Fortune’s Formula is mainly about the Kelly criterion. This book was recommended in Richer, Wiser, Happier. The is my third book from its recommended book list. I would like to see what be can learned from this book to apply in the stock market.
William Poundstone is an American author and columnist.
Fortune’s Formula has a prologue (The Wire Service) and 6 parts. As these 6 parts contain quite a lot of chapters, I am not going to list them here.
Part One is Entropy.
Part Two is Blackjack.
Part Three is Arbitrage.
Part Four is St. Petersburg Wager.
Part Five is RICO.
Part Six is Blowing Up.
Part Seven is Signal and Noise.
Fortune’s Formula is more like a biography, rather than an investment book. It features a lot of people, either directly or indirectly involved in the stock markets, including Claude Shannon, the father of information theory, and Edward O. Thorp. It reveals the backers of Edward O. Thorp in Beat the Dealer which Thorp concealed in his book.
The main thing that is discussed in this book is the Kelly formula. According to the author, it is the best strategy for a gambler as it offers the highest compound return with no risk of going broke. It calculates the betting size for a wager. Its formula is shown below.
Kelly formula = Edge ÷ Odds
- Edge: How much you expect to win, on the average, assuming you could make this wager over and over with the same probabilities. It is a fraction because the profit is always in proportion to how much you wager, i.e. profit divided by wager. Profit is calculated by multiplying chance of winning with expected winnings and then minus the wager.
- Odds: It measures the profit if you win. For example, an odds of 8 to 1 means a winning wager receives 8 times the amount wagered plus return of the wager itself. In this case, odds is 8.
From this formula comes the Kelly criterion. The criterion says that when faced with a choice of wagers or investments, choose the one with the highest geometric mean of outcomes. This means we should choose the instrument with the highest compound return.
Louis Bachelier’s A Theory of Speculation in 1900 says that a stock price goes up only when it does better than people anticipated and goes down when it does worse than predicted. Stock prices are more volatile than corporate earnings. Thus, investing solely in stocks involves large dips in wealth periodically. Nonetheless, the value of a financial gain (or loss) depends on the wealth of the person it affects.
Fortune’s Formula is easy to read but you need to spend some brainpower to understand its contents. I think this book title is based on a paper presented by Thorp in 1961. From this book, I see clearly that different fields might come together to create new path in another field. The author is a gifted writer, the epilogue is interesting enough to lure people to learn more about the gambling system and the interest is sustained through his storytelling.
To beat the market, a trader must have an edge, a more accurate view of what bets on stocks are really worth. Furthermore, successful trader must worry about other people copying his trades. I would like to try Shannon’s proposed method of investment. It involves the implementation of a half-half split between a high volatility instrument and cash, then rebalance daily. To do this, I have to find a zero-commission broker first and it would be a US broker. I wonder if this would produce a good result.
One-sentence summary for Fortune’s Formula: Out of all the instruments worth investing, choose the one with the highest compound rate of return.
- Life is a gamble.
- The sad fact is, almost everyone who gambles goes broke in the long run.
- Expectation is a statistical fiction, like having 2.5 children.
- In the real world, nothing is a sure thing.
- The point of any average is to simplify life.
Interested in Fortune’s Formula?
You may get the book from through the link below*.
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