The Adventures of a Modern Renaissance Academic in Investing and Gambling

The following sections are included:

• Review Quotes
• Dedication
• Acknowledgments
• Contents
• About the Author

There is no way my travels and experiences can begin to match Leonardo’s but at least I set a high goal. In this book, I trace a career from a small town in Massachusetts to the big time as a graduate student at Berkeley in the 1960s which then was the greatest university in the world and then on to a life mostly in British Columbia with many visits across the world to do research, visit universities, attend conferences, consult and write books and work on some very interesting financial market research with some major institutions and very wealthy investors. Along the way, I moved across fields starting with chemical engineering at the University of Massachusetts in Amherst where I spent four delightful but difficult years from 1959–1963. Then the question was where to go to graduate school — I actually applied in five fields: chemical engineering, metallurgy (inspired by a summer doing work at Penn State University), patent attorney, one I forgot and an MBA in business…

I was born on August 30, 1941 in Adams, Massachusetts. I had the same birth date as my boyhood hero Ted Williams, arguably the greatest pure hitter in baseball history. Later, I discovered that Warren Buffett an investment hero, also shared the day…

This chapter is based on a talk given at the retirement of Professor Roger Wets at the University of California, Davis on October 10, 2008. Roger influenced my studies and research starting with a PhD course in stochastic programming in 1967. While Willard (Bill) Zangwill was my official PhD thesis advisor, with Jacob Marschak and Romesh Saigel as my committee, it was Wets who advised me the most in my dissertation on Stochastic Programming and the Theory of Economic Policy.

I left Berkeley in late summer 1968 and headed to Vancouver. My heart was set on a position at Stanford or the second choice UCLA but I did not get offers in either place after interviews. At Stanford, the person who beat me out was thought to have the potential to be a better teacher. Despite them thinking I was better at research, they took him. As I predicted then, he did not get tenure as he did not publish enough. I do not know about the teaching but top research universities like Stanford rarely will tenure weak researchers. I did get offers at Rochester and Northwestern but chose the new school University of British Columbia (UBC). In 1968, the business school, then called the Faculty of Commerce, was just starting. Like me, most of the faculty were young newly minted PhDs from top US universities. One of my Berkeley graduate school days roommates, Erwin Diewert was from Vancouver and always pushed the UBC case. He actually went to the University of Chicago but moved to the UBC economics department 2 years later…

My wife, Sandra, got the travel bug early. She was part of a very strong class in honors economics at the University of California, Berkeley — others included famous economists Robert Hall (Stanford) and Thomas Sargent (economics Nobel Prize winner, 2011 at NYU). She did research with star Professor Roy Radner, one of those possibly better than many economics Nobel Prize winners. Radner was friendly with Andreas Papandreau and became involved with the Center for Planning and Economic Research in Athens. Sandra went there on a fellowship after her undergrad for the academic year 1964–1965. There she met University of Wisconsin professor Arthur Goldberger which led to her going to Madison for an MA in Economics. She had two summers traveling around Europe and at Christmas went to Turkey and Israel with an overnight transit in Cyprus. It was her year of three divided cities: Berlin, Jerusalem and Nicosia. Indeed, she liked to travel!…

In my teaching at UBC I had some flexibility in the PhD class. I normally taught the PhD sequence on nonlinear programming and portfolio theory in the fall and then applied stochastic programming and asset-liability management in the winter. Over the years I had between 4–8 students and it was a great class to teach. My 1974 class started the stochastic programming asset-liability modeling work and had Jerry Kallberg and Martin Kusy both of whom wrote major papers with me. There were also other good students. Once in a while the PhD course could be in speculative investments and there I could cover the mathematics of that such as the nice book of Epstein (1977, 2012) plus the applications. Also I could go into interesting topics like blackjack, casino gambling, horse racing, lotteries, etc. The BC Lottery Commission had me as a consultant and that was a lot of fun plus a bit of extra income which was useful for a low paid professor in an expensive city…

The use of log utility dates to the letters of Daniel Bernoulli in 1738. The idea that additional wealth is worth less and less as it increases and thus utility tails off proportional to the level of wealth is very reasonable. This utility function seems safe for investing. However, I argue that log is the most risky utility function one should ever consider using and it is most dangerous. However, if used properly in situations where it is appropriate, it has wonderful properties. For long-term investors who make many short-term decisions, it usually yields the highest long-run levels of wealth. This is called Kelly betting in honor of Kelly’s 1956 paper that introduced this type of betting. In finance, it is called the Capital Growth Theory or Fortune’s Formula. Kelly was working at Bell Labs and was greatly influenced by Claude Shannon, the father of information theory…

The place and show betting system was based on academic papers in Management Science in 1981 and 1985 and popularized through the books Beat the Racetrack and Betting at the Racetrack in 1984–1986, Efficiency of Racetrack Betting Markets (1994, 2008), The Sports and Lotto Handbook (2008) and my 2017 book Exotic Betting at the Racetrack. Using this system people could win at the racetrack not knowing anything about the horses. It was purely based on mispricings which in finance is called weak market efficiency. If prices are not fair then that is referred to as a weak market inefficiency…

The S&P500 started trading futures on the index in 1982. That way you could take levered positions long and short on the large cap sector of the US stock market. That can be profitable but it is risky and if the market falls suddenly and you are long, then you can lose a lot of money. Many have done precisely this and I discuss some of that in Chapter 21. I was studying US calendar anomalies and from a teaching visit to UCLA in 1981/1982, I learned about the small cap effect and the January effect and their relationship…

This chapter recalls a memorable day on November 10, 1984 when Ed Thorp and I attended, with my late Vancouver colleague Bruce Fauman, the first Breeders’ Cup day at Hollywood Park. The purpose of the day in addition to fun, was to test my Dr Z system co-developed with Donald Hausch with some early help from Mark Rubinstein. The idea of the system is simple: use the data from a simple market, in this case the win probabilities to fairly price bets in the more complex markets, such as place and show. For example, with 10 horses, there are 720 possible finishes for show. Then one searches for mispriced place and show opportunities. This is a weak form violation of the efficient market hypothesis based solely on prices. How much to bet depends on how much the wager is out of whack and it is a good application of the Kelly betting system. We use a model that takes our bets into account and are solved with a nonlinear programming algorithm. There is a lot of data here on all the horses and not much time at the track. So a simplified approach is suggested. Don and I solved thousands of such models with real data and estimated approximation regression equations that only involve four numbers, namely, the amounts bet to win in the total pool and the horse under consideration for a bet, plus the total place or show pool and the place or show bet on the horse under consideration…

Daniel Siegelman of Fortune magazine wrote a short blurb about the Dr Z place and show betting system. He referred to it as the 2 minute sprint and had a lovely cartoon as shown below.

In the book Beat the Racetrack (1984 original version and the 1987 updated version), we did calculations concerning how many people could play the system optimally before the edge was taken out. Related to that and consistent with the 2 minute sprint idea is the idea to be rely and grab the edge before others can get it. Of course, in doing this you cannot over bet and we recommend that the bet be at the most full Kelly which in the one-dimensional case is the edge divided by the odds. These books also discuss the effect of differing track takes and all the features were put into a handheld calculator…

Beat the Racetrack attracted a lot of attention as it was purely based on mispricings. Because of this work, Jeff Yass, the main partner of Susquehanna in Philadelphia contacted me in 1987. Jeff was one of five partners, all about 28 years old who were friends at The State University of New York at Binghamton. They were betting racetrack pick 6’s, etc., successfully and moved to Philadelphia to start a firm market making on the Philadelphia stock exchange. This exchange is known as the home of bandits who nickel and dime on trades to generate fortunes. Jeff’s group were clever and hired young smart non-finance students from elite schools in the northeast and trained them to be market makers. They preferred students from philosophy, political science, etc., rather than finance graduates who might be corrupted by efficient market theory. The idea was to make those nickels and dimes and quarters by selling high at the offer and buying low at the bid in various markets. This was a good business…

The phone rang. Keizo Nagatani, a University of British Columbia colleague from the economics department called asking if I would be interested in going to Japan. Keizo, from Japan himself, had contact with Tsukuba University, one of the national universities and in the city where all the major Japanese manufacturing firms had research facilities. Yamaichi Securities, the fourth biggest Japanese brokerage firm and sixth biggest in the world had given the university money to support five visiting finance professors over the next 5 years. I had a chance to be the first…

The crash model prediction project worked well. There was no US literature on the topic, just data on crashes. In looking at the 1987 stock market crash, I quickly came up with the bond–stock earnings yield model (BSEYD). The idea is simple: bonds and stocks compete for the money. When interest rates are high, the money goes to bonds and when they are low it goes to stocks. Of course, no simple or even complex model works all the time, but I have found over the years 1948–2016 that this BSEYD model is very useful for at least two things. First, it is very good at predicting stock market crashes. Secondly, it is good at indicating when to be in and when to be out of the stock market for long-term investors…

Arbitrage is when you construct a sure bet so that no matter the outcome, you either break even or turn a profit. Most observers say that arbitrage does not exist but actually it does in many instances because there are different financial markets for the same sports betting or financial security situation. This is because different people have different sets of information and beliefs. Lets take the simplest case: either A or B wins. Let, O_ah be the British odds given on the event that A wins from betting source h and O_bi that for B winning from betting source i. With these UK odds, the odds are the total return per 1 unit bet. In comparison, US odds are UK odds −1 and their payoffs are US odds +1 = UK odds…

The world’s most famous and successful race track better has been Bill Benter. Bill, like many successful hedge fund and other traders such as Ed Thorp, Blair Hull, Harry McPike and Bill Gross, started out their mathematics of gambling careers by becoming professional blackjack players. This training, involving fast-moving market play, taught them about risk and return and the preservation of capital and its growth over time…

It was the fall of 1989 and we had just returned to Vancouver from Japan. The phone rang with a call from the Frank Russell Corporation in Tacoma, Washington about helping them with a financial planning model for Yasuda Kasai, a major Japanese insurance company. Russell was run by George Russell, the son of Frank and George had turned the business into a tremendous consulting operation. The basic business had just 40 clients such as IBM, Shell and the like but they all had huge company pensions. What Russell did was to recommend to those companies organizations to manage their monies for a small percentage fee. But the size was huge so this was very profitable. Other businesses included running their own portfolios and some specific projects. One of the latter was the model for Yasuda Kasai. They had worked on this for 9 months with little success…

The anomalies work was excellent. Russell had sharp well-trained MBA level people from the top schools like the University of Chicago but none were at my level of creativity and knowledge so I had many people wanting to work with me. Russell had very good data sources and the people there were skilled at the computer and statistical work needed to carry out good applied investment studies. What they needed was research creativity and how to generate good applied investment papers and get them published. I could supply that…

The Russell–Yasuda Kasai model was a great success and it was wonderful to implement a very good asset-liability planning model. After this model was implemented in 1991 and we won second prize in the Edelmann practice of management science contest in 1993, I kept on this line of research. In 1995, there was a 6 month workshop at the Isaac Newton Institute at the University of Cambridge. The facility is beautifully laid out with open spaces for research contact. These programs were very prestigious and people like Stephen Hawking were involved in other similar programs. Ours was called financial mathematics and the organizers invited me to put together 2 weeks of the program. They had known me from a workshop I was involved with in 1993 organized by Paul Wilmott and Sam Howison of Oxford University and Frank Kelly of the University of Cambridge. That earlier workshop led to a special issue of the Philosophical Transactions of the Royal Society in London. I wrote a paper on calendar anomalies with my Frank Russell colleague Chris Hensel…

Sometimes new research comes from unusual encounters.

In the winter term of 2005, I was a visiting professor at the MIT Sloan School of Management. I had always wanted to teach at MIT, ever since as a UMass chemical engineering student, we took a trip there. As I walked down the corridor every book I was using was a name on a door. On this visit, I taught a course in investment management, the second term of a year long sequence for engineering, robotics and other non-finance majors, largely PhD students who wanted to learn about investments. The first term term was taught by Andy Lo who arranged to provide me with his notes from the previous time he taught the second semester. I was thrilled to teach at MIT and put more effort into that course than any other I have taught in a long time. MIT has very good terms for visitors, basically they are paid half that of the regular professors, this argues that research and administration count half and teaching the other half. In the course I had three parts: my slides on practical investments, Lo’s notes and the text book by Bodie, Kane and Marcus (2005). My TA was helpful and I packed in a lot of material in each lecture. I expected top future stars to challenge me in the lectures but that never happened. In the midterm exam, I had a mixture of the book’s test problems and used their answers which were multiple choice, Lo’s notes and my lecture material. According to the book, there was one unique correct answer. Unfortunately, some of the students argued with the TA that some of their other answers were also correct. Being a visitor I deferred to my TA who was a PhD student, sticking to the one correct answer. I learned that the students were of two types: (1) those who loved the course and my teaching and were keen on learning several of whom went to hedge funds or Goldman Sachs or similar firms and I helped them with that transition; and (2) the other group who were worried about getting a top grade and were threatened given that we were strict on the midterm, so they marked me down in the ratings which I never looked at (according to my wife who looked at them). It was UBC basic statistics all over again: students uninterested but stronger students. All the MIT students had distinguished records coming into that great university so their fear of not being at the top is understandable. A couple years later, John Cox the MIT finance chair called me about teaching again. I had been very social and took all the seminar speakers to lunch and had been a good visitor colleague. Unfortunately, for John and me, a dean blocked the visit after consulting the ratings: one third terrific and two thirds luke-warm or worse, killed the idea…

What makes futures and other hedge funds and bank trading departments fail? The common ingredient is over betting and not being diversified in some bad scenarios that can lead to disaster. Once troubles arise, it is difficult to take the necessary actions that eliminate the problem. Moreover, many hedge fund operators tend not to make decisions to minimize losses but rather tend to bet more doubling up hoping to exit the problem with a profit. Incentives, including large fees on gains and minimal penalties for losses, push managers into such risky and reckless behavior. I discuss some specific ways losses occur. To illustrate, I discuss the specific cases of Longterm capital management (LTCM), Niederhoffer’s hedge fund, Amaranth and Société Genéralé and list some other similar disasters. In some cases, the failures lead to contagion in other hedge funds and financial institutions. I also list other hedge fund and bank trading failures with brief comments on them.

It was 1995 and the phone rang. Two colleagues were in Las Vegas and wanted to come up to Vancouver to see me. They had their own airplane — always a good sign. They were working in Nassau with one of them living in South Florida close by. They were looking for professors knowledgeable in the mathematics of gambling who wanted to work with them. Apparently others were not interested but I immediately was. They were already successful using trend following techniques and were looking for ways to improve their investment performance…

The US stock market had a big run from 1995 to 1999. The low interest rate policy of Fed chief Alan Greenspan with the attendant the so-called Greenspan put helped feed the rally. That put was the belief that if the stock market declined, Greenspan would initiate policies to prop it back up. In 2016, there seemed to be a Yellen put with very different, virtually zero interest rates. The January 1995 S&P500 as 470.42 with a price earnings ratio of 17.10, a long 30-year bond had a high 8.02% and an earnings yield of 5.85% so the BSEYD model was at 2.17, well below the 3.00 needed to be in the danger zone. By April 1999 the S&P500 had ballooned to 1335.18, a tripling of its value. The long bond had dropped by the Greenspan policies to 5.82%. The BSEYD was then just into the danger zone at 3.03. So the stage was set for a crash. The internet crash was on. Stocks with no earnings were trading with huge market values. Naive professors were trying to use faulty models to justify the high prices. So, unfortunately, their conclusion was disproved when the internet crash occurred…

President George W Bush pushed the case that all Americans should own their own homes. A low interest rate policy of Fed Chair Alan Greenspan fueled a bond rally with the rates declining from the mid-1990s through to the 2005/2006 peak in real estate prices. Real estate in the US overall has had its ups and downs since the 1700s. However, since the 1940s, the overall US real estate has increased dramatically and the latter part was up each year. The real estate rise in the period up to 2005 was very large and made people feel that the only direction for future real estate prices was up. Many were burned in the 2000–2002 stock market decline so went to a new asset class namely real estate…

In the fall of 2014, I was visiting the London School of Economics, which I do once or twice a year for a month or so. Besides having great resident academics they have an extraordinary strong connection to the very sophisticated London financial and political world. This combination is the best of all the universities I have visited. Though I have had extraordinary experiences at other universities as well, a few are standouts: Chicago Booth has the best research atmosphere, Berkeley and Stanford are the most pleasant, MIT has its fame but brutal weather and Oxford students were the best. Possibly the best single class was at the University of Zurich in 2003 where I had 10 really top students from across the country including the neighboring powerhouse ETH in an asset-liability management course…

Sandra and I have long had an interest in Greece. Sandra’s Greek connection started with her 1964 year at the Centre of Economic Planning and Research. Her undergraduate and later PhD advisor, Roy Radner was involved with Andreas Papandreou, head of the centre, from an important family (at the time Sandra was there his father was prime minister, later he became prime minister as did his son). Through this connection, Sandra had a fellowship at the centre for academic year 1964/1965 following graduation from Berkeley with honors in Economics. In 1970, she toured me around Greece and I too became enamored with the country…

The following sections are included:

• Predictable Crashes versus Those that are Surprises
• Some Background on Crash Measures
• Declines and Crashes not Predicted by the Measures
• The Mini Crash, January 1 to February 12, 2016
• Brexit Vote, June 23 to June 28, 2016
• The Trump Election Risk, October 24 to November 10, 2016
• Notes

Throughout history there have been countless ponzi and other swindles to cheat people out of their money. Sometimes the perpeturators get away with it for a long time or are never caught and exposed. Other times they are found out, disgraced and once in a while put into prison. Misinformation and false claims are at the heart of many of these swindles. The greed of the investors fuels the greed of the swindler. Low penalties for such activities make it easier for these swindlers to operate. These low penalties are all over the place in today’s financial markets and are a major reason for the blowouts in hedge funds and bank trading departments. Since the 2007/2009 financial market crisis there has been some progress in revamping the rewards and penalties for losses in financial markets but much remains to be done…

When I arrived in Vancouver in 1968, my salary at UBC, which was all my income, was C$12,000 per year less the taxes. Rochester offered more as did Northwestern in the US$13K range. In the first year I rented a house with a French psychiatrist, Pierre Flor Henry. The rent was $250/month or $125 each for a house that was way up Prospect Road in North Vancouver. The house we shared was a nice one and you could only see one house nearby with all the trees and shrubbery. At that time the lot next door was selling for $13,000, about the same as my salary. Lots at Whistler, the ski resort which was just opening up were $2,500 with $250 down and 3% interest. In those early days salaries were low but prices were too. A few of my colleagues bought houses in nice view areas near the university in the $30,000 area. Those houses in 2017 are worth about $3 million or more, a rise of more than 100 times in 48 years…

My first foray into racing was somewhat accidental, and at the low end. Not a good combination for any investment! Things started off beautifully, however. In September 2005, I was invited to speak to the management at one of America’s great classic racetracks, Keeneland. It is a beautiful site and I have used their library for research on several occasions. I spent 3 hours covering key issues facing the industry in the US, including rebating, betting exchanges and demand elasticity. I felt that the talk gave senior management plenty of food for thought, and a lively discussion ensued…

I end this book with pleasant memories of the opportunities I had, through the academic lifestyle helped by sabbaticals and summer breaks, NSERC and my own initiative to visit and make friends with people all over the world. This continues to the present day…

The following sections are included:

• Epilog
• Bibliography
• Index