Although humans have diced and dealt since ancient times, it was the gambling tables of Renaissance Europe that inspired the theory of probability, the core of the concept of risk. Driven by the desire to gain an edge, Girolamo Cardano, a gambler’s gambler and the most famous physician of his age, was among the first to investigate the frequency with which dice numbers were thrown. Later Pascal and Fermat applied mathematics to gaming brainteasers. In the process, they created a procedure for forecasting the likelihood of results. Over the years, mathematicians transformed this theory of probability into a powerful information tool. Graunt applied it to mortality analysis, Laplace as an aid in science, and Mendel, working with pea plants in an abbey garden, to genetics.

Eventually quantitative techniques of risk management emerged to become the basis of contemporary society in everything from insurance to investment, and from engineering and molecular behavior to medicine and weather forecasting. Yet, even as probability was being transformed, it was also being applied back to gambling by such innovators as Charles Babbage, the father of the programmable computer.* In the early 1960s, Edward O. Thorp, a mathematics instructor, used an early mainframe computer to apply quantitative finance to gambling and to prove that the “gambling market” was, in finance terms, inefficient (beatable). Thorp made a fortune testing and refining his strategy. In 1962, he published Beat the Dealer, which mathematically proved that by keeping track of the cards dealt, a blackjack (also known as twenty-one or pontoon) player could gain a positive return and eliminate the chance of being wiped out.

Thorp inspired a generation of new players, including Bill Gross, founder of California-based PIMCO, the world’s biggest bond management firm. Then a 22-year-old student, Gross traveled to Las Vegas in 1966 and turned $200 into $10,000 in three months. Although Gross later expressed disdain for the gambling lifestyle, he acknowledged the importance of the experience. Vegas, he said, was not about the money. “I wanted to prove that you could beat the system. Then I thought about what I could do that takes the same skills. I realized that it was investing.”

However, it cannot be said that Thorp and Gross gambled. Instead, they used a method to eliminate risk. Developing a “system” had been a long-standing gambling quest, but until Thorp’s research it was accepted that a winning system for a major casino game was mathematically impossible. Yet, although it was rigorous and demanded great concentration, those who correctly applied Thorp’s approach were assured that a positive result would eventuate. A central notion popularized by the system, later used to manage risk in investments, was the Kelly criterion (also known as the capital growth criterion). Devised in the 1950s to maximize the long-term growth rate of capital, it specifies how to allocate money given the choices available. It helps avoid gambler’s ruin by over-betting. In blackjack, a player runs the risk of losing their entire pot when betting more than 2% on any one deal, although bets should increase as card counting shows the edge increasing.

Thorp later applied his quantitative approach to convertible bonds and wrote Beat the Market. Although he has never purchased a lottery ticket in his life, the two hedge funds he ran, Princeton-Newport Partner and Ridgeline Partners, are said to have gone nearly 30 years with averaged 19-20% annual returns.

What Thorp, Gross and others took away from professional gambling was more than winnings. It was key insights of how risk could be managed that they would later apply to the investment world. These techniques have helped them ride out and thrive in rougher economic periods that brought others to ground. In essence, it helped them become masters of risk. 

* Debbie Harrison, A Victorian Hangover: Narratives of Addiction 1830-1900

Published by PROJECT  M in December 2008