential analyzer was essentially two machines in one, and his vision of an ideal computer using electrical circuits instead of mechanical linkages, laid the foundation for modern computing and his own success in information theory and investing. Shannon's work in Boolean algebra, which deals with simple notions like true or false, and his success in encoding these logical ideas into electrical circuits, proved that an electrical digital computer could compute anything. This breakthrough set the stage for the development of modern computers and Shannon's own achievements.
Shannon's diverse experiences shaped his future work in information theory: Collecting diverse experiences and learnings can open up unforeseen opportunities, as illustrated by Shannon's work on Project X and the development of information theory
Shannon's experiences and learnings from various stages of his life came together in unique ways to shape his future. This is illustrated by his work on Project X at Bell Labs during a personal crisis. Project X was a joint effort with Britain's Government Code and Cypher School to build a secure communication system called SIGSALY. Shannon's role was to prove the system's security, which led him to insights in information theory. He saw a secrecy system as identical to a noisy communication system, and this intersection of ideas led to the development of the bit as a unit of information. Despite criticisms of abandoning the field he created, Shannon's varied interests and changing direction were reflections of his personality. This story highlights the importance of collecting diverse experiences and learnings, as they can open up unforeseen opportunities. Shannon's work on Project X also underscores the impact of his past experiences on his future achievements, particularly in the development of information theory.
The importance of curiosity and a growth mindset in learning: Curiosity and a growth mindset lead to valuable discoveries and insights, illustrated by the speaker's experience with podcasts and the story of Ed Thorpe.
Being interested and passionate about learning new things, no matter the subject or the time, can lead to valuable discoveries and insights. The speaker shares his experience of using podcasts as a way to learn about artificial intelligence and was surprised to find that the interest in this field dates back to the 1950s. He also introduces Ed Thorpe, a precise and intelligent individual who, growing up, turned his wits to making money and was fascinated with increasing his skills per hour. These anecdotes illustrate the importance of curiosity and a growth mindset in learning and personal development. Additionally, the speaker emphasizes the value of studying the past to understand the present and the importance of original thinking rather than mimicking others.
A physics graduate student's quest to apply math to gambling: Edward O. Thorpe, inspired by the idea of using science to predict roulette outcomes, developed one of the first portable computers to calculate blackjack probabilities, overcoming academic challenges with the help of mathematician Claude Shannon.
Edward O. Thorpe, a physics graduate student, saw an opportunity to apply math and physics to beat seemingly impossible odds, specifically in gambling. At a party, he became intrigued by the idea of using science to predict roulette outcomes. Despite the common belief that gambling systems were worthless, Thorpe believed he could make money regardless of the wheel's perfection. He began studying roulette but discovered a paper on blackjack odds instead, which led him to build one of the first portable computers to calculate probabilities. However, he faced challenges in publishing his research due to academic submission requirements. Eventually, he met Claude Shannon, a renowned mathematician, who showed interest in both his blackjack and roulette ideas. Together, they worked on perfecting Thorpe's gambling systems, demonstrating the power of applying scientific principles to seemingly insurmountable challenges.
Shannon and Thorpe's Unsuccessful Roulette Prediction Machine: Claude Shannon and Edward Thorpe attempted to create a roulette prediction machine but faced challenges and ultimately failed due to technical difficulties. Thorpe later developed a successful blackjack strategy called 'card counting'.
The collaboration between Claude Shannon and Edward Thorpe resulted in the creation of a roulette prediction machine in the late 1950s and early 1960s. Despite the legality of their actions, they faced challenges and ultimately, the project was unsuccessful due to technical difficulties. Thorpe then shifted his focus to developing a successful blackjack strategy, which he famously named "card counting" and later published in his best-selling book "Beat the Dealer." The story highlights the innovative minds of these individuals and the complexities of attempting to beat casino games. However, it also underscores the risks involved and the potential consequences, including the eventual passing of laws against such activities in the 1980s.
From Mathematician to Successful Investor: Ed Thorpe's Journey: Mathematician Ed Thorpe applied his skills to investing, using the Kelly criterion to calculate risks and reap substantial rewards. Despite skepticism from academics, the success of investors like Buffett and Munger demonstrated the importance of calculated risks.
Ed Thorpe, a mathematician with no initial wealth, became one of the most successful investors of all time by applying unusual skills and understanding the importance of taking calculated risks, as exemplified by the Kelly criterion. Thorpe's paper on card counting in blackjack, presented by Shannon, gained widespread attention and led to him testing his theory in casinos with the help of investors. The Kelly criterion, a mathematical equation created by John Kelly, emphasizes the significance of even unlikely events occurring eventually and the sensitivity of ultimate compound return rates to rare events. This philosophy resonated with successful investors like Buffett, Munger, and Thorpe himself, who understood the risks involved and reaped substantial rewards. Conversely, academics, such as Paul Samuelson, held the belief that markets are perfectly efficient and no one could make excess returns. However, the failure of Long-Term Capital Management, a hedge fund started by academics who did not grasp the Kelly criterion, highlights the importance of understanding the risks and rewards of taking calculated chances.
Understanding Risks and Company Keep: Successful entrepreneurs minimize risks to ensure business survival. Be aware of the company you keep and stay focused on your goals despite unexpected challenges or unsavory characters.
Successful entrepreneurs understand the importance of minimizing risks to ensure business survival. This concept was applied by Ed Thorp and Claude Shannon decades before the stock market, even in their experiments with casino games. Thorp's encounter with Manny Kimmel, a mafia figure, highlights the importance of being aware of the company you keep. Kimmel, a skilled gambler, was intrigued by Thorpe's system and challenged him to prove it through games of chance. Despite Kimmel's lack of understanding of the mathematical concepts, Thorpe's consistent wins convinced him. This story underscores the significance of surviving the initial challenges and staying focused on your goals, even when faced with unexpected obstacles or unsavory characters.
Consequences of Power and Wealth: Amassing wealth and power comes with risks, including being challenged or crossing the wrong people, breaking rules, and unpredictable outcomes. The text illustrates these risks through the experiences of Willman and Manny.
Certain individuals, like the character Willman in the text, who have amassed significant wealth and power, can face dangerous consequences when they are challenged or crossed. This is evident when Willman, a wealthy businessman involved in illegal activities, is murdered after a dispute. The eventual outcome of Willman's death leads to Manny Kimmel benefiting from the portfolio of businesses they owned together, which eventually morphs into Warner Communications. Another important lesson from the text is the risks and consequences of breaking rules or attempting to outsmart systems, such as casinos. Thorpe and Manny's attempts to beat the casinos at blackjack using a card counting system resulted in their identification and eventual expulsion, limiting their potential earnings. Additionally, the text highlights the unpredictability of life and business, as the initial ventures of Willman and Manny evolved into something much larger and more successful than they could have imagined. Overall, the text serves as a reminder of the potential risks and rewards of power, wealth, and rule-breaking.
The Kelly System: Maximizing Profit and Protecting Against Ruin: The Kelly System, a mathematical theory for managing capital, offers maximum profit and protection against ruin by scaling wagers based on current bankroll size, ensuring exponential wealth growth and preventing bankruptcy.
The Kelly system, a mathematical theory for managing capital, offers maximum profit and protection against ruin when given a favorable betting opportunity. This system, developed by Bell Labs research scientist John Kelly, is important because it promises wealth growth and shields against bankruptcy. It's crucial for investors and entrepreneurs who believe they have an edge in their respective fields. The Kelly system's effectiveness is rooted in proportional betting, which scales wagers based on the current bankroll size. This feature ensures that one can never run out of money, even during losing streaks. The exponential growth of wealth in the Kelly system is a result of the same proportional betting principle. It's essential to note that having an edge is crucial, as Buffett, Munger, Thorpe, and Shannon all agree. However, Thorpe, a mathematician who used the Kelly system to build wealth, faced challenges when the gambling industry caught wind of his strategies. This led to threats and even physical attacks, illustrating the importance of understanding that humans may not always play by the rules.
Challenging the Efficient Market Theory: MIT professor Shannon, inspired by gambling, questioned the efficient market theory in stocks, contradicting Buffett and Munger's public support. They believed in potential for above-average returns, rejecting the theory as a myth.
Shannon and Thorpe, inspired by their experiences in gambling, challenged the efficient market theory in the stock market. Buffett and Munger, who also questioned this theory, contradicted their public statements supporting it with their personal investments in Berkshire Hathaway. Shannon, an MIT professor, studied the market with intellectual curiosity and a desire for gain, filling library shelves with books on economics and investing. He believed in the potential for above-average returns, as evidenced by success stories like the Lone Wolf and Hetty Green. Shannon's notes reveal his consideration of various market strategies and his rejection of the efficient market theory, which he saw as a myth. This belief was shared by Buffett and Munger, as demonstrated by their actions despite their public statements.
Learning from Past Experiences and Finding the Right Partners: Successful investing requires learning from past experiences, having unique insights, and finding the right partners to maximize opportunities.
Successful investing often involves learning from past experiences, having unique insights, and finding the right partners. Shannon, inspired by his experience with Harrison Labs, became a believer in the power of stocks. He later invested in Teledyne, which skyrocketed, allowing Singleton to use the inflated market value to buy other companies. Ed Thorpe, on the other hand, learned a valuable lesson about the importance of having an edge in the market after losing money on silver. He then focused on options and warrants, eventually developing the Delta Hedging System. After finding success, Thorpe looked for partners to manage outside capital. He initially considered Sheen Kasoff but ultimately chose a different partner, Mark Reagan, to start the Princeton Newport hedge fund. Both Shannon and Thorpe's stories demonstrate the importance of learning from past experiences, having unique insights, and finding the right partners in achieving success in the stock market.
Bicoastal hedge fund partnership of Thorp and Reagan: Mathematician Thorp and salesman Reagan's unusual partnership defied market efficiency beliefs, using computers to analyze data and outperforming 99.5% of mutual funds from 1969-1982
Ed Thorp, a mathematical genius and hedge fund pioneer, and his partner, Jim Reagan, had complementary skills and personalities that led to the formation of a successful bicoastal hedge fund partnership in the 1960s. Thorp, an introverted mathematician, focused on developing mathematical models to exploit market inefficiencies, while Reagan, an extroverted salesman, handled the business side of things. This unusual partnership defied the conventional wisdom of the time that the market was efficient and that human judgment was necessary for investment success. Thorp's unconventional approach, which involved using computers to analyze market data, was initially met with skepticism and criticism. However, his Princeton-Newport Partners hedge fund outperformed 99.5% of mutual funds in the 13 years leading up to 1982, demonstrating the power of a scientific approach to investing. Despite the success, Thorp remained cautious and measured, always testing his theories in the real world and expecting the unexpected.
Ed Thorpe's Long Journey to Becoming a Successful Investor: Mathematician turned hedge fund manager, Ed Thorpe, displayed patience and caution, outperforming during market crashes but faced setbacks due to untrustworthy partners.
Ed Thorpe, a mathematics professor turned hedge fund manager, displayed remarkable patience and foresight, taking nearly 15 years to leave his teaching job and become a full-time investor. Despite his wealth, he maintained a low profile and even built a bomb shelter in his home, reflecting his cautious mindset. Thorpe's Princeton Newport Partners hedge fund outperformed during market crashes, including the Black Monday crash of 1987, due to its market-neutral strategy. However, the fund faced a significant setback in 1987 when federal agents raided the office, leading to the departure of some partners and a loss of trust. This episode highlights the importance of choosing trustworthy business partners and the resilience required in the financial industry.
Edward Thorpe's Tax Avoidance Scheme and Its Impact on His Career: Edward Thorpe, a successful hedge fund manager, faced career setbacks due to his association with a tax avoidance scheme, but continued to excel in finance by starting his own firm
Edward Thorpe, a successful hedge fund manager, was involved in a tax avoidance scheme known as stock parking during the late 1980s. This scheme, which was being carried out in the East Coast office of his firm, Princeton Newport Partners, ultimately led to the dissolution of the partnership and the return of investors' money. Despite not actively participating in the scheme, Thorpe was still negatively impacted by the situation due to the interruption of compounding caused by the RICO charges. Thorpe, who had a remarkable 15.1% compound return rate after fees over 19 years, continued his career in finance by starting Edward Thorpe and Associates, where he managed his own money and achieved impressive returns. Despite being 87 years old, Thorpe remains mentally sharp and continues to inspire with his success in the industry.
The Perils of Overconfidence and Ignoring Risk Management: Overconfidence and underestimating risks can lead to massive losses, as seen in the case of Long-Term Capital Management, which used excessive leverage and bet against the market, resulting in a catastrophic loss for their investors.
Overconfidence and disregard for risk management can lead to catastrophic losses, as seen in the case of Long-Term Capital Management (LTCM). Despite promising better-than-market returns through scientific methods and software, LTCM's founders, Robert Merton and Myron Scholes, believed in the efficient market hypothesis and aimed to pick up small inefficiencies with massive leverage. However, they underestimated the risks involved, and when the market turned against them, they bet more instead of less, leading to a blow-up of their fund. This is the opposite of the Kelly criterion, a proportional betting system that advises adjusting bets based on bankroll size. LTCM used an astronomical amount of leverage, borrowing $29 for every dollar invested, leading to gambler's ruin and the loss of everything for their investors. The lesson here is to never put yourself in a position where you cannot survive, and to always be aware of the risks involved in any investment or endeavor. As Warren Buffett wisely said, "It's only when the tide goes out that you learn who's been swimming naked."
Mistaking Leverage for Genius: Overconfidence in one's abilities and excessive leverage can lead to significant losses. Be cautious and aware of potential risks.
Leverage, or overconfidence in one's abilities, can lead to significant losses, as demonstrated in the case of Long-Term Capital Management (LTCM) during the late 1990s financial crisis. This mistake of mistaking leverage for genius, as Steve Eisman put it, is a recurring theme throughout history and human nature. Individuals, even those with substantial fortunes, have fallen prey to this error, leading to devastating consequences. As early as 1738, Daniel Bernoulli warned against taking excessive risks, stating that a man who risks his entire fortune acts like a simpleton. Despite advancements in financial models and econometric analysis, these models can still be wrong, and extreme downside risks, or "fat tails," can and do occur. It is crucial to exercise caution and be aware of the potential for such events. The success of Claude Shannon in applying his ideas to the stock market, achieving returns that outperformed most professional money managers with much larger resources, serves as a reminder of the importance of sticking to a sound strategy and maintaining a disciplined approach.
Claude Shannon's Defiance of Market Theory and Success as an Investor: Mathematician Claude Shannon bucked market trends by focusing on earnings growth and company management, achieving a 20% annual return over 28 years.
Claude Shannon, a renowned mathematician, defied the Efficient Market Theory and became a successful investor by understanding his edge and focusing on it. He was a buy-and-hold fundamental investor who rejected price momentum and volatility, instead focusing on earnings growth and company management. Shannon's portfolio, which was heavily concentrated in Teledyne, would have shocked Harry Markowitz, the creator of Modern Portfolio Theory. Shannon's success can be attributed to his deep understanding and access to information, which gave him an edge. Entrepreneurs can learn from Shannon's approach by treating their business as their family's only asset for the next 50 years and focusing on areas where they have an edge. Shannon's investment record, which grew at an average of 20% annual return over 28 years, is a testament to his successful investment strategy.
Making a large number of informed decisions with high probability of success: Prominent tech investor Chris Sacca made $80 trillion worth of purchases and sales, equivalent to 1.25 million bets, and consistently achieves high-probability excess performance through long-term commitment and informed decision making.
Successful investing, as demonstrated by the example of Chris Sacca, involves making a large number of informed decisions with a high probability of success. Chris Sacca, a prominent tech investor, has made approximately $80 trillion worth of purchases and sales for his investors, which equates to around 1.25 million individual bets averaging $65,000 each. With hundreds of positions in play at any given time, this level of activity suggests a long-term commitment to investing and a high probability that the excess performance is not due to chance. The ultimate goal for individuals, as Chris suggests, is to strive for a similar level of high-probability excess performance in their own lives. If you're interested in learning more about Chris Sacca's story, you can purchase the book "Good Faith" through the Founders Podcast Amazon affiliate link or visit the website for more information. And, if you're looking for more book recommendations from Chris, you can check out the books he posts on his Amazon store, found at founderspodcast.com. Thank you for tuning in, and we'll be back next week to discuss more about the world of Chris Sacca and technology investing.