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Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street
     

Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

3.9 10
by Poundstone
 

In 1956 two Bell Labs scientists discovered the scientific formula for getting rich. One was mathematician Claude Shannon, neurotic father of our digital age, whose genius is ranked with Einstein's. The other was John L. Kelly Jr., a Texas-born, gun-toting physicist. Together they applied the science of information theory—the basis of computers and the

Overview

In 1956 two Bell Labs scientists discovered the scientific formula for getting rich. One was mathematician Claude Shannon, neurotic father of our digital age, whose genius is ranked with Einstein's. The other was John L. Kelly Jr., a Texas-born, gun-toting physicist. Together they applied the science of information theory—the basis of computers and the Internet—to the problem of making as much money as possible, as fast as possible.

Shannon and MIT mathematician Edward O. Thorp took the "Kelly formula" to Las Vegas. It worked. They realized that there was even more money to be made in the stock market. Thorp used the Kelly system with his phenomenally successful hedge fund, Princeton-Newport Partners. Shannon became a successful investor, too, topping even Warren Buffett's rate of return. Fortune's Formula traces how the Kelly formula sparked controversy even as it made fortunes at racetracks, casinos, and trading desks. It reveals the dark side of this alluring scheme, which is founded on exploiting an insider's edge.

Shannon believed it was possible for a smart investor to beat the market—and William Poundstone's Fortune's Formula will convince you that he was right.

Editorial Reviews

In 1956, two Bell Labs scientists discovered a formula for getting rich. One of these lucrative thinkers was mathematician Claude Shannon, regarded by many as the founding father of the electronic communications age. The other was probability expert John L. Kelly, Jr., a colorful, gun-toting Texas-born physicist. When Shannon and another mathematician tested the "Kelly formula" at casino tables, racetracks, and stock exchange trading floors, its success was incontestable. For instance, Shannon's stock portfolio showed an annual growth rate of 28 percent. In Fortune's Formula, William Poundstone spins an amazing true story about getting rich quick.
Publishers Weekly
In 1961, MIT mathematics professor Ed Thorp made a small Vegas fortune by "counting cards"; his 1962 bestseller, Beat the Dealer, made the phrase a household word. With Claude Shannon, the father of information theory, Thorp next conquered the roulette tables. In this prosaic but fascinating cultural history, Poundstone (How Would You Move Mt. Fuji?) tells not only what they did but how they did it. For roulette, Poundstone shows, Thorp and Shannon used a betting scheme invented by Shannon's Bell Labs colleague John Kelly, eventually applying Kelly's technique to investing, resulting in long-term records of extraordinary return with low risk. (Thorp revealed the secret in 1966's Beat the Market, but investors proved harder to persuade than blackjack players.) Many other characters figure into Poundstone's entertaining saga: a forgotten French mathematician, two Nobel Prize-winning economists who declared war on the Kelly criterion, Rudy Giuliani, assorted mobsters, and winners and losers in all types of investing and gambling games. The subtitle is not a tease: the book explains and analyzes Kelly's system for turning small advantages into great wealth. The system works, but requires unusual amounts of patience, discipline and courage. The book is good fun for the rest of us. Agent, Katinka Matson at Brockman. (Sept.) Copyright 2005 Reed Business Information.
Library Journal
In 1956, Bell Labs scientists Claude Shannon and John L. Kelly Jr. used their considerable smarts to devise a formula for getting rich and applied it to gambling at its height: Las Vegas roulette and the stock market. Poundstone examines the consequences-and the seamy underside. Copyright 2005 Reed Business Information.
Kirkus Reviews
Is there a secret mathematical equation to beat the stock-market smarties and outsmart the blackjack dealers? There sure is, says this erudite author. You can bet on it. Poundstone (Carl Sagan, 1999, etc.) offers a simple formula known as the proportional Kelly criterion. Using it, you can never lose your entire bankroll, and you will have a real edge. He touts the system with scholarship and documentation. And it's all artfully packaged with diverting tales of geniuses and gangsters. There are MIT scholars and Bell Lab theorists like Claude Shannon, Ed Thorp and the eponymous J.L. Kelly, and there are the colorful gamblers and crooks from Vegas to Wall Street like Bugsy Siegel and Ivan Boesky. There's ambitious young Rudy Giuliani and irascible old Paul Samuelson. The math geeks, con men, arbitrageurs and professors contribute their respective talents to conjectures regarding horse-racing in Hong Kong and hedge-fund management in Princeton. We are given instruction in the arcana of information theory, card-counting, portfolio construction, fat-tail distributions and logarithmic utility. Thus, we are led, quite ingenuously, into B-school notions and economic theory with real math and actual graphs. If the academic medicine gets a bit thick, it goes down quite well with the sugar of entertaining anecdotes. It's those stories that provide a selective picture of our civilization, a sociological survey of how risk is taken. For a good way to manage risk, Poundstone says, he's got the horse right here. Its name is Kelly. Readers will have to decide whether to simply bet their beliefs the old-fashioned way or to sign on to the discipline of Kelly's formula. Enticing elucidation beneath goodhumored history.
From the Publisher

“Seldom have true crime and smart math been blended together so engagingly.” —The Wall Street Journal

“An amazing story that gives a big idea the needed star treatment . . . Fortune's Formula will appeal to readers of such books as Peter L. Bernstein's Against the Gods, Nassim Nicholas Taleb's Fooled by Randomness, and Roger Lowenstein's When Genius Failed. All try to explain why smart people take stupid risks. Poundstone goes them one better by showing how hedge fund Long-Term Capital Management, for one, could have avoided disaster by following the Kelly method.” —Business Week (four stars)

“'Fortune's Formula' may be the world's first history book, gambling primer, mathematics text, economics manual, personal finance guide and joke book in a single volume. Poundstone comes across as the best college professor you ever hand, someone who can turn almost any technical topic into an entertaining and zesty lecture.” —The New York Times Book Review

Product Details

ISBN-13:
9780809046379
Publisher:
Farrar, Straus and Giroux
Publication date:
09/14/2005
Pages:
400

Read an Excerpt

Excerpted from Fortune's Formula by William Poundstone. Copyright © 2005 by William Poundstone. Published in September, 2005 by Hill and Wang, a division of Farrar, Straus and Giroux, LLC. All rights reserved.
Prologue:
The Wire Service


The story starts with a corrupt telegraph operator. His name was John Payne, and he worked for Western Union's Cincinnati office in the early 1900s. At the urging of one of its largest stockholders, Western Union took a moral stand against the evils of gambling. It adopted a policy of refusing to transmit messages reporting horse race results. Payne quit his job and started his own Payne Telegraph Service of Cincinnati. The new service's sole purpose was to report racetrack results to bookies.

Payne stationed an employee at the local racetrack. The instant a horse crossed the finish line, the employee used a hand mirror to flash the winner, in code, to another employee in a nearby tall building. This employee telegraphed the results to pool halls all over Cincinnation leased wires.

In our age of omnipresent live sports coverage, the value of Payne's service may not be apparent. Without the telegraphed results, it could take minutes for news of winning horses to reach bookies. All sorts of shifty practices exploited this delay. A customer who learned the winner before the bookmakers did could place bets on a horse that had already won.

Payne's service ensured that the bookies had the advantage. When a customer tried to place a bet on a horse that had already won, the bookie would know it and refuse the bet. When a bettor unknowingly tried to place a bet on a horse thathad already lost…naturally, the bookie accepted that bet.

It is the American dream to invent a useful new product or service that makes a fortune. Within a few years, the Payne wire service was reporting results for tracks from Saratoga to the Midwest. Local crackdowns on gambling only boosted business. "It is my intention to witness the sport of kings without the vice of kings," decreed Chicago mayor Carter Harrison II, who banned all racetrack betting in the city Track attendance plummeted, and illegal bookmaking flourished.

In 1907 a particularly violent Chicago gangster named Mont Tennes acquired the Illinois franchise for Payne's wire service. Tennes discreetly named his own operation the General News Bureau. The franchise cost Tennes $300 a day He made that back many times over. There were more than seven hundred bookie joints in Chicago alone, and Tennes demanded that Illinois bookies pay him half their daily receipts.

Those profits were the envy of other Chicago gangsters. In July through September of 1907, six bombs exploded at Tennes's home or places of business. Tennes survived every one of the blasts. The reporter who informed Tennes of the sixth bomb asked whether he had any idea who was behind it. "Yes, of course I do," Tennes answered, "but I am not going to tell anyone about it, am I? That would be poor for business."

Tennes eventually decided he didn't need Payne and squeezed him out of business. Tennes's General News Bureau expanded south to New Orleans and west to San Francisco.

This prosperity drew the attention of federal judge Kenesaw Mountain Landis. In 1916 Judge Landis launched a probe into General News Bureau. Clarence Darrow represented Tennes. He advised his client to take the Fifth Amendment. Judge Landis ultimately ruled that a federal judge had no jurisdiction over local antigambling statutes.

In 1927 Tennes decided it was time to retire. He issued 100 shares of stock in General News Bureau and sold them all. Tennes died peacefully in 1941. He bequeathed part of his fortune to Camp Honor, a character-building summer camp for wayward boys.
General News Bureau's largest stockholder, of 48 shares, was Moses ("Moe") Annenberg, publisher of the Racing Form. Annenberg was unapologetic about the social benefits of quick and accurate race results. "If people wager at a racetrack why should they be deprived of the right to do so away from a track?" he asked. "How many people can take time off from their jobs to go to a track?"

Annenberg hired a crony named James Ragan to run the wire service. By that time, there were scores of competitors. Annenberg and Ragan expanded by buying up the smaller wire services or running them out or business.

One man with the guts to stand up to Annenberg and Ragan was Irving WexSer, a bootlegger and owner of the Greater New York News Service. After Ragan started a price war with Greater New York News, Wexler sent a team of thugs to vandalize Annenberg's New York headquarters.

Annenberg knew that Wexler was tapping into General News's lines to get race results. It was cheaper than paying his own employees to report from each racetrack. So one day Annenberg delayed the race results on the portion of line that Wexler was tapping, Annenberg had the timely results phoned to a bunch of his own men, who placed big bets on the winning horses with Wexler's subscribers. Wexler's bookies, getting the delayed results, did not know that the horses had already won. By day's end, they had suffered crippling losses.

Annenberg's men went to each of Wexler's subscribers and explained what had happened. They refunded the day's losses, advising the bookies that it would be wise to switch to General News Bureau.

With such tactics, Annenberg's service—also known as "the Trust" or "the Wire"—expanded coast-to-coast, to Canada, Mexico, and Cuba. In 1934 Annenberg ditched his partners much as Tennes had done. Annenberg established a new, rival wire service called Nationwide News Service. Bookies were told to switch carriers or else.
* * *

The growth of General News Bureau paralleled that of the American Telephone and Telegraph Company In 1894 Alexander Graham Bell's telephone patents expired. Within a few years, over 6,000 local telephone companies were competing for the U.S. market. AT&T acquired or drove most of them out of business. Though AT&T's techniques were more gentlemanly than Annenberg's, the result was about the same. The government stepped in with an antitrust suit. The legal action was settled in 1913 with an agreement that AT&T permit competing phone companies to connect to its long-distance network. In 1915 the first coast-to-coast telephone line went into operation. The following year, AT&T was added to the Dow Jones average. With its now-legal monopoly and reliable dividend, AT&T was reputed to be a favorite stock of widows and orphans.

Few of those widows and orphans realized how closely the phone company's business was connected to bookmaking. General News Bureau did not own the wires connecting every racetrack and bookie joint. It leased lines and equipment from AT&T, much as today's Internet services lease cables and routers. Both telegraph and voice lines were used. As the system grew more sophisticated, voice lines provided live track commentary.

AT&T's attorneys worried about this side of the business. An in-house legal opinion from 1924 read: "These applicants [the racing wire services] must know that a majority of their customers are bound to be owners of poolrooms and bookmakers. They cannot willfully blind themselves to these facts and, in fact, set up their ignorance of what everybody knows in order to cooperate with lawbreakers."

On legal advice, AT&T put an escape clause in its contract with the wire lessees. The clause gave the phone company the right to cancel service should authorities judge the lessee's business illegal. AT&T continued to do business with bookies—while officially it could claim to be shocked that gambling was going on in its network. By the mid-l93Os, Moe Annenberg was AT&T's fifth largest customer.
* * *

Annenberg's takeover of the wire service business infuriated the other stockholders of General News Bureau, who now owned shares in a company with practically no customers. One stockholder, Chicago mobster John Lynch, took Annenberg to court. Annenberg attorney Weymouth Kirkland argued that, because the wire service was patently illegal, the court had no jurisdiction. He cited a 1725 precedent in which an English judge had refused to divide the loot of two disputing highwaymen. The court accepted Kirkland's bold defense.

Lynch appealed to Al Capone's mob. He felt he might got a sympathetic ear as Capone (then in prison for tax evasion) had already made unsuccessful overtures to Annenberg about acquiring the wire service. Capone's enforcer, Frank Nitti, told James Ragan that if he'd ally himself with the Capone mob, Annenberg would be dead in twenty-four hours.

Ragan said no. Annenberg skipped town for Miami. Negotiations between Annenberg and Capone's people dragged on for a couple of years. It was eventually agreed that Annenberg would pay Capone's people $1 million a year in protection money, but Annenberg would retain ownership of the wire service.

Then, in 1939, Annenberg was up on tax evasion charges. In order to prove he was a reformed man, he did the unthinkable. He walked away from the wire service.

The vacuum created did not last long. The wire service was quickly reconstituted under the name of Continental Press Service. James Ragan remained at the helm.

Again the Chicago mob approached Ragan about taking over. Ragan still wasn't interested. To protect himself, he prepared affidavits implicating Frank Nitti in the attempted murder of Annenberg. He let it be known that should anything happen to him, the affidavits would go to the FBI.

The most powerful Italian and Jewish mobsters of the time were allied in a national organization cryptically called "the Combination." The Combination decided it didn't need Ragan. It founded its own wire service, Trans-American Publishing and News Service, with the intention of putting Continental out of business.

Trans-American was run by Ben Siegel. Better known as "Bugsy," a name he hated, Siegel was a New Yorker who had moved to the West Coast. Trans-American's territory included Nevada—a special case, since gambling was legal there. Siegel decided that Nevada bookies should pay more, not less. He reasoned that casino book-making operations are a way to draw people into the casinos so that they will play the other games Siegel therefore charged the casino bookies the usual subscription price plus a cut of their income-in some cases, as much as 100 percent of the bookmaking income.
* * *

On June 24, 1945, James Ragan stopped his car at a Chicago intersection. A banana truck full of crates pulled up next to him. Someone on the truck pulled up a tarpaulin. Two shots rang out. One mangled Ragan's arm and shoulder. Ragan spent the next six weeks under police guard in a Chicago hospital. Despite that, someone apparently poisoned Ragan by putting mercury in his Coca-Colas, or his catheter, according to various accounts. With Ragan dead, the mob seized Continental Press.

The synergy of merging Continental Press and Trans-American did not escape anyone. It didn't escape Los Angeles bookies, who were compelled to subscribe to both wire services at $150 a week each. But Siegel decided that Trans-American was really his own business, not the Combination's. Siegel was building the Flamingo hotel and casino in Las Vegas It had cost far more than projected, and Siegel owed the construction company $2 million. Siegel told the Combination's "board of directors" in New York that they could have the Trans-American wire service back for only $2 million. The board's response was cool.

Siegel later got word that the Combination had called another board of directors meeting without inviting him. That was a bad sign. Siegel was concerned enough to track down the exiled Lucky Luciano in Havana. Siegel insisted he needed to keep the wire service and its profits one more year Luciano, still one of the most powerful men in the Combination, advised Siegel to give the wire service back immediately.
One implausibly verbatim contemporary account records Siegel's reply as: "Go to hell and take the rest of those bastards along with you. I'll keep the goddamn wire as long as I want."

There had been a rule that no board member got the death sentence. The Combination broke that rule for the first time with Siegel. On June 20, 1947, an unknown gunman took aim at Siegel through the trellis of a rose arbor in Beverly Hills. He fired a full clip of steel-jacketed bullets from a .30 caliber army carbine. Most missed. The four that didn't were more than enough to do the job. Siegel's right eyeball came to rest fifteen feet away, on the tile of a dining room floor.

A half hour before the murder, four toughs assembled in the lobby of the Flamingo. At the appointed time, they walked over to the manager and announced that they were taking over. The Combination took over Siegel's wire service, too.

Meet the Author

William Poundstone is the bestselling author of several nonfiction books, including Labyrinths of Reason and The Recursive Universe.

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Fortune's Formula 5 out of 5 based on 0 ratings. 1 reviews.
Guest More than 1 year ago
This is a fascinating book about the sociology of ideas and, specifically, about information theory. Author William Poundstone explores how Claude Shannon, the major developer of information theory, affected finance, investing and gambling. These activities seem disconnected, but they all rely on managing uncertainty. Like any great idea, information theory attracted major personalities: gamblers, mobsters, academics, economists, traders and people who just wanted to make money. The story weaves through a collection of memorable people (from seventeenth-century mathematicians to Ivan Boesky) to present pertinent mathematical and scientific theories, and to explore how people used them. At times, the connections between events seem strained, but they all come together. This book is encyclopedic, exceptionally informative, and packed with great stories and characters. We enthusiastically recommend it to anyone seriously interested in investing, the sociology of ideas, or gambling. Indeed, read it twice: once for its theories and practical investment advice, and the other to relish its personalities.