Similarities between Poker and Investing

[ozyman]

Looking to teach a friend who works in the investment management field about poker. What lessons/qualities are common for people who excel in both?

Thanks

[mrbaseball]

patience and discipline

[ngkent]

and big cahones

Both are zero sum games. Therefore you capitalize on other peoples errors in both. Thats all either one is about.

[zerosum]

Investing and poker are inherently probability exercises. IMHO, success in either requires recognition, respect and observation of the following guiding principles.

1. Focus on process versus outcome;
2. Constantly search for favorable odds;
3. Understand the role of time.

[topspin]

[ QUOTE ]
Both are zero sum games. Therefore you capitalize on other peoples errors in both. Thats all either one is about.

[/ QUOTE ]

The stock market is not a zero sum game.

[zerosum]

Quote: "The stock market is not a zero sum game."

On an absolute basis, I agree with your opinion. However, on a risk-adjusted basis, the stock market most certainly is a zero-sum game.

To be sure, one can argue about the means by which risk-adjusted returns should be calculated, and one can argue about the amount of time required to properly measure it. However, I think it is quite reasonable to believe that over a sufficient period of time, levels of risk are appropriately rewarded in the stock market, resulting in a zero-sum condition.

As a note, one should not be fooled by the common financial services industry claim that "value" stocks have outperformed "growth" stocks on a risk-adjusted basis as well as an absolute basis. The finacial services industry likes to claim that investing in "value" stocks delivers the elusive "free lunch."

What the industry does not talk about with its clients is that a growing body of research strongly suggest that the so-called "value" stock advantage is illusory, owing to previously applied pricing models that remove from consideration the financial distress risk of "value" stocks.

The industry also does not mention that the "value" indices it uses to make its "free lunch" claim do not account for the survivorship bias built into the returns. To wit, companies that fail or are on the verge of failure are regularly removed from the index by the vendors who construct and compile the index. Thus, a company suffering increasing financial distress to the point of having highly questionable future prospects is highly likely to be removed from the index. The result is that the index does not reflect the significant, if not total, loss of investment one would have suffered by holding the removed stock.

More can be said on this subject, but I think (and hope) that what I have provided is sufficient to give rise to a reconsideration of opinion.

-- ZeroSum

P.S., On a short-term basis, I agree that the stock market is not a zero-sum game, and my investment returns as well as the history of the selection process I use support my opinion to my satisfaction.

With respect to the absence of a zero-sum condition over the short-term, I believe that valuations do not respond with sufficient speed to information that has implications for longer-term prospects, thereby providing profitable opportunities. This condition, in my estimation, owes to the species beneficial feature of our nature that allows the vast majority of people to believe that they are above-average relative to the total population. In poker, those who hold such beliefs but lack the skill advantage are fondly called "fish." Remember, without fish skilled poker players would starve.

[midas]

The only thing that is common in poker and investing is that you need to put in time to learn each skill set. I think its easier for a good investor to be a good poker player but the reverse is not true.

Investing is much more difficult than poker - too many variables can affect the outcome of an investment and each investment is diffferent.

[adios]

[ QUOTE ]
2. Constantly search for favorable odds;

[/ QUOTE ]

In general how does one go about determining that they have an edge when buying a stock (or selling short if applicable) and how is that edge measured? Generally speaking, to me the way is to determine the fair value of a stock, look at the value the market has placed on the stock, and use the difference between fair value and the value the market is assigning to the stock as the indicator of whether or not you have an edge (realize that price volatility is a consideration). Is there another way?

[tek]

I believe the stock market is zero sum short or long term.

If I buy a stock for 10 and it goes to 12 I make 2. If it thern goes back to 10, the guy who bought it from me loses 2. Of course in between him and I it could fluctuate, but ultimately the trading profit and losses across all the investors who touch the stock will ad up to zero.

Thake options, I write a covered call option. You pay me a premium for the option. The stock goes sideways for two or three weeks. I win your premium and you lose it. Zero sum.

[tek]

I use charts. They aren't foolproof, but they work for me.

[zerosum]

adios,

I agree. It always comes down to your assessment of fair value relative to that assigned by the market.

The search for favorable odds happens when you calculate your perception of fair value. The process inherently requires estimates such as earnings and growth prospects, reasonable risk premium estimates for discount rates, consideration of competiton for the company's products, consideration of the company's industry, viability of product lines, current market penetration realtive to the industry and the estimate of the penetration possible for the industry itself, . . . . You get the pictue; the list of consideratons is very significant and not limited to this brief outline.

When you assign values to the considerations important to your calculation of fair value, you have, whether acknowledged or not, also assigned probability estimates regarding their likely occurrence. The accuracy of your estimates and the accuracy of your probability assignments form the basis of your ability to search for and find favorable odds.

[zerosum]

tek,

In order to contest your position that the stock market is a zero-sum game on an absolute basis, I'm going to extend your example and thereby offer an alternative result.

If you purchased X at 10, sold it at 14, and X then dropped to 12, you will have gained 4 and the purchaser will have lost 2. Your gain is greater than his loss and produces a net positive outcome.

[adios]

[ QUOTE ]
I use charts. They aren't foolproof, but they work for me.

[/ QUOTE ]

Yeah TA is an alternative that I didn't mention. I'm not disparaging TA but I do know that the approach zerosum elaborated on theoretically would work given you can do them well enough.

Not sure about the basis for TA though. In other words as a hypothetical example say that you believe head and shoulders formations gave you an edge. How do you prove that they do?

[Paluka]

[ QUOTE ]

Investing is much more difficult than poker - too many variables can affect the outcome of an investment and each investment is diffferent.

[/ QUOTE ]

You have to be careful to not confuse "more random" with "more difficult".
I think the biggest similarity between poker and investing is the ability of short-term results to convince a losing player he is a bad one. I think there are many "winning" investors who don't have any edge but just haven't reached the long run yet.

[topspin]

[ QUOTE ]
Quote: "The stock market is not a zero sum game."

On an absolute basis, I agree with your opinion. However, on a risk-adjusted basis, the stock market most certainly is a zero-sum game.

[/ QUOTE ]

I think you're confused about either how risk-adjusted returns work or the definition of a zero-sum game. Growth of the underlying company contributing to changes in its intrinsic value is what causes the stock market not to be zero-sum. Risk adjustment is merely a tool for relative pricing of two companies with different volatilities and does nothing to change this fact.

[topspin]

[ QUOTE ]
I believe the stock market is zero sum short or long term.

[...]

Thake options, I write a covered call option. You pay me a premium for the option. The stock goes sideways for two or three weeks. I win your premium and you lose it. Zero sum.

[/ QUOTE ]

Replace "stock" with "derivatives" and your statement is correct.

[zerosum]

[ QUOTE ]
"The stock market is not a zero sum game."
-- topspin

[ QUOTE ]
On an absolute basis, I agree with your opinion. However, on a risk-adjusted basis, the stock market most certainly is a zero-sum game.
-- zerosum

[/ QUOTE ]

[/ QUOTE ]

[ QUOTE ]
I think you're confused about either how risk-adjusted returns work or the definition of a zero-sum game. --topspin

[/ QUOTE ]

I can assure you that I am not confused about either.


[ QUOTE ]
Growth of the underlying company contributing to changes in its intrinsic value is what causes the stock market not to be zero-sum. --topspin

[/ QUOTE ]

I agree. But this position only speaks to whether the stock market is a zero-sum game based on absolute performance. It is silent on whether the stock market is a zero-sum game based on risk-adjusted performance.


[ QUOTE ]
Risk adjustment is merely a tool for relative pricing of two companies with different volatilities and does nothing to change this fact. --topspin

[/ QUOTE ]

Risk adjustment involves more than the consideration of volatility, or at least it should if you want to make better decisions. And risk adjustment is more than a pricing tool. Risk adjustment is more commonly used as a performance evaluation tool.

Risk adjusted performance evaluation normalizes returns across investments relative to the risks realized by the various investments. The process of arbitrage and a competitive, liquid market virtually guarantees that in the long-run the stock market is a zero-sum game on a risk-adjusted basis. Any advantage of return relative to risk is not sustainable long-term, though you may enjoy and exploit it short-term.

[topspin]

[ QUOTE ]
Risk adjustment involves more than the consideration of volatility, or at least it should if you want to make better decisions. And risk adjustment is more than a pricing tool. Risk adjustment is more commonly used as a performance evaluation tool.

[/ QUOTE ]

Perhaps you should be more clear about what "risk-adjusted basis" means to you. The terms you're tossing around all have standard meanings in the finance community.

The most common usage of the term "risk-adjusted returns" is for normalizing returns obtained by portfolio managers according to variance. It's based on modern portfolio theory -- in simple terms, riskier investments generally pay off more, and it prevents managers from "goosing" their returns by simply loading up on higher-risk investments. It's a performance measure (to make sure we're handing out grades on a level playing field) and has nothing to do with whether markets are zero-sum.

A game is zero-sum if and only if the total amount of money among all participants is constant -- one person's gain is another's loos. The fact that over the long run the total market cap of all publicly traded companies is continually growing, and thus all equity owners as a whole are becoming wealthier, is simple proof that this is not the case.

[zerosum]

[ QUOTE ]
A game is zero-sum if and only if the total amount of money among all participants is constant -- one person's gain is another's loos. The fact that over the long run the total market cap of all publicly traded companies is continually growing, and thus all equity owners as a whole are becoming wealthier, is simple proof that this is not the case.

[/ QUOTE ]

My previous posts should leave no doubt that I completely agree with you on this point. It has never been in contention.


[ QUOTE ]
Perhaps you should be more clear about what "risk-adjusted basis" means to you. The terms you're tossing around all have standard meanings in the finance community.

[/ QUOTE ]

Only at an elementary level are there standard meanings for "risk-adjusted basis" within the financial community. Even if you want to stay within the comfortable confines of Modern Portfolio Theory or MPT, you encounter profound problems of application. Remember, MPT is a theory. Some even say that when said quickly, MPT sounds like "empty." I rather like that irony.

But, now that I know you have at least passing knowledge of MPT, I can speak to you in terms of alpha, or, as you know, excess return relative to risk accepted. If you understand MPT, you should know that positive alpha exists only in the presence of commensurate negative alpha. Thus, any capture of positive alpha comes at the expense of another market agent suffering commensurate negative alpha. Thus you have a zero-sum game with respect to the stock market as considered on a risk-adjusted basis.

Returning to your contention that there are standard meanings of "risk-adjusted basis" within the financial community, I can only reiterate that such standard meaning is so superficial as to be practically devoid of useful meaning, let alone useful application.

Believe me, I know. I have over eight years' experience conducting research and due diligence on active management equity investors, many of whom are regarded as among the top practitioners in the United States. I have dealt with what "risk-adjusted basis" can mean more times on a daily basis than most people do over the course of their lives.

I have made a note to add a third rule to the two that I try to observe in the interest of friendship and general harmony:

1. Do not argue about politics;
2. Do not argue about religion;
3. Do not argue about the meaning of "risk-adjusted basis."


I hope this post clarifies my thoughts for you. I do not think that we disagree as much as we did not communicate effectively.

Peace be with you.

[topspin]

[ QUOTE ]
positive alpha exists only in the presence of commensurate negative alpha. Thus, any capture of positive alpha comes at the expense of another market agent suffering commensurate negative alpha.

[/ QUOTE ]

I see where you're coming from now. Yes, I agree with you here -- excess returns (those due to alpha) can be considered zero-sum. You're right that it looks like we're just differing over terminology: I'd consider zero excess return to be the same as a risk-adjusted return equal to the market return, which is non-zero, while it seems like you're using "risk-adjusted" and "excess" interchangeably.

The reason I originally replied was because of this sentiment:

[ QUOTE ]
Both [poker and investing] are zero sum games. Therefore you capitalize on other peoples errors in both. Thats all either one is about.

[/ QUOTE ]

This is patently untrue, and I didn't want anyone (mis)reading your followup post to get the impression that it was. Theoretically everyone can make zero mistakes in their investing, and everyone still makes money. In poker, if no one makes mistakes, all you do is swap dollars back and forth evenly. The poker analogy to the stock market would be someone walking up to your table and tossing an extra couple BB into every pot: the better poker players will win more, but now even if everyone played at the same level you're still all ending up ahead.

[zerosum]

[ QUOTE ]
I'd consider zero excess return to be the same as a risk-adjusted return equal to the market return, which is non-zero, while it seems like you're using "risk-adjusted" and "excess" interchangeably.

[/ QUOTE ]

I'm pleased that we agree and that we both undertand that terminology just got in the way. In my work, risk-adjusted return refers only to the value added/subtracted by an active selection process, i.e., the excess return. I agree that the reward to accepting systematic risk, the market return in your example, is non-zero. I'm just glad we did not get into a discussion of the issue that frustrates all risk adjustment methods: the joint hypothesis problem.

FWIW, I personally prefer to bootstrap returns relative to factors of risk, and I also place greater emphasis on downside deviation measurement.

[sprmario]

I'm thinking of one right now... can you guess who? /images/graemlins/smile.gif

[ QUOTE ]
I think there are many "winning" investors who don't have any edge but just haven't reached the long run yet.

[/ QUOTE ]

[tek]

The biggest similarities are:

1) Millions of people play in each arena, and most play poorly.

2) Most lie about their results.

3) Most repeat the same mistakes.

4) Most do not work on improving their game, except possibly by listening to equally unskilled players/investors giving wrong advice.

5) A few nits end up taking the discussion into arcane tangents.

[zerosum]

[ QUOTE ]

5) A few nits end up taking the discussion into arcane tangents.

[/ QUOTE ]

I completely agree. Here's a great example of one nit's arcane tangent.

[ QUOTE ]
I use charts. They aren't foolproof, but they work for me.

[/ QUOTE ]

Just a little humor, tek. I could not resist. Good flops to you.

[tek]

LOL. Good to see some more humor /images/graemlins/grin.gif

[DVO]

Warren Buffett ( who prefers bridge, by the way) would probably tell you something like this:

Both poker and investing are about waiting for opportunities to to bet huge overlays - and then betting big when you find them ( they are rare).

He's the ultimate 'tight-aggressive' investor. Superhuman patience combined with the willingness to go all-in.

In my experience, poker is much, much harder to succeed at in a major way. For one thing, in investing there are no antes or blinds. You can wait forever for your 'fat pitch.' No called strikes. ( This is Buffet's comment as well.)

Also, you are not facing a 5% rake in investing. This is a huge issue over time.

Another big advantage of investing is the natural inclination for growth ( Johnson & Johnson will most likely be bigger in 10 years than it is now. So will world-wide GDP. That momentum works in your favor if you choose a stock well.) No such natural momentum exists in poker ( I think).

Als, the swings in investing are just not as brutal or as damaging psychologically as they are in poker. If you are smart and patient, 4 out of 5 ( or some such number) investments will work out well for you. But you can play hand after hand perfectly and get hammered, as we all know.

[adios]

[ QUOTE ]
In my experience, poker is much, much harder to succeed at in a major way.

[/ QUOTE ]

I agree with all of your points and I'd like to add one more. FWIW IMO poker players in the aggregate are much more knowledgeable about putting money at risk and are basically much tougher competition. I realize that there are plenty of live ones in the poker world though.

[BarkingMad]

I don't want to stir the pot too much here, but I was surprised to read a post from someone with eight years of professional involvement in the markets arguing that stocks are zero sum.

I'm not a market professional, but I have alot of experience trading stocks, futures, and options. More importantly, I've done a huge amount of reading. The fact that the stock market is not zero sum is widely understood by professional traders.

Here's a simple explanation why.

The derivative markets (futures and options), are actually a zero sum minus game. It's possible for me to buy soybeans at $7.00 and for you to sell them at $7.00, and provided the market remains relatively unchanged, we both lose after slippage and commission. With derivatives, there are always two parties on each side of a contract. The number of game "players" is always Open Interest X 2. Thus, zero sum (zero sum minus, when trading costs are factored in).

In contrast, stocks are an equity creation mechanism that represent ownership in a company. It's possible for you to buy IBM at $75, then sell it to me at $100, and then for me to sell it to a 3rd party for $120.

More significantly, It's possible (and common) for the winners to outnumber the losers at any given point in a stock's history. The converse is also true. Thus, stocks are not a zero sum game.

-Lance

[adios]

Here's what zerosum stated in his original post in this thread:

[ QUOTE ]
Quote: "The stock market is not a zero sum game."

On an absolute basis, I agree with your opinion. However, on a risk-adjusted basis, the stock market most certainly is a zero-sum game.

[/ QUOTE ]

Are you still at odds with this?

[tek]

[ QUOTE ]

In my experience, poker is much, much harder to succeed at in a major way. For one thing, in investing there are no antes or blinds. You can wait forever for your 'fat pitch.' No called strikes. ( This is Buffet's comment as well.)

Also, you are not facing a 5% rake in investing. This is a huge issue over time.

Another big advantage of investing is the natural inclination for growth ( Johnson & Johnson will most likely be bigger in 10 years than it is now. So will world-wide GDP. That momentum works in your favor if you choose a stock well.) No such natural momentum exists in poker ( I think).

Als, the swings in investing are just not as brutal or as damaging psychologically as they are in poker. If you are smart and patient, 4 out of 5 ( or some such number) investments will work out well for you. But you can play hand after hand perfectly and get hammered, as we all know.

[/ QUOTE ]

There are no blinds, antes or rake in financial markets, but there is opportunity costs. If your investments are not moving much, you are losing profit you could make in some other investment.

GDP has an equivilant in poker--the poker market has been expanding for many years.

Swings in investing can be brutal depending on what you invest and the the time period you hold them.

Just a few thoughts on a Sunday morn...

[DVO]

"There are no blinds, antes or rake in financial markets, but there is opportunity costs. If your investments are not moving much, you are losing profit you could make in some other investment."

1) Poker has rake costs plus opportunity costs (Investing has only opportunity costs ( assuming you do it yourself)

2) Good point, if you assume the additional players are disproportionately 'fish'..a reasonable assumption.

[BarkingMad]

The reality of the situation is at odds with the quote you posted. ‘Risk adjusted’ has nothing to do with it.

The crucial point is that in stocks there is not an equal number of sellers taking the opposite side of each stock buyers position. A company issues shares, and investors buy them. The only way to profit if the stock goes down is to “sell short” by borrowing shares from an institution and then selling those shares to a buyer, but short sellers are not crucial to the existence of the market. In many cases, there are only buyers.

Look at a chart of stock that is at an all time high, and ask yourself, where are the losers? There are none. The investors are winning, and the company that has issued the shares is winning.

This win-win scenario is impossible with zero sum games.

In zero-sum games the amount of winnable money is fixed. Whatever is gained by one player, is lost by the other player; the sum of gains and losses is zero.

In stocks, the sum of gains and losses does not have to equal zero (and rarely does). Therefore, the stock market is not a zero sum game

-Lance

[BadBoyBenny]

[ QUOTE ]
There are no blinds, antes or rake in financial markets, but there is opportunity costs. If your investments are not moving much, you are losing profit you could make in some other investment.


[/ QUOTE ]

There are trading fees, or management fees for mutual funds. These fees, what I consider to be a cost of liquidity are very similar to the rakes in a casino as I consdier them the cost a creating the games and drawing in diverse groups of people.

[ QUOTE ]
GDP has an equivilant in poker--the poker market has been expanding for many years.

[/ QUOTE ]

This analogy makes some sense, but the financial markets are the equivalent of a few world-wide poker games. My home game does not grow because more people watch poker on TV. The field size of local tourneys do though, so I see your analogy as being partially correct. More so if you live by and play at a casino.

[ QUOTE ]
Swings in investing can be brutal depending on what you invest and the the time period you hold them.


[/ QUOTE ]

Very true, and this is a good reason why it is better to have a financial advisor who is good a risk management than one who recommends hot stocks or guarantees rates of return.

[sofere]

The stock market is absolutely zero sum, even if the total market cap grows. This is due to the economic concept of opportunity cost. When you buy a stock it is obvious what your are gaining and what you are giving up. However, when you sell a stock you are not only selling the stock at its current level, but you are selling all of the future gains/losses and dividends from that moment on.

For example, Person A buys XYZ stock at $10 and sells it for $15. That person has obviously gained $5/share. Now lets say person B buys that stock from person A and the stock goes up to $100/share. Not only has person B gained $85/share on XYZ, but person A lost $85/share due to opportunity cost. Person B is exactly $85 dollars richer and person A is exactly $85 poorer than if the transaction had never taken place. This concept of opportunity cost means that almost by definition, investing must be a zero sum game even if the gains and losses are difficult to perceive.

[sofere]

[ QUOTE ]
tek,

In order to contest your position that the stock market is a zero-sum game on an absolute basis, I'm going to extend your example and thereby offer an alternative result.

If you purchased X at 10, sold it at 14, and X then dropped to 12, you will have gained 4 and the purchaser will have lost 2. Your gain is greater than his loss and produces a net positive outcome.

[/ QUOTE ]

Yes but you bought the stock from someone at 10...that person also lost $2/share due to missed opportunity. Loss of 2+2 = 4 plus your 4 gain = zerosum.

[tek]

[ QUOTE ]
[ QUOTE ]
There are no blinds, antes or rake in financial markets, but there is opportunity costs. If your investments are not moving much, you are losing profit you could make in some other investment.


[/ QUOTE ]

There are trading fees, or management fees for mutual funds. These fees, what I consider to be a cost of liquidity are very similar to the rakes in a casino as I consdier them the cost a creating the games and drawing in diverse groups of people.

[/ QUOTE ]

Ok, management fees could be considered a rake if they are charged no matter what the investment rresults are.

As far as brokerage fees, they are not charged unless a trade is made, so I don't consider them to be blinds or antes...

I'm even amazing myself at what a nit I'm being /images/graemlins/smile.gif

[BarkingMad]

[ QUOTE ]
The stock market is absolutely zero sum...

[/ QUOTE ]

The above statement is incorrect. Any number of tangential arguments can be made to support the quote above, and they will all be wrong.

This is fundamental stuff, critical to understanding our economy, how capitalism works, and being a sucessful investor/trader. This "zero sum" misconception has far reaching social and political implications that I'm not going to make a career of writing about here.

Consider this though. When a company develops new products that improve people's lives, employs new workers, issues stock, and generates tax revenue that previously did not exist, something has been created.

When a company or an individual gains wealth, they did not necessarily do it at someone elses expense. Wealth can be created.

The stock market can create (and destroy) wealth. Zero sum games transfer wealth, they cannot create it. The stock market is <font color="red"> not </font> a zero sum game.


Link (http://www.investopedia.com/terms/z/zero-sumgame.asp)

[Paluka]

[ QUOTE ]
The stock market is absolutely zero sum, even if the total market cap grows. This is due to the economic concept of opportunity cost. When you buy a stock it is obvious what your are gaining and what you are giving up. However, when you sell a stock you are not only selling the stock at its current level, but you are selling all of the future gains/losses and dividends from that moment on.

For example, Person A buys XYZ stock at $10 and sells it for $15. That person has obviously gained $5/share. Now lets say person B buys that stock from person A and the stock goes up to $100/share. Not only has person B gained $85/share on XYZ, but person A lost $85/share due to opportunity cost. Person B is exactly $85 dollars richer and person A is exactly $85 poorer than if the transaction had never taken place. This concept of opportunity cost means that almost by definition, investing must be a zero sum game even if the gains and losses are difficult to perceive.

[/ QUOTE ]

This entire post is rubbish.