Garry Kasparov, the legendary chess champion has written a fascinating article entitled “The Chess Master and the Computer” in the New York Review of Books. The main subject of the article is a precis of a book entitled “Chess Metaphors: Artificial Intelligence and the Human Mind” which is written by Diego Rasskin-Gutman.

However, despite the subject of much of the article being chess Kasparov makes some remarkable comments with relevance to the Texas Holdem Investing concept and how perhaps poker may now be the best game for teaching risk.

The core subject of “The Chess Master and the Computer” is how the advent of chess supercomputers has changed the face of the chess world, and in many unpredictable ways.

Game (and Investment) Outcome Space

Early in the article Kasparov refers to the interesting analogies that are used to explain the vast range of potential moves in a game of chess. One of the more powerful metaphors used is that when a chess player attempts to look out 8 moves there are as many possible games as there are stars in the galaxy!

At the end of the article Kasparov then talks about how poker has all of the complexity of chess, with the added layer of incomplete information (chess players can see all of the pieces), which may mean it is a better medium for teaching about making decisions in uncertain environments. Clearly the investment world to be one of the ultimate uncertain environments, thus making poker an ideal tool for learning the core concepts of investing.

Education of Chess Players (and Poker Players and Investors)

One of the unintended consequences of chess supercomputers is that younger players who are familiar with computers can now play and learn against “professional” chess supercomputers from the comfort of their home. The ability to learn at such levels has created a new breed of chess masters, often from unlikely countries such as Norway.

The relevant point here for Texas Holdem Investing is how the internet allows poker players and investors to train at their craft from anywhere in the world – you don’t need to be based in New York or Chicago (for investing) or Las Vegas (for Texas Holdem).

Kasparov also notes that playing chess on computers where there is access to information on the right types of moves and strategies has helped players accelerate and compress the learning process for chess. Kasparov refers to the well-known “10,000 hours to expertise” cited by Malcolm Gladwell, and seems to imply that computerised chess learning has compressed the amount of time it takes to reach the 10,000 hour mark.

This idea is an integral part of the Texas Holdem Investing concept and program. Learning by computer does not reduce the 10,000 hours, it just makes it a lot easier to get there in the shortest possible space of time. Essentially, one can play more scenarios in a shorter space of time, and can access a vast computerised database (the Internet!) of information on strategy improvement.

This theory of fast-forward learning that can be achieved for investors in terms of the key skills of risk management, investing discipline, and emotional control is one of the unique benefits of Texas Holdem Investing (for a longer discussion see “Texas Hold’em Poker – The Fast Forward Button for Investment Training”).

Poker is better than chess for teaching risk in current times

Kasparov finishes off the article with an incredible observation by a former world chess champion who clearly still retains a passion for the game of chess.

Kasparov proposes that chess may be the wrong game for our current times and that poker may be more appropriate. He notes that poker is a game of imperfect information and variable stakes which means that players can learn to appreciate the effects of risk management, chance, and bluffing. As Texas Holdem Investing notes, these are three critical elements in the sphere of investing (bluffing is not always an obvious aspect investing, but try telling that to someone who loaded up on Enron stock based on the reports from management).

The chess master notes that poker outcomes are significantly dependent on human psychology, which indeed is a critical aspect of navigating the investment world. Kasparov feels that perhaps poker can help individuals learn how to take risks and so the mass take-up of the card game is not a bad thing.

According to Kasparov learning poker can teach people that there are no rewards with out corresponding risk. This is one of the most vital lessons that must be learned before putting your money at risk in the investment world. Texas Holdem Investing shows how to systematically approach learning poker so that you can embed this lesson into your mental circuitry before swimming with the investing sharks.

Kid Dynamite of the Friday In Vegas blog posted an excellent article – “Synthetic CDO’s, Spanish 21 and Sports Betting” (also posted on SeekingAlpha and Clusterstock) – which uses gambling, sports betting, and even references to Susquehanna in an effort to explain why perhaps Goldman Sachs and other financial institutions are not totally at fault for some of the recent investment losses suffered through so-called CDOs – Collateralized Debt Obligations.  The CDOs were backed by so-called sub-prime mortgages which were made to borrowers with questionable credit histories.

It is yet another example of how the world of sports betting and card speculating can be used to educate non-investors about the world of investing.  However, the piece also shows how perhaps gambling, and poker, can be used to educate professional investors about how to view investment opportunities.

A key point from Kid Dynamite’s article is that learning effective gambling requires you to always look for any kind of edge that the other side has in a game.  In gambling the other side is either the “house” in games such as Spanish 21, or other players in games such as Texas Holdem Poker.  Taking this analogy to the world of investing helps to develop a mindset that you should always consider why someone is willing to take the opposite side of your trade or investment decision.  If you are willing to buy shares in a particular company, why is there a willing seller.  The corollary to this in Kid Dynamite’s article is that one should always be careful when taking the other side of a trade with Goldman Sachs, due to their successful track record.

However, I think that there is an unexplored side of this article and it is to do with the well worn investment phrase “This time it is different”.  This phrase is all too often ignored by even seasoned investment professionals.

The theory put forward about Goldman (and other investment banks and associated firms) committing fraud in the sub-prime market is that CDOs were filled with “trash” mortgages that had no hope of repayment.

Indeed there was an element of “trash” mortgages being placed into these sub-prime CDO vehicles, but the CDO structurers did not think that the majority of the mortgages would not be repaid.  Like “Junk Bonds” in the 1980s the theory behind sub-prime CDOs was that the higher interest rates on the underlying mortgages would compensate for the higher level of defaults.

Where the investment world (including the professionals who structured and purchased the CDOs) fell short in the analysis was falling for the “this time it’s different” story in relation to the US housing market.

In gambling (as readers know I like to use Texas Holdem as the best comparison to investing) one realises that the rules and cards are always the same and that a consistent strategy should be adhered to on an ongoing basis, even if it seems that due to the recent results that the rules and cards are different.

By thinking that “this time it is different” it’s like going to play a game of Texas Holdem and thinking for some reason that the pack of cards is different because you are performing well, until you get busted out through poor risk management when the run of cards reverts to the mean.

The CDO structurers and purchasers assumed that “this time it is different” and that an asset class – US housing – could never fall in value across the country.  And so models were calibrated, structures were developed, and marketing documents were created that were based on US housing valuations always increasing.

In booms an element of fraud always emerges to some extent, and in the sub-prime crisis fraud did cause a higher level of underlying trash mortgages than expected.  The uncovering of the fraud can often prick the bubble as it did to some extent in the sub-prime crisis, but booms are generally founded on sound theory that is extrapolated too far because of “this time it is different” expectations.

Investors, both retail and professional, need to ingrain into their mindsets that the world of investing and its inherent laws rarely changes, just like the rules of Texas Holdem (and other games of speculation).

Sometimes investing returns (and runs of cards) can be different for extended periods of time before snapping back to normal, often with savage and far-reaching consequences.

Steven Begleiter is the latest (ex-)investment professional to hit the headlines for exceptional performance at the Texas Holdem Main Event at the World Series of Poker which starts on November 7^th at the Rio Hotel in Las Vegas.

However, there is a twist with Begleiter because his investment background is quite different to past investor participants in the WSOP who have been successful.

The “Texas Holdem Investors” who achieved success (and money) at previous WSOP event finals were typically from backgrounds in trading, fund management, or hedge funds.  Here are some examples:

• David Einhorn – Einhorn runs Greenlight Capital and is one of the most successful hedge fund managers of recent times.  Einhorn came 18th in the 2006 WSOP and won $659,000 which he donated to charity.  The amazing part of the story is that Einhorn had only taken up playing poker a few years previously.
• Bill Chen – Chen is a serious mathematician who works in the statistical arbitrage department of Susquehanna, the poker-friendly options trading firm.  Chen won $785,000 in two events at the 2006 WSOP but even with that level of winnings still decided to keep the day job.
• Robert Varkonyi – Varkonyi won the last World Series of Poker Main Event before television coverage of the event became widespread.  He studied Electrical Engineering at MIT and then went into investment banking in options trading.  Varkonyi now trades options for Gargoyle Strategic Investments which is a hedge fund.

The common theme is that these players usually work in an environment where they are risking at least some of their own capital in a fund where trades are generally made over shorter time frames ranging from days to months, but seldom years.  It is easy to make the connection between this type of investment process and poker.  Ari Kiev, a respected trading coach, describes the similarity based on the necessity in both fields to make “high probability bets in an instant with insufficient information”.

There is now hope when it comes to poker for the current poor relatives in the financial world – the investment bankers (like the Masked Financier).  Many years ago the investment bankers were the heavy hitters of Wall Street, mastering massive merger and acquisition transactions with no capital at risk, until over the last 20 years the traders took over the reins of profit (and capital).  And the traders were cleaning up at the World Series of Poker too, even though they didn’t do so well at the banks trading CDOs and similar instruments.

But now along comes Begleiter who worked in corporate strategy at Bear Stearns before he was shunted aside after the forced takeover by JP Morgan.  And Begleiter now works for a private equity firm – Flexpoint Ford, where he may well be using the skills that he gained in investment banking (and perhaps poker).  As with trading, there are a number of parallels between the process of private equity (and venture capital) investing and poker.  Begleiter himself compares the all-in showdowns of Texas Holdem poker to the high stakes bidding wars that often take place during merger and acquisition transactions in investment banking.

The Masked Financier, and all the other investment bankers out there perhaps including The Epicurean Dealmaker, will be rooting for Steve Begleiter at the Rio Hotel this Saturday.

Part 1 of this post series discussed why sports analogies should be used with care when discussing their relevance to investing and trading. With those points in mind Part 2 goes through Dr. Bob Rotella’s 10 Rules on Mental Fitness from and notes some areas where the interpretation of Dr. Rotella’s rules for golf should be made with care in the context of poker and investing. Being an amateur golfer myself, I do have a little bit of insight as to how to make the transition. In the title of each rule there are brackets to indicate investment and poker related amendments.

Rule 1: Believe you can win (over the long term)

Generally in sports to do well the player needs to do a high percentage of things right. If an investor holds out that standard as being necessary it will only lead to heartbreak. It is a recognised fact that even the best investors and traders (and poker players) lose on up to 40-50% of their investments. But it is how they handle the losses (cut them) and profits (maximise them by letting them run as long as possible) that makes the difference. There is one golfing analogy that is somewhat appropriate here. The great Ben Hogan once said about golf that “This is a game of misses. The guy who misses the best is going to win”. It is the same with investing and poker. You need to believe not just that you can win, but that you can extricate yourself from your bad decisions effectively. This will increase your chances of winning in the long term.

Rule 2: Don’t be seduced by (near term) results

This rule is appropriate to poker and investing on both sides – the up and down. Near term results that have recently occurred should not influence your strategy and tactics. The natural volatility inherent in both poker and investing means that short term results can seem to be much worse or better than expected. Such deviation from long run expectations should be ignored, although given the strength of human emotions particularly in the face of losses this is easier said than done. Playing a lot of focused Texas Holdem poker can help to train your emotional responses in the face of such losses to prepare yourself for the larger field of investing.

Rule 3: Sulking (and going on tilt) won’t get you anything

This rule is true with sports, poker, and investing. Sulking and getting emotional about a situation that has gone against you is most likely to make your performance worse. Dr. Bob explains how Padraig Harrington’s acceptance of a terrible last hole in the British Open in 2007 was what helped him to move on to the play off and then win it despite his terrible play (and luck) on the 18^th. Similarly, in investing (as with poker) it is vital to put bad investments (and hands) firmly behind you and move onto the next play.

Rule 4: Beat them with patience

Patience certainly is important in the poker and investing worlds, as it is with golf. One needs to wait for the right starting cards or the right type of investment that meets your screening criteria. However, the patience in poker and investing is somewhat different to that needed for sport. Tom Kite did indeed patiently shoot par on the last day of the US open, but he had to do a lot of work to hit par. The patience necessary in poker and investing is to be able to wait through long periods where nothing is happening and you are not making any plays.

Dr. Rotella’s advice to always make the conservative play is sometimes incorrect for investing and poker. When things do go your way with an investment or poker hand, typically those situations can be where you make the largest returns and you can often only hit the high returns with some level of aggression. Don’t throw caution to the wind, but do push your luck when it comes knocking.

Rule 5: Ignore unsolicited swing (and poker / investing) advice

The only person who knows how you invest or play poker is you (and perhaps your mentor if you have one).

Unlike golf, you are less likely to get unsolicited advice on how to invest or play poker. What you are likely to get is large amounts “tips” on the next hot stock or security. You should disregard all the “experts” and continue to focus on your own methods.

Rule 6: Embrace your personality

Dr. Rotella suggests that you should operate on the course according to your personality. Unfortunately, there is a prior decision you need to make regarding your personality and investing (or poker). That decision is: does your personality suit the markets or the poker table. Sometimes your current personality may not be the right one to embrace before you hit the tables or the stock exchange.

The good news is that with training it can be possible to manage (or at least tone down) the parts of your personality that won’t work in the worlds of investing and poker.

So, you may need to alter your personality and then embrace your personality.

Rule 7: Have a routine to lean on

Dr. Rotella is a proponent of making his golfing students develop a routine for each shot. This helps to focus the mind on the shot at hand by providing some “hooks” for the player to hang onto amidst the maelstrom of tournament pressure.

This is a very good piece of advice for poker players and investors. Too often these pursuits are glamourized based on the money involved and the rush of emotion. In reality the player or investor should focus on calming down and trying to follow the same consistent methods that is used for each hand and investment.

Such a routine is particularly helpful as a way of helping players and investors to re-focus after either a huge success or a big loss. Typically after such events your mind is likely to wander and having a routine to fall back on can help bring you back to your normal methods and pace of activity.

Rule 8: Find peace on the course (or at the table, or in the markets)

Apparently golfers that have practiced hard often freeze when they get onto the course because they have built up so much pressure in their head that they cannot enjoy the game. So Dr. Rotella advises that you make the course your sanctuary where you can enjoy things without a fear of making mistakes.

The poker and investing worlds are actually fantastically interesting, made more intense by the involvement of your money. But you should try to focus on the interesting parts of the game and the market, and not solely zero in on your possible or actual mistakes. You will probably enjoy things a little more, and with less pressure on yourself you are likely to perform better.

Rule 9: Test yourself in stroke play

Stroke play in golf is where every shot counts, not like some of the other game variants (such as “stableford”) where if you shoot worse than a certain score on a hole you can only lose so many points. So Dr. Rotella maintains that to really test yourself you should play strokes as often as possible. One of the key elements of successful stroke play is risk management, because if you don’t watch your downside you could end up taking lots of shots on one hole.

And so it is with investing and poker.

There are types of investing (like options) and poker games (like tournaments) where your downside is limited to your entry price and your upside is considerable. Like with stableford in golf, playing and investing in these “limited downside” types of situations too often can cause you to lose your downside risk management skills. So force yourself to test your poker and investing abilities in cash games and cash markets.

Rule 10: Find someone who believes in you

“No person is an island” – John Donne.

And the same goes for poker players and investors and traders. Although these pursuits are solo occupations, you can always benefit from support provided by someone you know and trust. In particular, such a support person can help you when things are not going so well. Just like Ben Hogan’s wife wouldn’t let him give up golf when it was not working out, when you got on tilt or have a bad run of investments it helps to have someone who believes in you to help keep you going.

…………….

The Masked Financier is not the only investment professional who has reviewed Dr. Rotella’s rules and applied them to the investing arena. Please read Charles Kirk’s take on Dr. Rotella’s rules at the Kirk Report.

This is Part 1 of a 2-Part post series.  Part 2 is available here.

Charles Kirk of the eponymous Kirk Report wrote a recent guest post entitled 10 Rules For Better Trading for Wall St. Cheat Sheet (which is produced by the Hoffman brothers, Damien and Derek). In the post Charles takes an article from Golf Digest – 10 Rules For How To Win Your Major – written by the sports psychologist Dr. Bob Rotella and discusses how the 10 rules in the Rotella article can be applied to trading.

As readers of Texas Holdem Investing know The Masked Financier is a promoter of the use of gaming analogies to explain the elements of investing and trading. And it is interesting to note that The Masked Financier has heard lately that Dr. Rotella has started to work with traders. However, one needs to exercise care when using sporting analogies for investing because in some cases the dynamics of sports situations don’t translate directly to investing and trading.

Clearly there are a number of elements that make sports an good medium for discussing the characteristics needed for good investing and trading.

• Ambitious players in sport need to practice hard by repeating similar actions again and again, learning from mistakes is essential, and commitment is necessary even when all seems lost.
• Risk management is an important part of sports, as is the case with investing.
• Performance and using good judgment under pressure is a key requirement for sporting excellence.

However, there are two major issues that mean sport is not an entirely appropriate framework for discussing, teaching, and learning investing.

• In sport the player can generally affect the outcome of the game (or situation within a game) by direct influence on either the player’s own performance or by affecting the performance of the other player(s) in the game. In most investing markets, the investor cannot in any way affect the performance of the securities that have been selected. There are some markets where the investor can affect outcomes such as private equity where the investors generally take control of the company being acquired and can make management changes. But these situations are in the minority and the average investor is often unable to access these asset classes. A good sportsperson may find the investing world somewhat frustrating because once an investment is made it is a case of waiting without being able to do anything pending a view on where the market moves. Even a team sports manager, while not on the field, can make changes to the team and its strategy.
• Commitment when all is lost is an important part of sports – often described as the “never say die” attitude. In the field of investing commitment to your business and trading plans in the face of poor short and medium term results is an important part of improving your likelihood of success. However, in the context of an individual trade, commitment when all is lost can be a serious flaw, leading to the phenomenon of “doubling down” on bad investments when clearly the original thesis has turned out to be wrong. This type of commitment to a lost investment cause in the face of facts can have negative effects on your investment capital levels.
• In sport the game itself generally does not involve putting money at risk. Naturally in professional sport the players’ salaries and winnings are affected by their performance, but the payment profile here is generally one of upside only i.e. playing badly in a game will never result in a player losing salary or prize money (unless in the case of foul play), just forgoing extra earnings. And clearly in amateur scenarios there is no money at risk at all. Since putting money at risk is such an intrinsic part of investing (and trading) this difference between sporting scenarios and investing needs to be taken account of carefully.

One recent unfortunate description of how prowess in sports does not necessarily lead to financial ability is a recent piece by the New Rules of Investing blog about the poor investment and financial records of professional athletes.

The next part of this post will provide an interpretation of Dr. Rotella’s 10 rules on golfing mentality from the perspective of the Texas Holdem Investing method. This perspective will also take account of the two issues described in this post.

Jeff Yass (and his trading firm Susquehanna) is a prominent example of Texas Holdem Investing in action. Although Yass has been intensely secret about himself and his firm in recent years he first appeared in the popular investment media through an interview with Jack Schwager for “The New Market Wizards: Conversations with America’s Top Traders”.

However, just this week the Philadelphia Magazine has written a detailed background piece on Yass and Susquehanna – Beating the Odds – which demonstrates the extent of the close links between poker and trading / investing. Susquehanna already featured on this site where it was described how the firm had held a poker tournament earlier this year in Dublin to select trainee traders for its European operations.

The Philadelphia Magazine piece goes to greater lengths in explaining some of the inner workings of Susquehanna and the integral role that poker plays in the training and work ethic of the firm’s traders.

One of the key parts of the article describes the timeline of Yass’ road to generating immense wealth through Susquehanna. Yass started learning his ideas about how the world of investment works through playing poker. He then spent some time gaming in Las Vegas before getting a seat on the Philadelphia stock exchange where he began to build his options trading empire. Clearly, this is an explicit real-life example of the Texas Holdem Investing education process in action.

The article proposes that the foundation of Yass’ brilliance is his ability to make rational decisions repeatedly in fields that are typically swamped with emotions – such Texas Holdem poker and investing. And part of this ability to make rational decisions is based on the capacity to analyse the probabilities of a situation properly and not simply based on the mental short cuts that people often apply and which are generally wrong. The example in this article, which in turn is from the New Market Wizards interview, is the explanation of how to guess correctly in the “Make A Deal” game show that was hosted by Monty Hall.

Yass’ operating style at Susquehanna in the investment world also bears a strong resemblance to one of the other great (Texas Holdem) investors – Warren Buffett (and Berkshire Hathaway) – who has been mentioned on this site. Like Buffett, Yass operates with a low profile and located Susquehanna in a nondescript building in the suburbs of Philadelphia, far away from Wall Street. Quite similar to the Berkshire Hathaway headquarters in Omaha.

Yass started off playing poker in college where he and his colleagues found poker as a way of honing the skill of using probability and game theory for risk taking. Poker also taught the group that the critical element of risk taking was to find an edge which would last over the long term and then apply it relentlessly.

Yass did believe the markets were more than just about enabling financial success but that they also provided social utility. Markets in securities enabled ideas and risk to be converted into financial amounts which could then be traded, thus making it easier to turn ideas into useful items and services for society. Yass’ thesis focused on the benefits of stock options in this context. This is an interesting and compelling concept and an antidote to the generally accepted wisdom that the market is a “casino”.

Yass then went to Vegas to “hit the tables”, where he described that he took many knocks but at the same time learnt a great deal. Texas Holdem Investing also provides a learning investor with the ability to take some hard knocks and learn from them in the poker world before risking serious capital in investments.

After leaving Vegas Yass moved to Philadelphia and took a seat on the exchange just as the world of options was taking off into the stratosphere. Yass found the “game” of options to be identical to poker. The options trader had to read the cards over the course of the game time (analyse the way in which a stock might move over a specific time frame) and read the other players in the game (the buyers and sellers of the option being traded). The options trader had to do this fast in a moving market, a skill which Yass had developed through his years of playing poker

One of the fundamental principles at Susquehanna is that when the odds appear to be in favour of the trader then the capital risked should be significant. This is tied into the theory of positive expectancy from poker – if a player makes the right decision in a particular situation then over time the player will come out ahead, regardless of the individual results. Another core principle of the firm is to bet many times and quickly, and to cut out of losing trades quickly. This is another play straight out of the poker world – play as many games as fast as you can, cut out of the bad ones quickly, and then bet big on the good ones.

Susquehanna hosts in-house poker tournaments with cash-prizes as a way of recruiting new traders and finding out if their decision-making abilities fit the firm’s requirements. The Philadelphia magazine journalist puts this into words that closely epitomise the Texas Holdem Investing method – “reckless poker player equals reckless trader”. Of course one can start off as a reckless poker trader and then improve, which is also possible for an investor.

The article also describes how Susquehanna utilises in-house games of poker “front and centre” as a teaching tool. This is because of the Susquehanna founders’ strong beliefs about similarities between poker and investing (this principle is the central tenet of Texas Holdem Investing). Poker tutorials in Susquehanna are designed to remove (the author uses the more dramatic term “bleed out” – one wonders if that is a quote from a Susquehanna employee) the harmful emotions that can colour rational decision-making. And this use of poker for education is based on an edict from the top by Yass to institute the game as a core part of training. Perhaps Wall Street banks (and universities) could take notice of this initiative.

In classic reverse Texas Holdem Investing style one of Susquehanna’s founders – Eric Brooks – left the company to play professional poker and won the World Series of Poker in 2008. Interestingly, he donated his winnings to the Decision Education Foundation which teaches children the science of decision making.

The article closes with some of the author’s thoughts on where Susquehanna is now and how Yass has maintained strict secrecy for some time. However, the Masked Financier is not too interested in all that. Validation for Texas Holdem Investing from one of the major options trading firms in the world is sufficient.

This post is a guest post on WallStCheatSheet.

Part 1 of this post series introduced the concept of similarities between poker and investing. It then proceeded to describe 5 key areas of similarity. Part 2 now goes on to explain an additional 5 key elements where both fields share characteristics.

6. Unavoidable Expenses: Investing and Poker both have unavoidable expenses associated with playing.

In Texas Hold’em poker the obvious expense is that of the “blinds”. For 2 games, in each full set of games around a table, each player has to put up a certain bet amount before seeing any cards. Therefore, even doing nothing has a cost in poker. This is the cost of being in the game.

However, in poker there are other costs that are more hidden. The cost of getting to a casino if you’re playing in a bricks and mortar session, or the cost of getting the appropriate software and hardware to be able to play online (assuming that this is legal).

The obvious cost for investors is the commission paid upon entry and exit from an investment or trade. These costs have dropped dramatically even for retail investors, but they are still expensive in the context of realistic return targets. For example a standard medium-risk return strategy would look to achieve 10-12% annualized returns. If an investor is incurring combined entry and exit costs of 1% per investment, the investor requires gross returns of 11.5-13.5% to achieve net returns at the target level.

Another, more hidden cost for investors is that of acquiring information. Although basic pricing and news services are free (e.g., Yahoo Finance), if an investor is serious about making money, it would be necessary to pay for more targeted and up-to-date news and pricing services. Further, even if the information is free, there is a time cost involved. So, to get in the game one must ante up with commissions and information costs.

7. Performance Analysis is Vital

Both poker and investing lend themselves well to performance analysis. At the end of each game and investment trade you will have a number of statistics about what happened. Analyzing these performance statistics is essential to identify problems with strategy and to help improve results over time. Unfortunately both poker players and investors tend to neglect this element of their respective fields. As a result, they experience continuous losses and no improvement.

Both fields often cause the player to learn more from losses than gains. Therefore, although losses are painful, since they cannot be avoided they do provide the benefit of a learning opportunity.

In Texas Hold’em poker there are three main sets of statistics which need to be analyzed. These statistics must be collated and analysed both individually and collectively to ensure that a player has a full understanding of all aspects of gameplay and bankroll management over time:

• Game statistics show betting patterns based on the pocket cards, table cards, and the betting of opponents;
• Session statistics are the aggregated game and bankroll statistics of each session, which demonstrate how game statistics change during the course of a session and how bankroll risk is managed; and,
• Bankroll statistics demonstrate the progress of your bankroll over time in terms of changes to total size and the amounts put at risk relative to the types of limits played.

Similar to Texas Hold’em, investing has different sets of statistics for each element of the investment process:

• Screening statistics are often overlooked statistics for investment professionals and warrants a separate discussion here. Its analogy in Texas Hold’em poker is the percentage of pocket cards played out of total hands dealt. Because this is an explicit part of Texas Hold’em, it is easy to measure. But investors on the other hand rarely give consideration to how many times they trade compared with the amount of trades they evaluated. Overtrading, a problem that affects many investors, starts at this stage and monitoring this statistic can help reduce it;
• Individual Investment statistics show the trade size, holding period, change in position size during the investment, and exit data including returns;
• Portfolio statistics provide details of the aggregated investments across a portfolio over a selected period of time to identify trends in the aggregated individual investment statistics; and,
• Capital Management statistics demonstrate the changes in your overall capital over time based on the investments made. The statistics that must be analyzed are mainly based around the volatility of the change in capital levels and the reasons behind the volatility.

8. Constant Risk Management: Risk management is necessary at various different levels in both poker and investing, and the levels are similar to the types of statistics discussed in the previous section.

In Texas Hold’em the player needs to first manage overall bankroll risk by ensuring that the bankroll is of sufficient size relative to the target limit levels being played. Then session risk needs to be managed — in particular to focus on avoiding going on tilt in response to poor results. Finally, game risk must be managed based on how the cards evolve and in relation to the amount of your money in the pot and what is required to stay in the game relative to the game situation.

Investors need to manage their overall capital in relation to the trade sizes. The risk needs to be managed for each investment based on the amount of capital invested and how the trade performance has played out relative to the original investment thesis.

9. Emotional Control: When poker players and investors are subjected to the strains of monetary losses, profitable gains, and volatility of their accumulated capital, it is inevitable that emotions will run high … unless you have some Vulcan in you.

Therefore, developing your ability to control emotions in the face of such a financial rollercoaster is one of the core elements of being a successful investor and poker player. Losing emotional control, particularly when results are going against you, is often devastating for your overall return levels. The term used for this loss of control in Texas Hold’em is “going on tilt” where typically the player starts making more bets than is rational based on actual cards in an effort to recoup losses.

It is true that certain individuals have a better psychological disposition to deal with the emotional rigors of poker and investing. Despite different emotional dispositions it should be possible for the majority of people to acquire the emotional control necessary to achieve success. However, there is only one effective way to develop this control, and that is by actually playing poker or investing with real money. Only then can a person find out what emotional responses actually occur in response to wins and losses. Following the discovery of this emotional feedback, the player or investor can start to work on controlling the urges effectively.

10. Discipline

This is probably the most critical similarity between Texas Holdem and investing. It is intertwined with all of the previous points raised. Discipline needs to be maintained from the start of playing poker and investing to maximize the likelihood of success. Like emotional control, discipline may need to be acquired because not everyone has it to start with.

It takes discipline to get through all of the issues above, ploughing a solo furrow, developing a business plan, maintaining a serious approach, dealing with the vagaries of luck, learning probability, managing expenses, collecting and analyzing performance data, managing risk on an ongoing basis, and controlling your emotions.

Conclusion

The comparisons between Texas Hold’em poker and investing discussed in these posts produce a compelling rationale for using poker as a tool to help improve an investor’s skill set. Learning the skills that are required to be a good Texas Hold’em player can help to increase your understanding of how to invest sensibly, profitably, and with low risk levels.

To read Part 1 of this series, click here.

This post is a guest post written for WallStCheatSheet.

Peter Lynch – one of the most well known US money managers – has written that one of the most valuable educational tools for a would-be-investor is playing poker. Other investment titans also have great regard for the skills that an investor can learn from playing Texas Hold’em. These include Bill Gross, David Einhorn, Steve Cohen, and even Warren Buffett. Buffett has preached his investment wisdom using the medium of poker more than once.

However, many investors feel that poker is simply a form of gambling where there is a significant element of luck involved. They find it hard to believe poker is similar to investing and can be used to teach investing. As I will demonstrate below, these two beliefs are untrue.

Note: In the title and the rest of this post you will see references specific to Texas Hold’em poker. This type of poker is generally regarded as one of the most complex forms of the game. Therefore, Texas Hold’em is one of the best poker forms to teach investing concepts.

There are many similarities between Texas Hold’em poker and investing:

1. Solo Occupations: Both investing and poker are ultimately solo occupations.

People are well aware that poker is a solo occupation because only you can sit down at the table and start playing. Ultimately, investing is essentially a solo occupation too. There is only one person who finally pulls the trigger on making an investment or a trade. Yes, that person may have support from a team of researchers, but when it comes down to putting the money on the line there is only one person who can make that decision.

Another way of demonstrating how investing as a business is a solo occupation can be shown by comparing investing with other types of businesses. Granted, many businesses can be operated by a sole trader. However, in most cases they won’t scale up well. You can’t manage a company like GE without a support cast of thousands. However, Warren Buffett can control the entire wealth of Berkshire Hathaway from Nebraska, simply making investment decisions on his own (well okay he gets some help from Charlie Munger).

2. Business Plan Required: If you want to invest, trade, or play Texas Hold’em successfully, you need to develop a business plan and learn the patience to adhere to this plan.

This is one of the most important parts of good investing and poker play, yet it is probably the piece of work that is ignored most often by both investors and poker players. A business plan for Texas Hold’em poker should outline the following aspects of your poker strategy:

• The type of games you will play (e.g., limit, pot limit, no limit, cash games, or tournaments);
• The game strategy you will use which should tie in with your chosen game type, skills, and mentality (i.e., tight or loose aggressive);
• The bankroll you will need to start playing with — both at an overall level and for each game you play;
• Your “limit movement” strategy (i.e., how you will increase/reduce your limit levels based on your results); and,
• How you will record and analyze your performance.

The similarities with an investment business plan are remarkable. Such a plan must incorporate the following elements:

• The type of securities in which you will invest (e.g., stocks, futures, options);
• The strategy you will employ when investing which should be based on the type of security you are investing in, your investing abilities, and your emotional capabilities;
• The starting capital you will need to have before beginning to invest — both for each investment and at an overall level;
• Your investment sizing strategy which would be based on your overall capital level, risk strategy, and ongoing performance; and,
• What tools you will employ for recording and analyzing you investment track record.

3. Serious People Make Money: When practiced properly by serious people, both activities are done with the objective of making money.

Many professional poker players have become famous since the mass promotion of the World Series of Poker: Doyle Brunson, Phil Hellmuth, and Chris Ferguson (and don’t forget the Texas Hold’em Investing hedge fund supremo David Einhorn). These players all focus intensively on their poker and it is often their sole source of income. No Friday night games with the friends for these players. And it isn’t all glamor either – sitting out long runs of bad hands in half empty casinos isn’t exactly Hollywood. Unfortunately the non-serious players typically lose all their money with the exception of the rare big win which keeps their interest.

The difference between the serious and non-serious people in investing is much more tragic than in Texas Holdem Poker. The serious investors also generally support themselves fully with their gains from investing. They focus fiercely on the markets and concentrate on analyzing them as much as possible based on their various strategies. The names are well known – George Soros, Warren Buffett, Ken Griffin, Peter Lynch, and we can also look to the example set by the various traders interviewed here on Wall St Cheat Sheet by Damien and Derek. However, at least the non-serious poker players aren’t in it to help secure their retirement. The non-serious investor tries to put money to work in the markets without sufficient preparation, research, and determination. This typically leads to inadequate relative returns, or even worse, complete losses of capital.

4. Element of Luck: There are elements of luck in both fields in the short-term, but in the long-term the skill of the player/investor should be expected to result in financial gain.

Short-term luck in poker and investing cuts both ways – good and bad. In Texas Hold’em Poker good luck can come by being dealt AA pocket cards, which then helps to win a big pot. Or, luck can come when the river card completes a flush to beat the opponent with three of a kind. On the other hand, the bad luck can come when the AA pocket cards with a third Ace on the flop is beaten by the amateur who started with 27 offsuit and ends up with a poker of 7s. But in the long-run, the good player will maximize the benefits of good luck and minimize the damage of the bad to produce an ultimately positive return.

Luck in investing is based on the fact that despite endless analysis and research about a company, a security, or a market, something unexpected can always happen that causes an investment to perform better or worse than expected. BP can find new oil in the Gulf of Mexico. Ebay can sell Skype for nearly the purchase price. These are both examples of good luck. On the other hand, Washington Mutual can announce it has run out of funds not long after one of the smartest private equity managers invested billions of new capital. Or, Bear Stearns can go nearly to zero out of nowhere before being acquired by JP Morgan.

The intelligent investor will ensure that the portfolio is constructed in such a way that it can survive such incidences of bad luck by sizing investment positions appropriately. At the same time, good luck can be taken advantage of by letting the profits from a position run as long as possible after the good news has emerged. Thus, the strong investor will never be immune to the effects of luck, but can manage the portfolio in such a way to benefit and protect from luck where possible and help achieve long-term positive returns.

5. Knowledge of Probability Needed: Investing and poker both require a knowledge of probability and statistics for the “player” to perform well.

Poker requires players to evaluate approximately the probabilities of winning a game based on the player’s pocket cards, the cards on the table, and the likely cards held by the other players. The key concepts are:

• Pot Odds – comparing the amount expected to be won in a game with the probabilities of winning based on the current situation;
• Implied Odds – adjusting the Pot Odds to incorporate the likely future betting which will occur in the game; and,
• Expected Value – the long-term value of the current situation for your hand based on how effective the hand is over a large number of hands, which would smooth out the effect of bad beats and good luck in the short-term.

Statistics knowledge is also important for poker when analyzing the results of your play, determining how effective you have been, and where are your weak points.

Investing requires knowledge of probability in order to calculate the expected value of your planned and actual investments based on the probability universe you have developed for the investments according to knowledge of the situation. This way of thinking allows you to compare the risk and reward elements of each investment in a rational way which prevents emotion from overtaking your thoughts process.

Part 2 of this series will continue the description of similarities between poker and investing with the final five key elements.

The Irish Times reports today that the University of Limerick has installed a fully operational virtual trading floor.  The floor has 24 computers (starts at about 1:25 mins – gotta love the dramatic Gladiator-like background music) with all of the data needed to simulate trading at an investment house.  Unfortunately, there is one thing missing – providing students with the experience of putting real money at risk, both their own and that of other investors.

In typical hyperbolic fashion, the current chairman of Thomson Reuters, Mr. Niall Fitzgerald (ex CEO of Unilever, who I’m sure is no stranger to trading and hedging in commodities) states that the only thing missing was “the adrenalin rush that comes from realising you’ve lost €50 billion rather than €5 billion”.  That is indeed missing, but in reality the majority of people training in this virtual trading floor (and others like it) will never be putting 5 billion of anything at risk, probably not even 5 million.  But it is a huge gap in the training provided by this type of service.  One year of consistent virtual trading is probably worth less than one day of trading with real money on the line – either your own or the capital of other investors.

Mr. Fitzgerald, in his speech for the opening of the virtual trading facility, had some harsh words to say regarding the recent financial crisis being caused in part by “trading for trading’s sake”.  These views are no doubt founded on his vast experience in the business world.  However, the Masked Financier would venture that it is more likely that it was “trading for option-like huge monetary upside with no downside” that is perhaps closer to the mark regarding the trading aspects of the recent financial crisis.  Mr. Fitzgerald does point out correctly that it was a lack of knowledge of trading activities at the top of major financial institutions which led to the huge build up of hidden trading risk.  However, trading is something that many non-financial companies engage in en masse (like Unilever for example) and Mr. Fitzgerald correctly points out that trading is an important part of running many businesses.

However, from the Texas Holdem Investing perspective, the most interesting piece of the article comes at the end.

A trader from Susquehanna states that any aspiring trader should also try to become a good poker player.  The Susquehanna trader proposes that putting this on a CV or resume will help to show that in addition to virtual trading experience, an aspiring trader can also demonstrate skill and success in putting money at risk – their own money, and winning.  Another Susquehanna trader also features on the video about the virtual trading floor (about 2:15 min).  It also turns out that Susquehanna is an investor in UL’s virtual trading floor (whatever that means exactly by being an “investor” in a college facility).

Susquehanna is a major global trading firm founded by Jeff Yass and five other partners.  Poker is an integral part of training, work, and life as a trader at Susquehanna.  Recently Susquehanna hosted a poker tournament in Ireland to help identify new trainee traders for its European headquarters in Dublin.  A major reason for this approach is because one of the core beliefs at Susquehanna is that the skill sets for poker, investing, and trading are similar.

As noted on this site previously, playing Texas Holdem Poker can provide a large amount of risk taking experience in a short space of time, since one can play many more hands of Texas Holdem in a college day compared to the likely amount of virtual trades that could be executed.  So, the question from The Masked Financier is: why not have a real poker room as part of the new UL virtual trading room facility, where students would be asked to put up some of their own money in a controlled environment to provide them with real-life experience of taking financial risk.

The Volokh Conspiracy blog posted today about the debate regarding whether poker is a game of skill or not.  The Masked Financier tried to make a comment on the post but couldn’t do it after repeated blocking by the “spam” filter.  It accused the Masked Financier of trying to sell “medication or gambling”.  That sounds a lot like the Google Adwords filter, which won’t allow advertisements for gambling or medication, but it will allow advertisements for “3 Stocks Ready To Surge” from the improbable “Penny-Stocks-Exposed” website (watch this space).

Anyway, ever the resourceful investor, the Masked Financier decided to write a post about my thoughts here.  Then I can link to this post from Volokh’s article without any stress.

Anyway, onto the main point of the post.

The main reason why the element of chance in Texas Holdem poker is overstated is because the vested interests analysing the game in the US (who want to keep it banned it online) never take into account how chance affects performance in the long term.

In individual poker games, there always is an element of luck involved once you have opted to play and are then affected by the cards that are dealt and the other players hands and betting moves.

However, by playing with a disciplined and well thought-out strategy the strong player can significantly reduce the effect that luck has on results in the long term.  Bad beats will happen, but their effect will be outweighed by folding lots of bad hands and playing good hands well.

As a proponent of using Texas Holdem poker to teach investing, the Masked Financier proposes that investing is indeed very similar to Texas Holdem with respect to the effects of luck.

Once you have selected an investment, you simply cannot predict what will happen going forward with any precision.  You could be lucky and the next day the company issues a huge profit upgrade, or you could be unlucky and it could be another Enron.

However, in the long term utilising a suitable risk management strategy can, as with Texas Holdem, minimise the effects of luck on investment returns.

Texas Holdem has suffered from negative publicity because the players are often loud, brash, and drink alot.  Traders are nothing like that in the investment world.  Oh, perhaps I should stop this train of thought.  Or we might have to ban large parts of Wall Street from operating.