Book Club: Fortune's Formula - William Poundstone

This book is incredible.  In a sentence, it’s a historical tale of the mathematicians and scientists who devised systems to ‘beat the casinos’ and ultimately reap massive fortunes (for some) in the stock market.  Fortune’s Formula has something in it for the gamblers, the academics/economists, the active traders and the history buffs.  

For me, Poundstone’s book gave a time series and a story that tied together a lot of the formulas and names I have come across in my studies of financial markets.   I had always known of the Kelly betting system, but not until now do I have a vivid picture of the man who created it and the success it had in the gambling world.   

The book also goes through the early days of option pricing (called warrants back in the day) and told the story from conception up through the origins of the Black Scholes pricing model  (the most popular options pricing model used today).   I have studied the math extensively, but never the history of the men who created it nor the environment in which it was ‘born’.  Fascinating stuff!

I thought our author did a terrific job of capturing the raging debate that sprung up in the academic community over what’s known as the ‘Efficient Market Hypothesis’.  For those of you that don’t know, it states that all financial markets are always trading at the right values and therefore it is impossible to make long term returns above ‘the average’.   This of course by induction means that anyone who claims to be a trader or money manager is a fraud and any success they’ve had has been sheer luck.  As you can imagine this notion is troubling to the men and women that work in our managed financial sectors.   Poundstone covered the extensive arguments posed by efficient theorists and economists as well as the back-stories of the fund managers who DID manage to return well above the market average year after year during those academic debates.

The Kelly system is a betting system designed to eliminate a gamblers risk of ruin (the chances of going completely broke).  It does this by recommending the bettor always bet a proportionate amount of his bankroll.  What proportion you ask?  Basically the amount of ‘edge’ you have divided by your total amount of money you have available to gamble.  Now the interesting part here, is that you don’t just place one bet, but multiple of varying sizes and probabilities.  For example at a horse race, the Kelly bettor does not just bet on the most favorable horse she bets on ALL the horses in degrees varied by the horse’s chance to win.  Now there are plenty of drawbacks to this system and even more counter arguments.  THey are described at length in the book so do read it if you’re interested.  Further reading about Kelly can be found here https://en.wikipedia.org/wiki/Kelly_criterion

Verdict: Read it.  Rarely do you find such a good combination of writing, history and academic research (with real life application).