Book Report: Fortune’s Formula

Reading Time: 3 minutes

“The sad fact is, almost everyone who gambles, goes broke in the long run.” – Fortune’s Formula, pp. 49

This is meant to be more of a book report, than a review.  In particular, I want to highlight three lessons from the book, Fortune’s Formula by William Poundstone, that I found impactful.  This also serves as a way for me to recall influential points in the book.

I enjoyed the book, which was an introduction into a few folks I did not know much about – Claude Shannon, Edward Thorp, and John Kelly, Jr.  And it covered topics that I always find entertaining – investing, making money, math, and even had a section titled “Entropy.”

However, three topics that did alter my perspective were:

  1. Correlations

“LTCM goofed by greatly underestimating the chance of a panic in which its trades would become highly correlated.  The fund was making hundreds of simultaneous bets.  It operated on the assumption that these bets had low correlation.” – pp 294

It has been awhile since I have spent time on Long Term Capital Management (LTCM), although When Genius Failed by Roger Lowenstien is still sitting on my bookshelf after many moves.

The above quote caught my attention.  

As I have written previously, the increasing correlations between asset classes in today’s market seem like something folks should be taking into consideration.  The same rising tide has caused all boats to float.

  1. Survival 

“The Kelly bettor cannot be ruined in a single toss.” – pp. 297

“It is that even unlikely events must come to pass eventually.  Therefore, anyone who accepts small risks of losing everything will lose everything sooner or later.” – pp .297

“This illustrates the ‘paranoid’ conservatism of Kelly betting.  The chance of hundreds of coins simultaneously coming up tails is is of course astronomically small.  No matter – the ideal Kelly gambler’s ‘survival motive’ precludes taking any chance of ruin whatsoever.” – pp. 295

The theme of always ensuring you live to fight another day in the Kelly system reminded me of a main theme in Antifragile by Nassim Nicholas Taleb.  To paraphrase, if the action undertaken has the risk of ruin or death, then the overall probabilities can be a little pointless.  In other words, once you are ruined or dead, the probabilities of future gains are irrelevant.

“This fragility that comes from path dependence is often ignored by businessmen who, trained in static thinking, tend to believe that generating profits is their principal mission, with survival and risk control something to perhaps consider – they miss the strong logical precedence of survival over success.” – Antifragile, pp. 160.

  1. Overbetting

“For true long-term investors, the Kelly criterion is the boundary between aggressive and insane risk-taking.  Like most boundaries, it is an invisible line.” – pp. 298

Investment sizing or “bite size”, as well as appropriate levels of diversification, is something I have been spending time on.  The entire Kelly system is designed around the appropriate way to size bets based on the ratio of the edge – how much you expect to win – compared to the odds – the public odds.

“A fractional Kelly bet doesn’t sacrifice much return.  In case of error it is less likely to push the bettor into insane territory.” – pp. 233

But given where the market seems to be and the increasing correlations, I have been keeping bite size small.

“Risk management is a tough lesson to learn on the job.  It can take years for ruinous overbetting to blow up in a trader’s face.” – pp. 303

This would be called “resulting” in the terminology of Thinking In Bets by Annie Duke.  Giving too much credit for the outcome, regardless of the process.