Poker and Investing: Two Roads to Profit
Corwin R. Cole, a.k.a. [vital]Myth
Why should Investing Interest You?
As poker players, we dedicate our time and effort to the goal of making money, just like most people in the workplace. Fortunately, we get the added bonus of having fun doing it. At its essence, investing in financial securities is pretty much the same: we wager our investments based on the knowledge we possess, with the intent to gain profit. And in my opinion, this is as exhilarating as limp-reraising AA on the final-table bubble of a big tournament.
In many respects, investing is just as much a game as poker, and it has the same fundamental objective: to make correct decisions showing long-term profit. So if you love poker, it should be right up your alley. There are also other significant benefits to investing. With some of your money tucked away in stocks, bonds, and the like, nice tax breaks are bestowed upon you. Your portfolio also serves as a pseudo “backup bankroll” that you can’t lose on the tables. That’s a nice cushion to have if poker is your primary source of income.
Similarities: It’s All Betting
Besides the objectively positive aspects of investing, some of the similarities between it and poker make it attractive to people like us. Decisions made at the poker table are bets that your hand is less likely to occur (that is, it’s stronger) than your opponent’s. Similarly, investments are wagers that your chosen securities will increase in value (except in short positions, but I won’t get into that). From the strategic standpoint, all you can do as a poker player is to make the most well-informed decisions possible, based on the information available. For an investor, it’s all the same.
When I make a read that my opponent is a weak player and he is showing abnormal strength on a monotone flop, and I decide to let go of my bottom set facing an all-in overbet as the pot lays me just shy of 2:1, I’m combining all the information I have to form the most logical conclusion. Sometimes my assessment of the situation is wrong, and he just has overcards with the ace of the suit on board. That’s just poker. In the same light, when I study a company and discover large free cash flows, high-quality debt, strong growth figures and the potential for significant gains in market share, I’m just using all the data I can gather to conclude that the company’s stock will rise in value. Sometimes my evaluation is wrong, and the stock was already overvalued and can’t fairly grow. That’s just the market.
These two profit-based endeavors have similar underlying theories as well. Poker is a game of incomplete information. I can never know exactly what my opponent holds, so I can rarely calculate with absolute certainty the value of any decision I make. Regardless, if I develop a feel for it and use my logic, I can approximate the value of my decisions fairly well. Investing is a similar game. No matter how many financial and income statements, balance sheets, and earnings reports I read, I can never know for certain that the supply-and-demand profile of a company is conducive to sustained growth, or that the economy will support its growth at all. But if I study the markets, recall my micro- and macroeconomics, and research a corporation’s current value, then I can make educated (and hopefully somewhat accurate) predictions of its future value.
Differences: Sources of Value, Costs to Overcome
Despite the similar decision-making inputs and objectives in poker and investing, success does not have the same source in both. In poker, the origin of the value I gain is clear: when my opponents make mistakes, I win and they lose. This is just a loose verbal statement of Sklansky’s Fundamental Theorem. But in investing, value can take many forms. Long-term investments, especially in fixed-income assets, can realize gains simply due to general economic prosperity. Short-term trades often have value stemming from market mispricing and/or overreaction to news events. Ultra short-term investments (mainly various forms of arbitrage) have value tied intrinsically to market and quotation inefficiencies. And overlying all types of investments is the general idea that social behavior in the markets is, to a degree, predictable, and this allows the predictor to realize profits. Sometimes it’s not clear what kind of value we hope to gain from a given investment, and it’s never clear exactly how likely we are to make the right bet. In poker, you can count your outs and do some arithmetic to determine exactly how likely you are to win the hand. Investors have no such luxury. The market determines prices in most cases, and the market, like a mob, can – and often will – do whatever it wants.
Furthermore, poker players have only one simple cost to beat when playing – the rake. And it sits right there next to the dealer, completely transparent and always the same. Unfortunately, investors have some more complicated and severe costs to fight. First, the act of trading has a fee, which varies depending on the brokerage service employed. Next, investments in funds (the most common type for less-savvy investors) often have commission fees and tons of other technical fees attached to them as well. As investments get more exotic, further fees and losses due to market technicalities can occur as well, such as in credit default swaps, short debt positions, and anything with a large bid/ask spread.
Applying Your Poker Skills
Still, there is significant potential for poker players to succeed in financial markets. One of the simplest principles of winning poker is to selectively choose hands with a high probability of showing down the greatest strength. This applies directly to investing: it is fundamental to invest in securities likely to gain value. Another simple poker precept is to overcome variance by playing large amounts of hands. The investor’s analog is diversification, investing in an array of securities so that any single loss is not a large one. Next, poker stresses bankroll management and general dedication and discipline. Investment requires the same things. Some investment methods entail a reasonable risk of catastrophe, while others are essentially risk-free (such as U.S. Treasury Bonds held to maturity). To play correct poker, you can’t sit with your whole bankroll on the table, and to be properly invested, you can’t dedicate your whole portfolio to high-risk assets. To realize success in poker and move up limits, you must be an active player and continually improve your game, always maintaining everything you’ve learned along the way. You must be willing to push your edges and play with confidence. Similarly, to realize significant gains in your investments, you’ve got to carry with you all the knowledge you’ve gained from prior trades and studies, and apply it using small pieces of your portfolio. You must actively manage your investments and continue to improve upon your selection methods if you’re going to make real money in financial markets.
Another key concept in poker is to know your opponents. You have to take notes on the people with whom you play, get into their heads, understand what they’re thinking and even know how they view you at the table. Theoretically, if you could play with the same people all the time for the rest of your life, and they remained significantly poorer players, you would always be able to get the most out of your poker sessions because of the completeness of information at your command. You’d be able to make well-timed bluffs and maximal value bets, as well as maintain exactly the image that best suits your game. The same is true with investments: the better you know the securities in which you invest, the more opportunities you can spot for profiting from their movements. If you follow a basket of stocks very closely, and you have a strong feel for their reactions to particular news events and their intra-day swing patterns, as well as the development of the supply and demand of their market, you will be able to make short, intermediate, and long-term trades with a solid success rate. You should take notes on your investments just like you do on your opponents at the poker table. Just as you want to understand how your opponents think on the felt, you want to know how the market thinks about the securities you follow. Ideally, you want to be extremely knowledgeable of a select group of players whom you exceed in skill. Similarly, your goal in portfolio management is to be extremely accurate in predicting movements in a set of securities that you can trade consistently.
Getting Started: What Investment Really Means
So, if you’re going to invest money in financial markets, you’re going to have to start off with a general perspective of your attitude toward risk. If you are planning to invest a significant portion of your current cash, and intend to continually add to your portfolio over the course of your lifetime, hoping eventually to build something with which you can retire, then it should be very important to you not to lose any large chunk of your portfolio. That is, if you want to depend on your investments for retirement, you should steer clear of big risks. On the other hand, if you’re only interested in investing a small portion of the money you have, and you just want to try your best to create a monstrous portfolio from humble beginnings, then your aggressive style is suited to consistently taking real risks with your investments. After all, if this is your approach, then even if your portfolio’s value went to zero, it wouldn’t be a huge hit to your overall financial health.
The more risk-averse you are, the more diversified you should be and the more heavily weighted you should construct your portfolio in fixed-income assets. These are essentially loans (called bonds) that you offer to some institution, such as the United States Treasury, a city, or a corporation. In return, the institution promises to repay the loan over a certain time period, with a given interest rate. Barring a catastrophic occurrence within the institution, if you hold these bonds until the date at which they’re repaid (called maturity), you’re guaranteed to make a profit. Because of the extremely low risk associated with holding bonds to maturity, a portfolio with a significant portion of them necessarily has a negligible probability of decreasing in value to zero. While it’s imperative that a high percentage (60-70%) of a risk-averse portfolio be parked in bonds, that does not mean there’s no place for more aggressive investments. With the other 30-40% left for equities (stocks), there is plenty of room to work in some investments with potentially high-percent returns, though they won’t double or triple you up.
The risk-friendly investor can take many more chances with speculative assets. Micro- and small-cap companies, with innovative products or services and strong business models, might have the potential to become the Wal-Marts, Starbucks, and Microsofts of tomorrow. And if you spot just a few of them at the right time, you’re liable to make a small fortune in your portfolio. The problem is that there is only so much room for titans like the companies above. Not every great-looking small company can become such a financial giant. In fact, very few of them can. So along the way, you’ve got to be prepared to take substantial losses when a good idea just never pans out, or when a great company turns bad, or when a fantastic new product unexpectedly becomes obsolete through the advent of another product. Risk in the financial markets is very real and not to be taken lightly, but if approached correctly and handled appropriately, can bring a good (and lucky) investor great fortunes.
With all of that laid out, there are many options (pun intended) available to the interested investing novice. Just for starters, we have the ubiquitous stocks. There are those types of stock that are most straightforward, representing shares of ownership in a company. Then there are those that are a bit more exotic, such as index tracking stocks and shares of exchange-traded funds (ETFs). These represent shares of equity in an entire index of companies (such as the NASDAQ) or the value of an entire investment fund focused on a particular type of asset, such as gold, China, or oil, respectively. Along with stocks, there are bonds, which I described above. Bonds are heavily traded and represent huge volumes of money in the total financial market, and they take on many different forms, each with their own covenants and unique characteristics. And in a pure form of betting, there is the world of derivatives, or contracts representing bets that have value derived solely from the value of something else. One common type of derivative is a stock option, which is a contract that allows its owner to buy or sell the stock at a specified price on or before a specified date. Note that the contract itself only has value because the stock has value! These instruments I’ve just described are only a cursory introduction to the vast world of investment opportunities available. Not all forms of investment are suited to everyone, and the majority of them are completely unknown to casual investors. But the financial universe is enormous and fascinating!
For professional, aspiring, and purely amateur poker players alike, the prospect of managing a portfolio of financial investments has a lot of merit. In many ways, experience and knowledge about poker can be of great aid in the investment universe. Alongside the common theoretical veins between these two games are some interesting differences that give both their own exciting characters. Investing is clearly a +EV addition to anyone’s life, and with tax benefits and the potential to produce huge gains, as poker players we should all consider doing it some day. If you choose to do so, which I hope you will, begin with an assessment of your risk attitude and some serious studies on the fundamentals. Check out the links below for a good start.
To read more about investing and the types of assets in which you can invest, follow these links:
http://www.aarp.org/money/financial_p...onsix/basic_investing_principles.html - basic investing principles
http://en.wikipedia.org/wiki/Bond_%28finance%29 – all about bonds
http://www.investopedia.com/university/stocks/ - all about stocks
http://personal.fidelity.com/research/etf/content/etf_basics.shtml.cvsr - ETFs and index funds
I would like to thank Thorladen (liquidpoker.net), Dr. Gary R. Evans, Ph.D (Harvey Mudd College), and Joseph Montemayor (Vice Pres., Credit Strategy, Payden & Rygel Investment Counsel) for their input in the composition of this article.