The best investors have a similar trait to the best gamblers: they bet when the odds are overwhelmingly in their favour.

Former ‘bond king’ Bill Gross, of Pimco fame, discovered this at an early age.

His path to finance began by chance. He was in his final year of college when he had a bad car accident which sliced open his scalp. While bedridden, he read a book called Beat the Dealer by Edward Thorp, who was then a maths professor.

Written in 1962, the book detailed how you could win at blackjack by using a system for counting cards. When Gross recovered, he went straight to Las Vegas, where he played 16 hours a day over the next four months. He turned his initial US$200 into US$10,000.

Once done, his thoughts turned to what to do with his future. He later recalled:

“I said, well, I obviously enjoy mathematical application of a system of some sort, and hard work, and diligence. What’s the adult form of gambling? It’s the stock market. Maybe you can’t outfox it, but let’s see if it can be done. Right then and there I said, ‘I’m getting into the money management business.’”

The rest is history.

Randomised luck versus systematic edge


Most people think of gambling as randomized luck. And they’re largely right. At a casino, the casino normally has the advantage.

For instance, you can go to a casino and play blackjack. The dealer will give you, and all other players, two cards face up, while the dealer gets one card face up and another face down. From there, the aim is to get as close to cards totalling 21 as possible, without going over.

But your chances of winning a hand are 42.22%, while the odds of a tie are 8.48%. Conversely, the odds of the casino winning are 49.3%. That’s because the casino dealer has the advantage of going second and can make decisions based on your position. You may get lucky for a few hands, yet if you play long enough, the statistical odds will come back to beat you.

Bill Gross wasn’t interested in relying on randomized luck though. When he read Thorp’s book, he saw a system of counting cards that could tilt the odds in his favour. He then applied that odds-based mentality to give him an edge in bond markets.

‘A man for all markets’


Edward Thorp went on to have an amazing career too. He wrote ‘Beat the Dealer’ when he was 30 and the book not only inspired Gross but generations of professional and amateur gamblers. Several students at MIT successfully used the card counting method, and their exploits became the basis for the 2003 best-selling book, Bringing Down the House, by Ben Mezrich, and subsequent film, '21', starring Kevin Spacey.

After Thorpe’s book was published, several wealthy individuals bankrolled Thorp so he could use his system at casinos. He was originally welcomed by casinos as they didn’t see him as a threat. As his fame spread, Thorp started wearing disguises, but the mobsters who ran the casinos at that time were onto him and fought back (through violence and other means).

The public corporations which eventually took over the running of casinos from mobsters became smarter at eliminating card counting. They altered table rules to discourage gamblers from counting opportunities.

With the money he’d amassed from gambling, Thorp began investing in the stock market. He figured gamblers and investors shared the same psychological makeup. He developed a system based on arbitraging the price differences of two correlated securities, such as a company’s shares and its warrants.

He outlined his system in the book, ‘Beat the Market’, in 1967 and formed a hedge fund in 1969 to put the theory to work. Over the next 19 years, Thorp’s hedge fund returned 20% per annum, or a cumulative 2,734% compared to the S&P 500’s 545%.

In 1991, Thorp was a consultant to hedge funds and a client asked him to review his portfolio. Thorp approved the portfolio with one exception – an investment in a hedge fund run by a guy called Bernie Madoff. Thorp saw that Madoff’s returns were fake. 17 years later, Madoff was indicted for a Ponzi scheme worth almost US$65 billion. Thorpe said he didn’t blow the whistle on Madoff as he owed a duty of confidentiality to his own client.

Buffett’s edge


Before Thorp, Warren Buffett had developed his own odds-based system for beating the stock market. He started by following his teacher Benjamin Graham into value stocks, where he’d often buy a stock valued well below the net assets on its balance sheet. He eventually changed his investment system to focus on quality stocks valued cheaply.

As his publicly listed company, Berkshire Hathaway, got larger, Buffett started buying whole companies. He became attracted to insurance companies, which gave him two things:

  1. A cheaper source of funding than offered by banks or equity markets;
  2. A way to play the odds via insurance.

Buffett realized that insurance was an odds-based system, where you price insurance according to the odds of a future event happening. Insurance has since formed the backbone of Buffett’s empire.

Buffett’s partner, Charlie Munger, has expressed how he uses the horse racing betting system as a way to approach investing in the stock market:

“To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for the horse with one chance in two of winning which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”

Mohnish Pabrai’s dhandho investing    


Buffett follower, and successful investor, Mohnish Pabrai, has put his own spin on things with ‘dhandho investing’ – investing in stocks where there’s a high degree of uncertainty but low risk. Pabrai suggests most investors mistakenly see high uncertainty and high risk as the same thing:

“Low risk and high uncertainty is a wonderful combination. It leads to severely depressed prices for businesses – especially in the pari-mutuel system-based stock market. Dhandho entrepreneurs first focus on minimizing downside risk. Low-risk situations, by definition, have low downsides. The high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes. You end up with the classic Dhandho tagline: Heads, I win; tails, I don’t lose much.”

Pabrai gives several examples of low risk, high uncertainty opportunities that his fund has invested in. In 2000, he invested in a US funeral services business, Stewart Enterprises, whose stock had slumped more than 90% from its peak. Stewart had bought many other funeral services businesses (a roll-up business model) and taken on a huge amount of debt. The market was pricing the company as if it was about to go bankrupt.

Pabrai saw that bankruptcy was possible, but also that the business was making good money, and had options to refinance its debt and sell-off some businesses to raise cash. He reasoned that the risks of bankruptcy were low, while the odds of the business getting through their bad patch were high. Soon after the company announced that it was considering selling its businesses outside the US and the stock price took off. Pabrai doubled his money in under a year.