4/1/13 – Gambling and Investing: A Review of Fortune’s Formula by William Poundstone

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 1, 2013 10:36:26 AM

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At the end of the quarter, we all look at our statements and evaluate how we’re doing. Depending on the results, we either congratulate ourselves or start to ask what went wrong—and what we can do about it. The implicit assumption here is that we are in control of our investments.

To a great extent that’s true, of course, but the markets are beyond anyone’s control. Trying to manage that uncertainty has been the great quest of modern finance. The management of uncertainty is also characteristic of another financial endeavor: gambling.

The math behind the two is essentially the same, and math is at the center of Fortune’s Formula. But this isn’t a math book per se—it’s a book about how people use math to invest, gamble, or both.

Unusual for an investing book, Fortune’s Formula spans a wide breadth of topics—information theory, blackjack, hedge funds, the collapse of Long-Term Capital Management—weaving them all into a comprehensive framework. By bringing the people who created and applied these tools to life, it provides a glimpse behind the scenes, offering insight into how and why certain headlines happened.

It also provides—and this is the reason I’m reviewing it—a conceptual framework for looking at risk that is somewhat different from the norm, as expressed in this quote from page 297: “[E]ven unlikely events must come to pass eventually. Therefore, anyone who accepts a small risk of losing everything will lose everything, sooner or later. The ultimate compound return rate is acutely sensitive to fat tails.” The book was published in 2006, and that quote seems prescient in light of the events of 2008–2009.

Risk management has always been front and center for gamblers—less so for investors—and many of the mathematical tools discussed have gambling roots. The notion of gambler’s ruin is never far from the thoughts of, for example, Ed Thorp, the math professor, professional gambler, and founder of one of the most successful hedge funds ever, who occupies a central place in the book. If the notion of overbetting had been more on the minds of the managers of Long-Term Capital Management, perhaps it would not have collapsed.

By developing, in a nonmathematical way, ideas such as the Kelly criterion (which defines the divide between aggressive investing and insane investing), the different varieties of risk analyzed in financial theory, and a different perspective on some of the foundations of modern portfolio theory, such as diversification, this book provides an accessible—and entertaining—expansion of context for most investors.

Make no mistake: this is not a textbook, and you won’t find detailed methodologies here. Instead, Fortune’s Formula seeks to popularize some important ideas that aren’t generally understood. By broadening the reader’s understanding and posing some interesting questions, Poundstone forces us to consider whether we fully comprehend some of the assumptions we use daily.

Fortune’s Formula was published in 2006, and I originally read it several years ago. Post-2008, its message is even more appropriate and worthwhile, which is why I decided to reread it. If you’re looking for an entertaining story that’s accessible but will make you think, I recommend this book.

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