When I was young people called me a gambler. As the scale of my operations grew, I became known as a speculator. Now I am called a banker. But I have been doing the same thing all the time. - Ernest Cassel

To win, you must understand the game, you must understand the players, and above all you must understand yourself. - Source unknown

Einhorn WSOP

Getting rich slowly in the markets is an achievable goal. Just find the risks that everyone else irrationally hates right now. That’s the one that is available at the right price and will yield good returns.

You might say, those risks are hard to find. Not always. Actually, predicting the asset everyone is going to love next year is hard or impossible. Noticing what everyone hates right now, what people are going to call you a complete idiot for buying, is a lot easier. When you invert the question, you can often find assets that are at historically good relative value, are going to offer decent returns over the next few years, and strategies that have historically outperformed consistently in the long run.

Now, I said it’s simple, not easy. Winning the gold medal in the 100 meters or the marathon is simple: just run faster than everyone else. In hindsight, superior strategies look simple. But they need preparation and discipline and the ability to suffer pain in the short run. In fact, they work well in the long run precisely because they can hurt a great deal in the short run. So very few people can apply them consistently.

In this post, we’ll talk about poker as an analogy for risk in the market. We’ll talk about good risk vs. bad risk, and telling the difference. Mathematically, people don’t take enough risk, e.g. Kelly-optimal. But that’s OK because it’s all about taking no more risk than you can emotionally deal with.

Poker is a perfect laboratory of human risk-taking. It teaches lessons directly applicable to investing. Both are games of analysis and decisionmaking under imperfect information and uncertainty; psychology and human emotion; and ‘luck’… which in the long run is variance, the winding road to the inevitable fate your skill, preparation, mental toughness, or lack thereof have destined you to.1

It’s all about understanding value. (With apologies to Howard Marks, it’s “all about” a lot of things.) If you have a pair of aces, that’s a little like a value stock. Your hand, right now, is worth a lot more than people at the table know. Your goal is to get the right price for it.

If you have four of one suit, that’s a little like a startup or growth stock. Your hand right now, in terms of competitors it can beat, is laughable. But it might grow into a monster, so it has a lot of option value. Your goal is to get in cheap enough that it’s worth hanging on to it. Hold onto it as long as you’re priced in. And either make your hand and take down a big pot, or semi-bluff and sell it for a nice price. Or walk away if it gets too expensive.

It’s all about using all the information at your disposal. Fundamental analysis is understanding your hand’s value in the context of the flop, the turn, the river, and probable outcomes. Technical analysis is trying to figure out how strong your opponents are based on their tells. Knowing their past history can give you an idea of what they might have and how they might respond to your play. If all there was to the game was past history, there would be a lot of rich historians. But only a fool bets without thinking about how the game has been played until now, who is in the game at what price and how they might feel about that and respond to action.

It’s all about expected value, or risk versus reward. You want to get involved only where you know you have an edge. When money management allows, you want to get into cheap hands where you have big upside. You need to hone your sense of whether, based on what you know about your opponents, how they played the hand, and the frequency of different hands, yours is likely to be better.

It’s all about knowing what you don’t know. Once you attain a certain level of mastery, there’s going to come a time when you think you have the game, the market, the other guy figured out. And then it behaves in a way you didn’t quite expect. You need to accept that it’s a game of imperfect information, and you’re not at the top of the information waterfall all of the time. Not even close. In the market, whenever I got blind-sided, I could usually look back and see it didn’t come out of left field. The information was out there, somewhere, and somebody had it. When the market has a lot of one-directional volume on seemingly insignificant news, goes down on good news or up on bad news, that’s a tell that there might be more to the story. When your poker adversary is playing strong with no concern for what others might have, or acting a bit out of character, look out.

You make most all of your money on a few critical decisions. A good player might have an edge of a couple of big blinds an hour. And the pots can be 10-50 times that. The key to the game is to make the right call on the big pot most of the time. When you double up twice in a row, remember that. The volatility obscures how good you are in the short run. It’s easy to confuse a couple of good situations where you made the right call and didn’t get sucked out on, with being a shark.

Depending on the type of investor and market you are in, you may make all your profits and then some on a couple of home runs. The rest of the time you are managing risk, trying not to blow up on something stupid, and making sure you are around and properly positioned when opportunity arises.

But, even more, it’s all about money management. You have to grind it out and manage to stay in the game until you get that big hand with significant positive EV. If you bet too much, even when you have the edge, variance is going to destroy you. Most of the time, it’s more important to not blow up on something stupid than to make a hero call. You win by not losing. When your stack gets low, you have to assess not only how big an edge you have, but if it’s big enough to risk a big part of your stack, and how likely you are to get as good a hand before you’re forced to go all in.

Shelby Davis said, “You make most of your money in a bear market; you just don’t realize it at the time.” Dan Harrington said, “You become a big winner when you lose. Everyone plays well when they’re winning. But can you control yourself and play well when you’re losing? And not by being too conservative, but trying to still be objective as to what your chances are in the hand. If you can do that, then you’ve conquered the game.”

It’s all about patience. You don’t need to play every hand. You don’t need to play every hand where you have an edge. As Warren Buffett, says, there are no called strikes in investing. (There is only opportunity cost in investing, but in poker you have blinds/ante). You need to make sure that when you do commit to a big pot, you have a real edge.

It’s all about well-timed aggression. The guy who gets in strong and early has the edge. Much more so in poker because it puts the adversary on the defensive, makes your hands harder to read, makes the opponent do the wrong thing. But buying on a scale as a stock goes down is like limping. You have the biggest position on when it’s what the market wants you to do. Don’t do it. Pyramiding on winners is the superior risk-reward strategy.

You can’t be afraid to look stupid. If it’s the right time to raise, you raise, you don’t worry how you look if you get called. And if the other guy raises back at you, if it means you’re beat, you fold, you don’t worry about changing your mind. A lot of times it’s better to do the opposite of what people expect and you can’t worry too much about what people think. That being said, you need to be a little sensitive to table image and aware if people think you fold every time people play back, or a maniac raising with nothing.

The big stacks have the edge. They can afford to buy information, throw their weight around. The little stacks have to be crafty and opportunistic.

It’s all about optionality, convexity, risk asymmetry, and getting them on your side. You want strategies where you tend to have the most money in the pot when you have the best odds in your favor. Conversely, when something is going south, you have to be able to get out while the getting is good. Cut your losers quickly and be all-in on your best hands.

The last thing you want is situations where you will win a small pot if you’re right, and get in a showdown for your entire stack if you’re wrong. Don’t bet big on the river with a hand where anybody worse is guaranteed to fold and anybody better is guaranteed to call. You want to participate in situations where you can make a lot of money if things work out, and you can get out cheap if they don’t. Good: all the bad news is in the stock and any upside surprise will make good money. Bad: The best case is priced in and any slip will cause the stock to crater.

It’s all about context and process. A play that might be terrible at a certain time and in a certain size might be brilliant at a different time, or with a different size.

Typical scenario: Novice player sees pro and tells him about some big hand where he got knocked out of a tournament and asks what he should have done. Pro asks: “How big was your stack? How big was your opponent’s stack? What were the blinds? Where were you sitting? Where was he sitting?” Novice says, I don’t remember, just tell me what I should have done! You can’t give advice to anyone unless you know their entire portfolio, their assets, their liabilities, the things they need to spend on now and in the future, their ability to withstand loss of income and psychological stress from asset values rising and falling. 2

It’s a game that requires thinking on many levels. In poker, it’s something like this:

  • 1st Level: What cards do I have?
  • 2nd Level: What do my opponents have?
  • 3rd Level: What do they think I have?
  • 4th Level: What do they think I think they have?
  • 5th Level: Yes, you can keep going and going…

In investing, it’s not enough to interpret or predict earnings, you have to understand what other investors are thinking, what is priced in to the market. It’s Keynes’s beauty contest, or Howard Marks’s second level thinking. In Keynes’s words, “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

You need next level thinking to win. But if you’re thinking more than one level ahead of the market, like Vizzini in The Princess Bride, you’re overthinking it and you’re going to have hard time. (ie if the market is just focusing on the next earnings report and you are focusing on the product pipeline and earnings five years out.)

It’s all about not going on tilt. You have to manage your emotions in the face of inevitable ups and downs, idiots getting in your face and criticizing you, and maintain Zen-like inner peace and concentration on what the game is telling you, and the plays you can control. If you can just avoid the big mistake that wipes you out, you will have opportunities to do well.

There are important differences, too. Most important, investing is a positive-sum game. Maybe even, at least in the last 30 years, more positive than we have a right to expect. In a casino with a rake and tips for dealers, poker is a negative-sum game.

Also, you can’t bluff the financial markets, unless you’re the axe in a market. In poker, you can bluff successfully, when you have a stack advantage, table image, position, and your opponent doesn’t have a monster hand. And if you don’t overdo it. You must bluff occasionally to get value for your made hands, but not too often. (If you’re bluffs are making money at the margin…you should bluff more! You’ll make money at the margin, and confuse your opponents more.) But in the market, nobody cares about your rep, unless you’re Warren Buffett. As a small investor you’re always the small stack that everyone else is trying to push around. They call it no-limit for a reason. You can’t always totally control the size of your risk, your big stacked opponent can put you all in at any time, or reset the size of the pot and the pot odds you face. Since you can decide how much risk to take in the markets, it usually pays to be boring, sit on the sidelines until you get a great hand, and then bet strong. And the market can’t fold on you, demand ante or a big blind, and you can always get all your money in at or near the price it shows.

But this really the one, most important thing. There is good risk and bad risk and you need to be able to smell the difference.

The really, really bad risk is the one that hits you out of left field because you didn’t know what you were doing. The novice bets with top pair, top kicker, (ie AJ with a jack high flop), gets raised, and he calls for his whole stack against a pair of queens. Or, he thinks he’s invincible with a pair on the board giving him three of a kind, and someone has a full house. These are situations where a bad player thinks he has a strong hand, and a good player thinks of all the ways he can be beat, and does not get in a position to lose everything unless he is very likely to be ahead (or is the small stack and has no alternative, which eventually happens to everyone).

If you’re that guy, in investing or in poker, the thing to do is 1) acknowledge that you still have things to learn 2) keep bets small, and 3) seek help. Keep learning and building a better process. Otherwise, in the words of Jesse Livermore, fortune will deliver an educational wallop and present her bill.

Another bad risk is the one where you have a good hand, but you don’t really have the conviction to back it up. You’re out of position. You’re up against tough players with big stacks. You bet weak. You run into a bunch of callers or someone raises back at you. Now what? If a little adversity is going to rattle your conviction and shake you out of your position, you shouldn’t have bet in the first place. Act strong or do not act.

The bad risk, to the experienced player, is where you know you’re in pretty good shape against most hands, but you smell a rat. There is something just a little too cute and deceptive and the guy you’re playing is good enough that you don’t really know where you stand. Or the player is not that good or has been out for a lot of hands is suddenly confident and aggressive. You’re out of position, behind the information curve, and before you know where you stand you will be committed for a lot of your stack. That’s the time to see if you can buy information cheap, reassess, and possibly run away before you get in too deep.

The good risk is where you have an awful knot in your stomach over all the scenarios where you’re going down in flames. But you evaluate the hands and your opponents and you know the odds. Against that fear, you act strong, and know that if you play right, you might run into a ridiculous bad beat or cooler, but in the long run it’s a winning strategy. The good risk is the one you are paid well to take, and take in the right size in the context of the game as a whole. Embrace it and learn to love boldly seizing it.

The tough guy to play is the guy who is on the ball, doesn’t miss a thing, doesn’t get emotional about the inevitable twists of fortune, is patient and focused on making the right play, regardless of the outcome, and puts you on the defensive and makes you make tough decisions. Be that guy (or gal).

David Einhorn and Brooklyn Investor have some good discussions on poker and investing, and I’ve borrowed/stolen all of this from them and others. Also a good read, Kid Dynamite on folding quads at the 2013 WSOP.

1 The fact is, we just don’t live long enough to turn investment luck into variance. You’re only going to live through as many major market regimes as you can count on your fingers and (maybe) toes. Taleb is correct when he says the impact of randomness in human affairs is underrated (even though he’s usually an insufferable pompous ass when he says so). Then there are the geographical and historical and environmental headwinds or tailwinds you are born into. If you were born in the postwar era in the US, you got a good start. If you were a male born in France in 1893, you were more likely than not dead, maimed, or shell-shocked by 25.

2 That’s why most StockTwits streams are terrible and will make you a worse investor. The good investors won’t post, won’t explain the strategy and context for every trade in 140 characters. The bad ones won’t tell you the bad outcomes. You’ll get a ton of conflicting, bad advice, and feel like a bunch of idiots are successful and you’re not. If you want to look smart, don’t tell your plans to a bunch of people who don’t understand them. Just do what you do. And if you have to, write an occasional blog post. No value idea is very good unless most people think it’s a terrible idea and have good reasons why you’re an idiot for even considering it. That’s the huge value of social media and crowdsourcing like StockTwits and Estimize _ they give you a very good idea of what thinking is in the market, which by definition is not going to outperform. (Also, a poker pro is not going to learn much from typical poker chat… but a novice will get massive value.)