Streettalk:Why Poker Players Make Great Investors

Remember the line from the old pogo cartoon, "We have met the enemy and it is us"?

Brian O'Connell

So it goes in poker, one of our most enduring and popular cultural pasttimes, where understanding human emotion and evaluating behavioral management can help achieve success. Let's face it, under pressure, people usually don't make the best decisions and they don't demonstrate the soundest judgment.

That's why, in my opinion, poker and investing have much in common.

Allow me to explain.

In the stock market, pressure from having all that money on the line triggers what Wall Street gurus call the "herd mentality." That's when investors buy when everyone else is buying (when prices are usually at their highest), and sell when everyone is selling (usually when stock prices are at their lowest). They say fear is a great motivator and that's true of the average stock market investor and the average poker player. Fear of being left out of a bull market or fear of walking away from a pair of 10's when a face card comes up in the draw. Fear leads to bad decisions on a Wall Street trading floor or at a high-stakes Vegas poker table.

Greed is another human emotion that, left unchecked, can ruin an investor or a poker player.

In his speech, "What Poker Can Teach You About Investing," given at the Mandalay Bay Resort in Las Vegas on November 7, 2003, David Nelson, senior vice president, Legg Mason Funds Management, opined that 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.

Nelson, a guy who knows where poker and investing intersect, draws the following analogy on gambling, greed, and the importance of exercising probability scenarios on a poker game.

"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)."

It's Nelson's point that the toughest part of poker, and one of the toughest parts of investing, is that people have a difficult time making decisions on a rational, logical—rather than emotional—basis. "There are a number of behavioral issues: cognitive illusion, attitudes towards risk, mental accounting, over-confidence, at work in a poker game," Nelson continues. "All of these are quirky ways in which people make decisions that cause them to be bad poker players and poor investors. In poker and in investing, 'hope' can be a very expensive word. When you're in a poker game and you start out with three good cards in a 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."

Nelson has a point. 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 probabilities involved. You must understand human nature, especially your own. And you must be able to control your emotions.

If you can't, you'll wind up the type of risk-taker who confuses luck with skill, and who doesn't know when to leave money on the table and walk away.

UNDERSTAND MONEY MANAGEMENT

Your success at investing, as in poker, also has a lot to do with evaluating risk and exercising good decision-making skills based on risk evaluation.

There is, after all, a great deal of risk when you buy stocks. First and foremost, the value of your stock may go down, even disappear. But that doesn't happen often, especially if you do your homework and invest in companies that make good products, have good management, and generate solid profits. Still, as part owner of a given company, you're taking more risk in actually owning the stocks than you are if you, for example, loan a company your money in the form of a bond investment. At least with bonds, there's a guarantee built into your investment that you'll get your principal (the amount you invested) back, plus accrued interest. It's set in stone.

Stocks aren't like that. There's no flat-out guarantee that you'll earn any money. Heck, you can even lose it all. If the company pulls an Enron and goes bankrupt, shareholders are among the last folks to get their money back, behind the armies of bankers and lawyers and IRS agents standing in line ahead of you. If there's anything left, the shareholders can divvy the proceeds up. But by then, after the professional vultures have filled their bellies, there's usually nothing left on the carcass of any value.

That's the bad news. The good news is that, sooner or later, the stock market will notice the company you diligently researched and invested your money in. It rewards the company and its shareholders by increasing its value by raising the price of the stock. When a stock price goes up, that means demand for the stock is high. Since more folks want to be like you and own your stock, the price of the stock goes up correspondingly. It's all supply and demand, folks. If you really harness your portfolio to a winner—Microsoft, Google, or Wal-Mart—the return on your investment can go much higher than the 11% or 12% that stocks historically earn. Those stories about Microsoft secretaries retiring as multimillionaires aren't urban legend. Plenty of people who bought that stock early and hung on to it saw their investments rise astronomically. But that's the payoff for taking more risk with your investments.

There's the risk factor again. After all, nobody wants to fold; they want to be aggressive and raise and win the big pot. But in the average neighborhood poker game, there may be only 30, 40, or 50 hands in a given night. In poker, your mathematical probabilities estimate that in a game with 50 hands and five players, you'll draw the best hand roughly once every five hands. Consequently, four out of five hands you could very well be folding. In a game with 50 hands, that means 40 of them you're cooling your heels on the sidelines. That's 80 percent of the time.

For the average player who may sit down with his or her friends only once a month or so, it goes against human nature to back down 80 percent of the time at the poker table. People want to get in there and swing the bat, take the shot, go for the gusto. If not, where's the fun? But in poker, as in investing, the best players are the ones who have the patience and discipline to fold a bad, even mediocre-to-decent hand

Good poker players and good stock traders know that exercising risk probability scenarios, and using the information found in such scenarios to accept some losses, is the single most critical strategy they have in their arsenals.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, 79 Radcliffe Drive, Doylestown, PA 18901, 267.880.3144, fax 267.880.1939, brian.oco@verizon.net