From Bloomberg's Markets Magazine, December 4:
In the early stages of the quantitative revolution, bridge players and gamblers helped bring rigor and innovation to markets.
The modern financial system is a house of cards, according to a popular metaphor on both the left and the right. It turns out this is literally true.
From 1970 to 1990, the world moved from a 19th century economy based on gold, banks, stocks and bonds to a global derivatives economy based on intangible parameters, upstart financial innovators, hedge funds and options. The brave new world required people who were good at both math and betting. Today, of course, we train such people in quantitative finance programs, but in the early days they could be found at bridge and blackjack tables. Also playing other games and betting on sports.
Before 1970 few traders knew much serious math, and few serious math people knew much about risk-taking. Investing didn’t seem to offer many interesting intellectual challenges. Exchange rates were fixed, and so was the value of the dollar in terms of gold. Interest rates were heavily regulated, and academics had shown that stock prices moved at close to a random walk. There were no listed markets for options—economists Fischer Black and Myron Scholes wouldn’t publish their groundbreaking paper on how to price such things until 1973. Regulations suppressed innovation and restricted freedom of action. Finance was dominated by deeply conservative, heavily regulated, white-shoe firms that hired on the basis of social connections, religion and skin color rather than brains.
And then everything changed. Inflation spiked, and interest rates went on a roller-coaster ride. Outsiders struggled with regulators to introduce the products that ultimately helped investors and savers but also asked them to embrace risk: money-market funds, index funds and 401(k) plans, among others. In the wild chaos of the era, the most promising new markets were heavily mathematical. Mortgage-backed securities exploded in the second half of the 1970s, and pioneering trader Lew Ranieri famously said, “Mortgages are math.” Many of the great quantitative hedge funds were founded in the ’70s, and similar strategies were beginning to drive the trading profits of the most aggressive commercial and investment banks. Stock options began trading on the Chicago Board Options Exchange in 1973.
This new world created a chicken-and-egg problem. The innovations required sophisticated mathematical traders in diverse areas. But until these markets and businesses became established and profitable, with high-paying jobs to offer, no one would put in the work to learn the skills.
In the mid-1970s, I was earning a living playing poker and betting on sports, but I sensed finance was beginning to offer attractive games that could support higher stakes. That insight ultimately led me to a career as a trader and risk manager.
When I was researching my 2006 book, The Poker Face of Wall Street, I interviewed many other traders who got into options and other mathematical trading in the 1970s and early ’80s. The ones I knew were mainly former games professionals, but I was surprised to learn that was also true of many other traders. Moreover, I discovered that I had run across most of the people I spoke to at the poker table, or at conferences for advantage gamblers, or in bridge, gin rummy or backgammon tournaments. These people didn’t migrate to financial work independently, as I had; they were recruited by networks of game players. In my book, I detailed the story of the most prolific headhunter, bridge champion Mike Becker. After Becker lost his life savings in a bad interest-rate bet by his investment manager, his bridge partner Ron Rubin staked him to trade options on the American Stock Exchange. (Rubin used the money he’d won in the world backgammon championship.) Becker later recruited bridge champions as well as experts in poker, backgammon and Go into the business.
The games continued when players started trading and running hedge funds. The most famous game from this era was liar’s poker, played with serial numbers on dollar bills. But trading rooms were beehives of games and betting schemes that would appear, go viral and disappear like internet memes. Many financial institutions continued to recruit game players even when mathematicians, physicists, computer scientists and finance Ph.D.s were available. The proprietary trading firm Jane Street Group is famous for the games it created for interviewing and training, such as Estimathon and Figgie.....
....MUCH MORE
If you look at the quantfathers the history goes back at least a decade earlier than this author states.- "How did Ed Thorp Win in Blackjack and the Stock Market?"
- Journal of Investment Consulting: Interview With Edward O. Thorp
- Markets, Risk and Gambler's Ruin
- Traders Copy Academics Who Copy Traders: “Does Academic Research Destroy Stock Return Predictability?”
- "How Information Got Re-Invented"
- The Bit Bomb: The True Nature of Information
The subject of this article, Claude Shannon has a couple interesting connections to finance/investing/trading beyond 'just' creating information theory (along with MIT's Norbert Wiener who was coming in on a different angle of attack), more after the jump.
- "My Meeting With Claude Shannon, Father of the Information Age"
- "Betty Shannon, Unsung Mathematical Genius"
- "Claude Shannon, the Las Vegas Shark"
....The father of information theory built a machine to game roulette, then abandoned it.
Many of Claude Shannon’s off-the-clock creations were whimsical—a machine that made sarcastic remarks, for instance, or the Roman numeral calculator. Others created by the Massachusetts Institute of Technology professor and father of information theory showed a flair for the dramatic and dazzling: the trumpet that spit flames or the machine that solved Rubik’s cubes. Still other devices he built anticipated real technological innovations by more than a generation. One in particular stands out, not just because it was so far ahead of its time, but because of just how close it came to landing Shannon in trouble with the law—and the mob.
Long before the Apple Watch or the Fitbit, what was arguably the world’s first wearable computer was conceived by Ed Thorp, then a little-known graduate student in physics at the University of California, Los Angeles. Thorp was the rare physicist who felt at home with both Vegas bookies and bookish professors. He loved math, gambling, and the stock market, roughly in that order. The tables and the market he loved for the challenge: Could you create predictability out of seeming randomness? What could give one person an edge in games of chance? Thorp wasn’t content just pondering these questions; like Shannon, he set out to find and build answers.
In 1960, Thorp was a junior professor at MIT. He had been working on a theory for playing blackjack, the results of which he hoped to publish in the Proceedings of the National Academy of Sciences. Shannon was the only academy member in MIT’s mathematics department, so Thorp sought him out. “The secretary warned me that Shannon was only going to be in for a few minutes, not to expect more, and that he didn’t spend time on subjects (or people) that didn’t interest him. Feeling awed and lucky, I arrived at Shannon’s office to find a thinnish, alert man of middle height and build, somewhat sharp featured,” Thorp recalled.
Thorp had piqued Shannon’s interest with the blackjack paper, to which Shannon recommended only a change of title, from “A Winning Strategy for Blackjack” to the more mundane “A Favorable Strategy for Twenty-One,” the better to win over the academy’s staid reviewers. The two shared a love of putting math in unfamiliar territory in search of chance insights. After Shannon “cross-examined” Thorp about his blackjack paper, he asked, “Are you working on anything else in the gambling area?”
Thorp confessed. “I decided to spill my other big secret and told him about roulette. Ideas about the project flew between us. Several exciting hours later, as the wintery sky turned dusky, we finally broke off with plans to meet again on roulette.” As one writer, William Poundstone, put it, “Thorp had inadvertently set one of the century’s great minds on yet another tangent.”
Thorp was immediately invited to Shannon’s house. The basement, Thorp remembered, was “a gadgeteer’s paradise. ... There were hundreds of mechanical and electrical categories, such as motors, transistors, switches, pulleys, gears, condensers, transformers, and on and on.” Thorp was in awe: “Now I had met the ultimate gadgeteer.”
It was in this tinkerer’s laboratory that they set out to understand how roulette could be gamed, ordering “a regulation roulette wheel from Reno for $1,500,” a strobe light, and a clock whose hand revolved once per second. Thorp was given inside access to Shannon in all his tinkering glory....
Also:
"How Claude Shannon Invented the Future"
In last week's link to Quanta Magazine's "Maxwell’s Demon And The Physics Of Information." I went off on a Claude Shannon linkfest tangent and completely forgot to link Quanta's own post on the guy.
From Quanta, December 22, 2020:
Today’s information age is only possible thanks to the groundbreaking work of a lone genius.
"How Claude Shannon Helped Kick-start Machine Learning"
From IEEE Spectrum, January 25, 2022:
The “father of information theory” also paved the way for AI
There was also a shout out to Shannon from the quants at Ruffer in July 2021's Ruffer Review: "Navigating information"
