"What Poker Can Teach You About Investing" [Archive]

Sniper

10-18-2005, 12:01 AM

For the benefit of those having trouble with the link to Legg Mason's conference transcript...

What Poker Can Teach You About Investing

David Nelson
Senior Vice President, Legg Mason Funds Management

The very quick précis of my talk is in Bill's portfolio management comments from the annual report of 2003 which is in your packets, specifically the quotation from Walter Pierson who is a personal hero of both Bill's and mine. He says, "ain't only three things to gamblin': knowing the 60/40 end of a proposition, money management, and knowing yourself." Pretty much the same thing applies to investing.The very quick prcis of my talk is in Bill's portfolio management

Why talk about poker? Well, we're in Las Vegas, so what better thing to talk about than gambling? Also, you can learn the basics of poker and investing in about five minutes and then spend the whole rest of your life trying to understand the nuances. I've been an investor for over thirty years and I learn things every day. Also by the end of our session together, you'll find that the skill sets for poker and for investing are surprisingly similar. A lot of the talks that you have heard today tie together. You'll see things in my talk that relate to some things that Lisa mentioned-the process of playing poker and the process of investing are more about how you make decisions. Terry talked about behavioral finance and poker is enormously influenced by the way people think. People make decisions in very quirky ways, as he pointed out.

Poker and investing are about good decision making. Let's take a little test here together. In decision number one, you have (A) the opportunity for a sure gain of $240 or (B) a 25% chance to gain $1,000. Which would you rather have? In decision number two, you have (C) a sure loss of $750 or (D) a 75% chance to lose $1,000. Which one of those two most appeals to you?

Amos Tversky and his partner Daniel Kahneman (who recently won the Nobel Prize) did a series of studies, and given a choice between the $240 and the 25% chance to gain $1,000, 84% of the people choose the sure gain (A). Given the choice between the sure loss of $750 or the 75% chance to lose $1,000, 87% of the people select the 75% chance (D). Overall, 73% wanted the sure gain and the 75% chance of a loss (A and D together) and only 3% selected the 25% chance of gain and the sure loss of $750 (B and C together).

Let's aggregate the outcomes of these two decisions and see where we come out. If you choose both A and D, then 25% of the time you gain $240 and 75% of the time you lose $760. If you choose C and D in aggregate, you have a 25% chance of gaining $250 and a 75% chance of losing $750. In the B and C aggregate, you make more when you win and lose less when you lose, so this combination is the most valuable. Yet, only a very small percentage of people actually choose this. Why? Because people are risk averse in the domain of gains (they would love to have a bird in the hand or a sure thing), but in the game of losses, they are risk seekers (people do not want to take a loss and they will do almost anything to avoid it). One of the things people do to avoid a loss is take a risk at losing even more in the hopes that luck will favor them. People, therefore, make sub-optimal decisions.

Poker is all about decisions. Warren Buffett wrote, "As they say in poker, 'if you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy!'"

I'd like to clear up a misconception that has been perpetrated by my boss, Bill Miller. I did not spend five hours at the poker table on Wednesday: I spent about an hour-and-a-half. [laughter] I did not have chips worth $200,000. I had a large stack of low denomination chips. Now, it was considerably more than $100 as well. So somewhere in that range of $100-$200,000 is correct. [more laughter] I'm not going to narrow my estimate any more than that. I will say that I made money, which I am pleased about.

I'm going to talk to you about low limit poker, which is a much different thing than high stakes poker like they play at the World Series of Poker, or no limit games. Those kinds of games are way out of my league and a different skill set obtains. There are distinct personality types for the different types of poker. I play in a monthly game with seven or eight guys. Some people consistently lose money and some consistently make money. The guys that make money don't seem to mind that much. They enjoy the conviviality and the experience. The guys that make money normally keep their mouths shut and don't rub it in too much. Imagine a matrix of personality types. There are people who are aggressive players and those who are passive players. There are also people who are loose players and people who are tight players. When you say a person plays tight, you mean that they don't play a lot of hands. Someone who plays loose plays lots of hands. Someone who is passive generally tends to be in a lot of hands but is never very aggressive and doesn't raise a lot. Someone who is aggressive tends to press the bet when he has the advantage. The kind of person you want to play against is someone who is a wild man-very aggressive, and plays very loose. The kind of person you don't want to play against is someone who plays very few hands and plays aggressively when he has the advantage-the 60/40 end of the proposition.

Now the key to winning in low stakes poker is folding. If you're playing an eight-handed game and the luck of the draw is evenly distributed, you're going to have the best hand about one in eight times. So seven out of eight times, if you're playing only your good hands, you should be sitting on the sidelines. People don't do that. When you play once a month or every couple of weeks, people want to mix it up. They want to be in the hands and get the action and see what the next card will bring. So they will not fold to the extent that you need to because it's no fun and it requires discipline and patience. You can see where I'm starting to head in comparing investing with poker. Successful investing is boring. It takes place over years of time and involves accumulations of wealth in periods of years and decades as opposed to minutes, hours and weeks. If you're at the country club and you're talking about the latest stock you bought, most people want to talk about the thing that went up $10 the last week. They don't want to say, "I'm in a mutual fund and I think I'll make 7%-8% annually until I retire and at that rate I'll be able to achieve my financial goals." But that's the way you really should be thinking about investing-over a lifetime.

This is something that Ken Warren said about Texas Hold-em: "More money is lost by players who know what the right thing to do is, but don't do it, than for any other reason. Having a strategy, a game plan and the discipline to stick to it are, along with a sufficient bankroll, the four most important things that a player needs to be a winner." You could say the same thing about investing. Game plan, strategy, discipline and obviously, bankroll.

There are a number of similarities between poker and investing. You have to be patient to do both well. Both are games of incomplete information. The tough thing about investing is the amount of information that you don't know and don't control. Lisa talked about scenario analysis and probability analysis. You don't know what's going to happen a lot of the time, but you do enough analysis so that the probabilities are in your favor when you make a particular investment. In poker, you weigh the odds in your favor by only playing those hands where you either have the best hand or have the best draw.

Understanding human nature is the biggest similarity between these two activities. People make very bad judgments. People underperform their own investments. The market goes up 12% and the typical mutual fund goes up 10%-11%. The average investor in those mutual funds makes 2%-4%. They do substantially worse than their own investments because they tend to buy when the market is up and they feel good, and they tend to get frightened and sell out when things are bad. People make all kinds of bad decisions at the poker table. They get too greedy and they get frightened. They don't analyze things on a probability basis and they don't know how to control their own emotions.

Here's an example of the use of probability from the poker realm. In a five card draw game, with a four flush (four cards to a flush plus one other card) or a four-card open-ended straight draw (let's say a 6,7,8 and 9) is it correct to call a $10 bet with $50 in the pot? You need to go through a mental process in considering this problem. If you have five cards in a draw game, there are 47 cards that you have not seen. If you are drawing to a flush, there are nine cards out of the thirteen in the suit that can help you and there are 38 cards that are of no help to you at all. Therefore the odds are 4.22:1 against making that flush. In the case of the straight, the four fives and the four tens help you, so there are eight cards out of the 47, and the odds are 4.88:1 against making the straight. The answer is that you are advised to make the call because the odds of making the flush or the straight are less than the pot odds (your $10 in a $50 pot).

You've seen this line in the Pogo cartoon: "we have met the enemy...and he is us." Nothing could be more true in investing. With nearly 30 years of investing experience, I have a hard time making decisions all the time on a rational basis as opposed to an emotional basis. The hardest thing for brokers or money managers in our business is to lengthen our time horizon. We look at our funds and get quotes every ten minutes or so. So three or four hours seems like a long time and a week seems like forever. A month or a year is infinity. When I was with Investment Counselors of Maryland I found that the clients that I talked to and met with once a year tended to do much better than the clients I met with once a quarter. The clients that called me up all the time to ask me about stocks or the economy tended to do the worst of all. The farther you can lengthen your time horizon in the investment process, the better off you will be.

Earlier today, Terry talked about a number of behavioral issues: cognitive illusion, attitudes towards risk, mental accounting, over-confidence. All of these are quirky ways in which people make decisions that causes them to be bad poker players and poor investors. In poker and in investing, "hope" can be a very expensive word. "I hope that the company willâ€¦" When you're in a poker game and you start out with a three good cards in seven card stud and then the next two cards are nothing, you should be out of that hand. You shouldn't be hoping that the sixth card or the last card will save you. That kind of decision process will cost you money. That's true in the investment process as well.

The same kind of maxims that will save you money at the poker table will save you money in the investment process. In poker, they say, "have the best hand, the best draw, or get out." In other words, know when you have the 60/40 end of the proposition. Know when the odds are in your favor and bet, or know when the odds are not in your favor and get out of the way. "Raise or fold," is another maxim used in poker. If you have a hand that's worth being in, then the hand is worth raising. If it's not worth raising, then it's probably not worth being in. You can save a lot of money in poker and in investing if you know when to say adios. But the thing that works against us is that people want to hope and they hate taking losses. They are willing to seek risk to avoid losses. They will not sell their losers. When people are thinking about money or gains or losses, they're not making decisions on a rational basis. And obviously, "cut your losses and let your profits run," is the standard maxim in investing.

Control your emotions. Losing your cool in poker-regret, anger, self-pity-is called "going on tilt." If you get angry and you start feeling sorry for yourself, you better get up and walk away because you're getting ready to give somebody a lot of money. The most important decision in poker and in investing is always "what is the right thing to do next?"

There are other similarities between poker and investing. The purpose of both is to make money. Game selection is critical to success. You want to play with as unprofessional people as you can find if you play poker. You need to be conscious of the "rake." Every gambling game is going to have a certain house rake. Every investment process will have some kind of fee or commission associated with it. Finally, you can learn a lot by analyzing your mistakes.

There are two main differences between poker and investing. Investing is not a zero-sum game, but poker is. Deception is not a part of the investment process, but it is critically important in poker. In fact people didn't even want me to put the word "deception" in this presentation because of the current environment.

In poker and investing, you have to have a game plan and the patience and discipline to stick to it. You have to minimize your losses and maximize your gains. You must understand the math of the game-the probabilities. You must understand human nature, especially your own. And you must be able to control your own emotions.

Q: In poker, probabilities can be calculated explicitly. In investing, probabilities are harder to determine. How do you assess probabilities in investing?

A: That gets back to the investment process that Lisa was talking about. The more ways you can come at an investment idea and the more methods you can use to analyze it, the better off you are. If a Central Tendency of Value is a relatively narrow range of values vs. a broad range of values, the probabilities of success are much higher.

Q: Can you give an example of when you folded and what the results were? Or when you wish you folded?

A: Rather than any specific example, I and most other people I know would be better off figuring out we were wrong sooner, and then getting out of the way quicker. As they say in the business, "there's no sin in being wrong; the sin is in staying wrong."