Friday, September 14, 2007

Poker and Investing

Sand105 posted an interesting essay on the similarities between poker and investing on the Motley Fool message boards. Here is part of it:
So how are poker and investing similar and dissimilar?
Similarities:1. Most importantly, both games involve incomplete information and randomness. The skill sets developed in one apply directly over to the other. Developing a logic train, calculating odds, and accurately inferring conclusions from incomplete information are exactly what is needed to be successful in both.
2. Both are beatable over the long term. Poker is equivalent to playing one game of chess along with a couple die rolls. Over the short term the die rolls rule – over the long term the chess matches determine the expectation. Equity investing is essentially the same.
3. Both have inherent costs. Poker has rake (5% of each pot, give or take), investing has transaction and frictional costs.
4. Both see black swans occur. No matter the skill set, sometimes the incredibly unusual occurs. Knowing how to recover from these setbacks is a very valuable skill set.
1. By its nature, poker is a negative expectation game if no players are better than one another (due to the rake). Investing naturally has a long term ~10% positive tilt due to the nature of the markets.
2. The inherent costs in investing are lower. As long as the investor doesn’t have huge turnover, transaction costs and frictional costs are well under the cost of rake in poker.
3. More often than not, choosing to do nothing in investing is the right choice. Poker typically requires more risk taking events.
4. The variance in investing is lower than poker. For every $1 I have made in poker over the long haul there has been a ~$10 standard deviation in those results (i.e. for every $1 there is a 67% chance my result will actually be from -$4 to $6 and a 95% chance it will actually be from -$9 to $11.) This type of variance isn’t typical of the equity markets.
5. In poker, to win in the long term a player simply tries to ride out the variance. An investor, however, can use variance to their benefit. BMW has talked about this extensively. Figuring out to what price an equity is likely to jog down to in the short term can greatly juice overall returns.
Lessons Learned:
As a person who has played over 1,000,000 hands of poker in the last few years and been involved in the markets for 15+ years, there are some things that I have learned that I hope folks will find useful.Pretty much in the order I think they are important, these are lessons I think provide for success in both poker and equity investing:
1. Emotional control. Yep, after all the talk about logic trains and odds, I firmly believe emotional control has the most effect on long term results. This is multifaceted. The primary emotion one needs to regulate is tilt (“fear”). Selling in panic is very, very often the exact wrong thing to do. Yet even very experienced investors have it happen. It can’t be stomped out completely – however minimizing it will do wonders for an investor’s return. On the flip side of the coin boredom can be almost as damaging. Playing a hand one shouldn’t or making a trade just because you haven’t had anything enticing float by in a while is usually a mistake. Coincidentally, Whatismyoption has just posted an excellent thread on this subject:
2. Recognize that once you buy and equity or put your money into the pot, that money should be treated as if it is no longer yours (in poker it actually is no longer yours). Most people base decisions on selling an equity based on whether or not it has been performing for them. This is wrong! It doesn’t matter if the equity has lost a bunch or gained a bunch since ownership – it is the prospects for the future, the odds that one will see a rise from that price point, that count. In a game sense, when you buy an equity you give your money to Mr. Market. He then takes it and walks around with it – you have no direct control over that walk at all. You are simply betting on the overall direction of his travels. All decisions should be based on that premise. Since most investors feel the loss of money as near physical pain (lots of studies out there on investor psychology), they watch their returns like a hawk and decide to sell based on past performance. Sell decisions should be based on changes in how speculative a stock is, changes in fundamentals, tax loss harvesting, finding a better opportunity, etc. Price by itself, and your buy point relative to that price, is irrelevant.
3. Recognition of high probability situations. Dhandho, in other words. Figure out how to get your money into play with a 60-40 advantage over and over and riches will follow. In investing there are choices every day to hold, buy or sell. Most of the time this will be to hold, but when the high probability situations roll by, grab on and get a piece.
4. The corollary to #3. Don’t bet unless you have lopsided odds. Taking those 51-49 bets, though positive, leads to very high variance. Leave that to the institutional investor who has the bankroll to spread those bets around in enough places to get to the long term. Most individual investors will never get there.
5. Playing games, chess, poker, etc keep the mind agile and greatly assist in both business and investing. Mental cross training. Learning emotional control. Recognizing that both poker, investing, business, and other difficult-but-satisfying-activities are lifelong pursuits and ones in which there is always something new to learn and improvements to be made.

I have found that poker (online Texas no-limit hold'em), stock trading, and sleep medicine are very similar- all three involve long hours staring at a computer screen.
Stock trading and interpreting a sleep study both involve looking at sometimes ambiguous sinusoidal data and trying to interpret the pattern. Online poker and sleep medicine both involve looking at flickering lights/constantly changing patterns on a screen.









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Jordan said...

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