Getting Schooled in Risk: The Lessons of Poker

“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

Getting rich slowly in the markets is simple. Just find the risk 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 that those risks are hard to find. They’re 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 turn the question around, you can more readily find assets that are at historically good relative value and are going to offer decent returns over the next few years, as well as strategies that have historically outperformed consistently in the long run.

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 investing strategies look simple. But they require preparation, 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 they are very hard to apply consistently.

I’m going to talk about poker as an analogy for risk in the market and about “good” risks versus “bad” risks.

Poker is a perfect laboratory of human risk taking. It teaches many lessons directly applicable to investing. Both are games of analysis and decision making under uncertainty, psychology and human emotion, and “luck,” which in the long run is variance — the winding road to the inevitable fate your skill, preparation, and mental toughness, or lack thereof, have destined you to.²

It’s all about understanding value. (With apologies to Howard Marks, CFA, it’s “all about” a lot of things.) If you have a pair of aces, that’s 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 cards of the same suit, that’s like a growth stock. Your hand right now, in terms of competitors it can beat, is laughable. But it might grow into a monster. Your goal is to get in cheaply enough for it to be worth hanging on to. 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. Your opponents are going to do whatever they can to make you part with it at the wrong price at the wrong time.

It’s all about expected value, or risk versus reward. You want to get involved in a hand when you have a significant 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 have played their hands, and the frequency of different hands — yours is likely to be better.

You make 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 are 10–50 times that. It’s all about making the right call on the big pot most of the time.

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 serious positive EV. If you bet too much, even when you have the edge, variance is going to kill you. When your stack gets low, you have to assess not only how big an edge you have but also whether 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.

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 said, there are no called strikes in investing. (There is only opportunity cost in investing, but in poker you have blinds/antes.) 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 player who gets in strong and early has the edge. (Much more so in poker because it puts the adversary on the defensive, makes your hand harder to read, and makes the opponent more likely to 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.)

The big stacks have the edge. They can afford to buy information and 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 a bet 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 a situation 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 off is guaranteed to fold and anybody better off 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.

The toughest person to play is the one 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, puts you on the defensive, and makes you make tough decisions. Be that person.

There are also important differences between poker and investing. Most importantly, investing is a positive-sum game. Maybe even — at least in the last 30 years — more positive than we should 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 like a dealer or a big active investor. In poker, you can bluff successfully when you have a stack advantage, table image, and 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 your bluffs are making money at the margin, you should bluff more! You’ll make money and confuse your opponents more.²) But in the market, nobody cares about your reputation, unless you’re Warren Buffett. As a small investor, you’re always the small stack that everyone else is trying to push around. So 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 or demand ante or a big blind, and you can almost always get all your money in at or near the price it shows.

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

Here is a typical scenario: a novice player sees a pro, tells them about a big hand where the novice got knocked out of a tournament, and asks what they should have done. The pro asks, “How big was your stack? How big was your opponent’s stack? What were the blinds? Where were you sitting? Where was your opponent sitting?” The 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.³

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

But here is really the single most important thing: There is good risk and bad risk, and you need to be able to sense 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 (i.e., A J with a jack high flop), gets raised, and calls for their whole stack against a pair of queens.⁴ Or the novice thinks they’re invincible with a pair on the board giving them three of a kind, even though another player has a full house. These are situations where a bad player thinks they have a strong hand and a good player thinks of all the ways they can be beat and does not get in a position to lose everything unless they are very likely to be ahead (or is the small stack and has no alternative, which eventually happens to everyone).

If you’re that person, in investing or in poker, the things to do are (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 don’t 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 good risk is where you have an awful knot in your stomach because of all the scenarios in which 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, it’s a winning strategy in the long run. The good risk is the one you are paid well to take and that you take in the right size in the context of the game as a whole. Embrace it, and learn to love boldly seizing it.

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 — something that seems deceptive — and the person you’re playing is good enough for you to not really know where you stand. That’s the time to see whether you can buy information cheap or to run away before you get in too deep.

Mathematically, most people don’t take enough risk. But that’s OK because it’s all about taking no more risk than you can emotionally deal with.

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. Kid Dynamite’s blog post on folding quads at the 2013 World Series of Poker is also a good read.

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. Nassim Taleb is correct when he says the impact of randomness in human affairs is underrated. There are also the geographical, historical, and environmental headwinds or tailwinds you are born into. If you were born in the postwar era in the United States, 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 age 25.

2. The expected value of a bluff at the margin also has to include the fact that a human opponent will adjust to more frequent bluffs and be more likely to call “value” bets (i.e., profitable bets where you are ahead). In a simplified game with both sides playing perfectly, optimal bluffing frequency results in breaking even overall on the bluffs themselves. The last marginally profitable bluff loses money on the bluff itself, but forces a perfect opponent to increase the frequency of calls on value bets. In a real game against imperfect players, you would bluff less than the optimal frequency against a player who is a “calling station” or reluctant to fold and more against a player who is “weak” or reluctant to call.

3. That’s why most social investing platforms, such as message boards, are terrible and will make you a worse investor. The good investors won’t post; they won’t explain the strategy and context for every trade. 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, such as StockTwits and Estimize: They give you a very good idea of the thinking that is prevalent in the market, which by definition is unlikely to outperform. (Also, a poker pro is not going to learn much from a typical poker chat, but a novice will get massive value.)

4. For example, suppose you hold A♠ J♠. Flop comes J♣ 2♦ 7♥. You put in a pot-size bet, and your opponent goes all in. What hands are you behind against?

• K K (6 hands including all suit combos: K♠ K♥, K♠ K♦, K♠ K♣, K♥ K♦, K♥ K♣, K♦ K♣)
• Q Q (6 hands)
• J J (1 hand since J♠ is in your hand and J♣ is on the board)
• 2 2 (3 hands since 2♦ is on the board)
• 7 7 (3 hands)
• J 2 (2 pair — 6 hands — 2 Js and 3 2s not in your hand or the flop)
• J 7 (6 hands)
• 2 7 (9 hands — 3 7s and 3 2s available)

No flush or straight is on the board. So, 36 possible hands out of 1,081 (47 ×46/2) are beating you. (42 if you include suited A J, which would win with runner-runner flush about 4.5% of the time and split the pot the other 95.5%, so would be slightly ahead.)

But you’re not playing against a random hand. You have to ask yourself how often your opponent will go all in when they are behind in that situation. Suppose there’s $200 in the pot and you have $100 left. You’re getting 2-1 pot odds. You should call if you think there’s more than a 1/3 chance you’re playing against someone who pushed all in with A 7 or A 2 or 9 9 or a stone cold bluff. (Oversimplifying and assuming whoever’s ahead wins — in fact, if you call with your pair against a set of 2s, you can win if a couple of As fall, or a J as long as quads don’t fall, or trip 7s on the board, enough to give you about 2% chance of winning [try it here]. You can also lose when you’re ahead against A 7, with a third 7 on the turn or the river, about 8% of the time. A lot can happen in poker.)

A clairvoyant opponent would optimally bluff 1/3 of the time in this situation because that makes you indifferent to calling or folding.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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