Author’s Note About “Beating the System” In the beginning of this book, we discussed economics. Now, here at the end, we will return to it. We have come full circle. It is remarkable that the ideas of physics play such a big role in economics. When Einstein was studying the diffusion of tiny particles in liquids he was able to explain their erratic motion – the Brownian motion – by a model in which these particles were subject to the incessant and erratic bombardment by the molecules of the liquid. This produces the random walk of these particles. The first essay dealt with the application of these ideas to the evolution of the prices of stocks. But Einstein also recognized that there would be fluctuations. Every once in a while the drunkard, who lurches with equal proba- bility in all directions, will make several lurches in the same direction. This can also happen with the stock market, and this essay deals with beating the system by using these fluctuations. Broadly speaking there are two theories as to how the stock market works, each one vehemently supported by its own cadre of pundits. On the one hand there is what is known as the “efficient market hypothesis.” This comes in various forms, but basically it proposes that, relative to the information generally available, all stocks at any given time are fairly priced. You can’t beat the system. You might as well pick stocks by throwing darts or by investing in an index fund. The future of the market is determined by a random walk. On the other hand, there is an equally distinguished group of pundits who argue that you can beat the system, basically because you can take advantage of fluctuations. These people also believe in an efficient market in the sense that they assume that these fluctuations relax-dissipate- back into the norm. In the first essay we saw how Bachelier viewed the market in terms of Brownian motion. In Brownian motion there are also fluctuations whose dissipation can be described mathematically. Here is an example taken from a lecture given by Edward O. Thorp, whom we shall meet in the essay to which this is the prologue. Suffice it to say that Thorp is one of the most successful money managers who has ever practiced that craft. In his lecture Thorp notes that, in the year 2000, the company 3Com decided to spin off its Palm Pilot division. This news was widely reported in places such as The New York Times. On March 2, 2000, 6 percent of Palm Pilot was offered to the public as an Initial Public Offering. Moreover, the value of these shares was $53.4 billion while the value of the rest of 3Com, which included the 94 percent of the 159 160 Author’s Note About “Beating the System” shares of Palm Pilot that were not in the initial offering, was only $28 billion. Within six months the company intended to distribute these remaining Palm shares to its 3Com stock holders. To someone like Thorp the implications of this were evident. You could borrow money to buy as many of the Palm Pilot shares as you could get your hands on. You could then sell them at once at the higher price. You would then wait until the rest of the Palm shares become available at a lower price and buy enough to cover your loan and pocket the difference. Of course, if the Palm shares went up in the interval, your investment would be toast, since you were obligated to return the borrowed shares in a predetermined time period in any event. Here you relied on the efficient market to dampen the fluctuation. It is interesting that both Bachelier and Thorp, although not Einstein, got their inspirations from the theory of gambling. In Thorp’s case it was blackjack. If you read on you will see why there is a theory of blackjack and how it might suggest these wider applications. Beating the System “Markets can remain irrational longer than you can remain solvent.” – John Maynard Keynes Up until August of 1957, I do not remember ever having played a card game for money. This had nothing to do with morals. I had been an undergraduate mathemat- ics major at Harvard, going as far as getting a Master’s degree before switching over to theoretical physics. During this whole time I had been doing mathematics day and night and, playing a card game like bridge, or even poker, where some mathematical skills were involved, was the last thing I wanted to do. Better to go to a movie. In the spring of 1957, when I was completing a two-year post doctoral at Harvard, I was approached by a recruiter from Los Alamos to go there as a sum- mer intern. Many members of the Harvard physics department had been to Los Alamos during the war, and one of them must have recommended me. The weapons laboratories such as Los Alamos and Livermore, in light of the then raging Cold War, were expanding and actively looking for qualified people. I had no particular interest in working on nuclear weapons, but I did have a great curiosity about Los Alamos, which was heightened by the fact that I was about to go to the Institute for Advanced Study in Princeton, of which Robert Oppenheimer, whom I had met, was the director. So I accepted the Los Alamos offer, which was conditional on my being able to get a so-called ‘Q-clearance’ – a very rigorous clearance needed by anyone working in the technical divisions of the laboratory. Soon after I got to the laboratory it became clear to me that I was going to have no assignment and would have nothing whatever to do with the weapons that were being designed there. It was also made clear that while I had a Q-clearance, infor- mation was only shared on a “need to know” basis. Since I did not need to know anything, I was not told anything. I had a colleague, also a post doctoral from Harvard, in the same situation. We shared an office, and I proposed that we work Author’s Note About “Beating the System” 161 on a problem in elementary particle physics that I had thought of but lacked the mathematical skills to do myself. During most of that summer we happily worked on our problem while, no doubt, bomb designing was going on all around us. We wrote up our paper, and the head of the Theoretical Division, Carson Mark, encour- aged us to publish it and identify the work as having been done at Los Alamos. He wanted the image of the laboratory to be something other than a bomb factory. During the summer I made friends with a more senior physicist named Francis Low. He had just been made a professor at MIT and was spending the summer in Los Alamos with his family. Francis also was not working on weapons, so I was surprised when, in the middle of August, he announced that he was going to Mercury, Nevada, to see some tests. In fact, my first thought was, “I want to go, too.” Francis suggested that I ask Carson, which I did. He was agreeable if I paid my way on commercial airlines and the like, which I was more than willing to do. It turned out that in 1956, four men, Roger Baldwin, Wilbert Cantey, Herbert Maisel, and James McDermott, had published a paper in the Journal of the American Statistical Association,1 called “The Optimum Strategy in Blackjack, “which was followed in the fall of 1957 by their 92-page monograph Playing Blackjack to Win: A New Strategy for the Game of 21.2 I will come back shortly to how they happened to write such a paper and book and, indeed, why there is such a strategy, after I describe the impact of this paper at Los Alamos. Mercury, Nevada, where the tests took place, is about 65 miles northwest of Las Vegas. As far as I could later determine, everyone connected with these tests, from the scientists to the soldiers on maneuvers, went to Las Vegas to play blackjack. Until 1956, there were probably as many strategies – essentially all losing – as there were players. But Baldwin et al. had found the Rosetta stone. It turned out that they had done their calculations on primitive electro-mechanical hand calculators. But Los Alamos had what was probably at that time the most powerful electronic com- puter in the world – the so-called MANIAC – used primarily to design weapons. It was elementary to program this computer to run blackjack hands by the tens of thousands to verify that the scheme actually worked. (It was also programmed to play a primitive game of chess without bishops and succeeded in beating a novice.) I have read some accounts of this blackjack history with nary a mention of Los Alamos. I suspect that this activity at the laboratory was not widely known. The net result of this was that a little pocket folder was produced from which one could readily read off the basic strategy. I use the term “basic strategy” delib- erately. It became the basis of the more advanced strategies that included it. Francis had taken the trouble to read the original article and noticed that if you followed the basic strategy you broke about even with the casino. One may recall A. J. Liebling’s gambler’s prayer: “Dear Lord, help me to break even, because I sure need the money.” In fact, the original authors said that the casino would come out marginally ahead, while later calculations using electronic computers showed that the player 1 Vol.