I just had the great pleasure of listening to Michael Covel’s recent podcast with Aaron Brown. I always love listening to Aaron Brown speak because I expect either to learn something new or to learn something different about what I thought I knew.
In case you don’t know about Aaron Brown, I’ll give you a thumbnail. He is the recently retired head of risk management at AQR Capital, the Vanguard of hedge funds with over $100 billion under management. But Brown is anything but a traditional Wall Street figure. His background is in applied math and gambling, especially poker, which he began playing profitably at age 14. As a Harvard undergraduate, he played with Bill Gates, George W. Bush, and Scott Turow.
Even at the age of eight, he read Edward Thorpe’s watershed, “Beat the Dealer,” which created card-counting as a robust strategy to beat the casinos at blackjack.
For those who don’t know Thorpe, he is a subject for many other blogposts. But suffice it to say for now that Thorpe was likely a more successful investor than even Warren Buffett, incurring only two losing months out of 240 for his hedge fund, Princeton-Newport Partners, with other performance and volatility metrics that are virtually unheard of. Additionally, same model that Thorpe used to determine prices for options and warrants for his hedge fund won Fisher Black and Myron Scholes the Nobel prize years after Thorpe had begun using the model in practice.
Besides conquering blackjack, Thorpe conquered roulette with a unique strategy consisting of (1) a wearable computer with receiver/earpiece, (2) a partner with transmitter to calculate the velocity of the roulette marble and the slot over which the ball dropped, and (3) a theory about the range of possible slots to bet on once the ball had dropped and begun bouncing around the wheel. Thorpe accomplished an astounding 44% edge in betting on roulette with this system, while the casinos themselves typically enjoy a much smaller edge of 3-5% over their customers.
What does Thorpe’s roulette system have to do with Aaron Brown? It’s something I never thought of but totally brilliant. While I had thought that Thorpe’s roulette discoveries were interesting, I missed the key insight according to Brown.
Thorpe’s roulette system is part Newtonian physics and part information theory. One part is measurable and predictable—the speed of the marble and where it drops from the rim of the bowl—the other random but capable of being modeled—the area of the wheel where the marble bounces after it drops from the rim. In brief, Thorpe’s roulette system constitutes a model for generating extraordinary returns by trading the financial markets, markets that have been falsely labeled as random. Success with Thorpe’s roulette system is also why success in trading the financial markets can look unbelievable to so many.
In the end, human beings are not capable of creating truly random systems, and that includes the markets. This is one key reason that momentum and trend-following approaches succeed and why so many can’t believe that they do.
Link below. It's a lengthy talk. Go straight to 48:38 for more insights.