Thursday, November 12, 2015

Instant Gratification in Poker and Investing

Poker and investing are similar activities.  Each a game of skill, where the end result doesn't necessarily reflect how well the game was played in the short term, but long term results are heavily influenced by constantly playing hands that offer positive expected value.  In the short term, randomness plays an important and unavoidable role; in the long term, those vagaries flesh themselves out.

Poker player, value investor, and Seeking Alpha contributor, Bram de Haas participated in a brief Seeking Alpha Q&A session that highlighted many of the similarities.  de Haas discusses that "one difference is that a hand of poker is settled in a matter of minutes or seconds . . . " while an investment can take years to come to fruition.  Timeframe is a factor that needs to be considered with the investor that the poker shark can ignore.  He further notes that he is less prone to judge his investments by their outcome as opposed to analyzing his application of value investment theories in reaching an investment decision.  His goal, it seems, is mastery of the approach; the results will take care of themselves.  His methods may need some tweaking every now and again, but he won't change course on a whim.  Lessons derived from the RESULTS of an individual poker hand or an investment are meaningless. 

Say, for example, in a hand of Texas Hold 'em, you hold a pair of kings, you push all of your chips in, then you get rivered (beaten by the last card flipped) by a long shot flush.  Are you going to conclude, "Man, pocket kings just don't work for me, so I'm going to avoid playing them from now on"? Of course not.  What if your investment in a mining company has a low price relative to its book value and earnings, revenues are increasing, and costs are decreasing, but then the commodity that the company mines falls out of favor globally and the company files for reorganization because it ceases to make money.  Are you going to stop investing in low p/b and p/e stocks with increasing revenues and decreasing COGS?  Probably not. 

However, people make this jump and draw these types of ridiculous conclusions in both the game of poker and the investing world.  They have to.  Both are zero sum games.  At a poker table of 6, where everyone buys in for $100, the total pot is $600.  At the end of the night (barring re-buys), there is $600 still on the table, just distributed differently.  Maybe Ron had a good night and is walking out with $300; maybe Wally, who seems to always come out ahead, walks out with $140.  Maybe the other four players lose $40 each, but the cumulative total hasn't changed.  The same occurs in the financial markets.  Maybe Bill Ackman's Pershing Square loses $50 million on some investment that he went short on.  Well, whoever (whether a single investor or multiple) took the other side of the bet and went long on the same investment is now, cumulatively, $50 million richer. 

Numerous books have discussed the concept of how fund managers (and, investors in general), in aggregate, can not beat the overall market.  Vanguard founder John Bogle in "John Bogle on Investing:  The First 50 Years" uses the same logic to promote investing in index funds.  His point is that a low cost index fund will very nearly match the index it seeks to mirror, with only the minimal cost to run the fund as the difference.  On the other hand, actively managed mutual funds have higher costs for marketing, management, and transactions, which sap overall investor returns.  By the nature of the industry, fund managers can not, on average, do better than the overall market.  Some may beat it, some may not, but on average, they MUST lose.  ALL funds need to deduct the cost of managing a fund.  So if the fund matches the market, the net return will be less than the market due to fund costs.

Back to poker.  Let's say, you want to impress your friends so you hire a dealer for the night.  He is paid a certain fee out of each hand dealt - maybe $0.50 per hand.  Over the course of the night, maybe 100 hands are played; the dealer is paid $50.  Now, instead of $600 on the table to be split among the participants, only $50 is left.  On average, an average player MUST lose money.  The expected value of all the wins and losses at the end of the night is no longer zero - it's negative! 

The only winners, on average then, are the dealer and the fund manager, who both collect fees from the participants.  So, why do we play? 

It would be easy to say that poker and investing are both crapshoots - it's the luck of the draw where winners and losers are determined solely by randomness.  But Warren Buffett would argue otherwise:
"I submit to you that there are ways of defining an origin other than geography. In addition to geographical origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village." 
So would Mike McDermott:
"Why do you think the same five guys make it to the final table of the World Series of Poker EVERY YEAR? What, are they the luckiest guys in Las Vegas?"
Ok, so a fiction story of Matt Damon taking KGB for tens of thousands of dollars might not be the best reference, but the fact remains that there are successful poker players who win consistently.  And there are investors who beat the average market consistently.  We see this and think we can do it, as well.  That's why we play the game.  But, what's the secret as to why your buddy Wally usually wins at poker and Buffett usually wins at stocks?

Well, since we can't rely on each individual event to provide accurate feedback, the goal needs to be to play the odds like an actuary and play the numbers like this guy just did.  We need to maintain a long term outlook and apply principles that have been proven effective historically.  Lucky for us, we have large amounts of data and powerful computers that can retrieve and assess historical information, providing valuable insight to methods that work.  Wally knows that maximizing profit by having the discipline to play only the best pairs of dealt cards is a superior strategy at the card table.  Just as Mr. Buffett knows the value investing techniques of Ben Graham and his disciples will provide above average returns in investing.

de Haas states:
"You have to study theory, know your fundamentals and approach each problem with those tools."
It's too easy to become discouraged when faced with unexpected, unwanted events - a cold streak at the poker table, an investment gone bad, a rejection letter from an applied-to college, getting laid off from a job - and we change our way of going about our business; we revise the rules we play by on the fly.  It's human nature and we need to fight that reactivity by setting ourselves up properly, mentally and emotionally, for when we encounter those events.  Mentally, we need to have the proper foundation of knowledge in our field to recognize the path that most likely offers the advantageous outcome.  Emotionally, we need to be aware of our cognitive biases and perceive when they are at work.

The thing to keep in mind is to maintain the discipline to stick with the fundamental theories that have been proven over the course of history to create the best opportunities for success in your chosen field.  We, as a society, rely too heavily on instant gratification in our endeavors.  We turn on the TV and listen to the pundits when it has been proven that experts are really no better than the average Joe at predicting future events.  On an individual basis, events may not go your way, but if you play the odds correctly with patience, discipline, and proper preparation, you should come out on top. 

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