Legendary quant Ed Thorp once wrote about his "45-year effort to ... beat markets" and shared his 'three steps for a successful market-beating model.' Thorp used examples from blackjack, convertible bond arbitrage, and statistical arbitrage. "In each of our three examples, the market was inefficient, and the inefficiency or mispricing tended to diminish somewhat, but gradually over many years. Competition tends to drive down returns, so continuous research and development is advisable." The paper is a fascinating look into his mindset. Three steps to building a model: First: "The key idea or “inspiration” – the domain of the visionaries." "Where do the ideas come from? Mine come from sitting and thinking, academic journals, general and financial reading, networking, and discussions with other people." Second: "Develop and refine the idea via quantitative and technical work ... the development of the idea into a model that can be tested in the real world – the domain of the quants." Third and last step: "Real world verification – the domain of the entrepreneurs." Steps: (1) idea (2) development, (3) successful real world implementation. Skills: (1) visionary (2) quantitative, (3) entrepreneurial. On markets and gambling: "I had never gambled in a casino. I avoided negative expectation games. ... But in the game as played, successive rounds are dealt from a more and more depleted pack of cards. To me, this “sampling without replacement”, or “dependence of trials”, meant that the usual proofs that you couldn’t beat the game did not apply. The game might be beatable." "The “gambling market” was, in finance theory language, inefficient (i.e. beatable); if that was so, why not the more complex financial markets?" On sizing bets: Thorpe used the Kelly criterion but modified it and slowly scaled up his bet size "to verify all was as expected (possible cheating?) and that I got used to handling that amount of money." "The idea, which has been valuable ever after, was to limit my bet size to a level at which I was comfortable and at which I could tolerate a really bad outcome." On sizing in investing: "Like gambling games, the magnitude of your bets should increase with expectation and decrease with risk. Further, one needs reserves to protect against extreme moves. For the long-term compounder, the Kelly criterion handles the problem of allocating capital to favorable situations. It shows that consistent overbetting eventually leads to ruin." On risk: "There were two principal aspects: local risk versus global risk (or micro versus macro; or diffusion versus jump). Local risk dealt with “normal” fluctuations in prices, whereas global risk meant sudden large or even catastrophic jumps in prices." "Two questions about risk which I try to answer when considering or reviewing any investment are: “What are the factor exposures”, and “What are the risks from extreme events?”."