This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
One day during my hedge fund years, my boss suggested that we should play some poker. He didn't suggest it because playing poker was fun. Rather, he suggested it because he believed that playing poker would hone our investing skills.
There are so many parallels between investing and poker that many good investors are good poker players and vice versa. One very famous hedge fund manager named David Einhorn even managed to rank 18th in the 2006 World Series of Poker.
So what exactly are the similarities between Poker and Investing? In this article, I'll highlight 5 aspects.
1. Game of Chance
Playing poker requires a mix of science and art, and the science part is all about statistics.
Having a better hand than the other person definitely tilts the odds in your favour, but there's always a chance that the better hand will lose if unfavourable cards come up later. This means that unfortunately, you can play your hand perfectly and still lose. On the other hand, you can play your hand wrong and still win quite often. But over time, playing your hands wrongly will likely end up losing you money.
Because the results don't necessarily tell you whether you played your hand correctly or not, analyzing your mistakes becomes difficult. On the one hand, you could reflect on a loss and conclude that you did something wrong when you in fact didn't do anything wrong, and change your playing style for the worse. On the other hand, you could reflect on a loss and conclude that you just had bad luck when in fact, you were making some mistakes.
Like poker, investing is also a game of probabilities and it comes with the same pitfalls. You can research a company thoroughly and make the correct decision to invest, but unforeseen events (e.g. employee commits fraud) can happen and cause you to lose money. This is why no investor, not even the great ones, have a 100% record when it comes to picking stocks.
However, for many people, the mistake lies in not doing enough research. When bad investors make money on a stock, they tend to attribute their success to their stock picking skills. However, when losses happen, they have the tendency to blame their losses on luck, just like losers at a poker table.
Like poker, investing is a game you play against other people. Whenever you buy a stock, you are buying from someone who thinks it's better to sell. Buying stock without better research than the seller is like playing poker with the odds against you.
2. Importance of Bankroll Management
Good poker players know that playing poker well isn't just about playing each individual hand well. It's also about making sure that bad luck doesn't wipe out your whole portfolio. This is known as bankroll management.
Because poker is a game of chance, committing too much money on even a high probability hand can backfire. For example, even if you calculate that you have a 75% chance of winning a hand, going all in with the hand means you have a 25% chance of losing everything. Thus, a good poker player seldom goes all in, even when the odds are in their favour.
The same principle works for investing, and it's the reason why investors should diversify their portfolios. Even if a stock that has a 90% chance of generating high returns, if the stock has a 10% chance of going to 0, committing all your money into the stock becomes a risky proposition.
In poker, because you often don't know the other players' hands, it's hard to calculate the exact probability of winning. Investing has a similar problem, but worse. Whereas there are a finite set of hands that other players could hold that could hurt your chances, there are a lot more things that you never thought about that could hurt your stocks.
Since you don't know the exactly probability of losing money on an investment, it's best to diversify your portfolio, even if you feel certain that a particular stock will do well.
3. 'Rakes'
If you play poker online or at a casino, you have to pay the venue a small portion of your bet every time you play. This fee is called the 'rake'. Even though the rake is small (typically less than 5%), seasoned players know that rakes can really add up over the long run.
The presence of rake has importance consequences on the way poker players play. Let me illustrate using an example.
Let's suppose that you're playing a hand of poker, and you have to pay $5.5 to continue. You believe that if you do, you have a 30% chance of winning a $20 pot. Without a rake, the expected outcome of making this bet is $20 x 30% = $6, which is more than the $5.5 you have to pay to continue. In this case, you might decide to make that bet.
However, let's imagine that the venue charges a rake of 5%, and let's imagine that you plan on paying an extra $1 tip to the dealer on a win (because it seems polite to do so). In this case, your expected outcome is ($20 - $1) x 95% x 30% = $5.4. Unless you don't plan on tipping that dealer, you shouldn't proceed with that bet. In conclusion, you should play less hands in the presence of a rake.
The same goes for financial markets. You can almost think of stock exchanges as giant casinos, with brokers being casino operators. Even though trading fees are typically small, they can really add up over the long run.
To give you an idea, many day traders trade in and out of stocks every day. If we assume that each trade only costs $10, and if we assume that the day trader trades twice a day (once to buy, once to sell) every day, the trader's bill would amount to roughly $5,000 a year. If the trader works with $50,000, trading fees would represent 10% of his portfolio.
Much like playing too many hands of poker, frequently trading in and out handicaps the investor from getting higher returns. It's better to sit out of investing altogether until more compelling opportunities knock on the door.
4. Emotions Play A Part
All poker players have heard of a phenomenon called 'tilt'.
Poker requires a lot of patience and concentration, and maintaining the discipline can be frustrating. Good hands often become losing hands due to the wrong cards showing up, and it can often take a long time until you get the next set of good hands.
Most players usually start off with good discipline. However as the night wears on, particularly if things don't go their way, they start to lose the discipline. They start to play hands they shouldn't, betting more money than they shouldn't, usually crashing and burning soon after. This state of having lost discipline is called being on 'tilt'.
Because investing is also a game of chance involving money, investors are also susceptible to their own emotions, albeit in a different way. When their investments go up, they often become bold and overconfident, and they start to make wrong decisions in the form of risking more money. When their investments go down, they become fearful and they make the mistake of pulling money out, when in fact the lower price makes their investments a more attractive proposition.
5. The Majority Lose Money
While poker is a game of chance, it is also a game of skill. A player who masters statistics, bankroll management, maintains her discipline and correctly reads other people will almost always come out ahead in the long run. On the other hand, anyone who is deficient in even one of these areas will struggle.
Studies have shown that only a small percentage of players consistently make profit from playing poker. For example, a study quoted by ESPN estimates that only 10 to 12% of players make profit, implying that the rest of the 90% of players consistently lose. The reason why so few people make money is due to 2 things - rake, and the fact that good players play more.
We've already talked about rake, so let me talk about the second factor. Human beings have a tendency to keep doing what they're good at, and to stop doing what they're bad at. This applies to poker where good players tend to play more hands. Let me illustrate this significance using an example.
Let's say that in a given year, 10 people play 100 hands of poker. One of these people is better than all the rest. In the first month, the good player plays against one of the other players. The good player consistently wins against the other player, and the other player leaves in frustration. In the second month, a new player plays against the good player. Again, the good player wins consistently against the other player and the other player leaves in frustration. In the next month, a new player joins in, etc. Because bad players quit and good players keep on playing, the good player makes outsized profits compared to the vast majority of other players.
Investing is the same way. Because it's also a game of skill, studies have shown that only a very small percentage of investors consistently generate above market returns, dooming the rest of investors to below market returns. Those who win consistently tend to be professionals like Warren Buffett who have mastered all aspects of investing much better than the average investor.
If you're a novice or even an intermediate level investor, it's far better to invest in index funds or ETFs than to pick individual stocks because by picking individual stocks, you're competing against professionals.
So there you have it. These are the 5 big similarities between poker and investing. If you're new to investing and want to learn the basics quickly, I invite you to check out our free book.
This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
