Many people think the stock market is like some big gambling hall. And to some, it is. Hedge funds, day traders and the like all look at the numbers whizzing by on their screens and make micro-second bets trying to outsmart the next guy, writes Steve Pomeranz Tuesday.
Let me say that using the words “poker” and “investing” in the same breath is truly distasteful to me. I spend my days teaching clients and listeners that investing is not about beating the market but rather a disciplined, long-term process for achieving financial and life goals. So, making any parallels between poker and investing is strictly verboten in my book.
But the fact that I do have to work so hard to distinguish investing from gambling suggests that like it or not, there must be some parallels.
So, let’s see if we can find them and learn the good, the bad, and the ugly. Maybe we can become better investors after all.
I spent time looking into the fundamentals of poker and noticed there are, indeed, some healthy key strategies that we can add to our toolbox. These strategies may serve us well both in poker and in investing:
1. Know when to fold ’em.
Good poker players fold a lot of hands. When played this way, the game can be a bit boring. But it’s a lesson investors need to learn to be successful.
In poker, success is about making money, not winning hands. And because most hands are losing hands, it takes patience and discipline to protect your bankroll while waiting for a playable hand.
In investing, success is about gradual accumulation of wealth over long periods of time, not the aimless pursuit of short-term gains. It takes patience and discipline to stick with a prudent long-term investing strategy when you’d really rather engage in risky transactions in the hope of seeing immediate, adrenalin-producing results.
But patience does not mean sitting idly by. Rather than characterizing sitting idly by, poker players learn what is, basically, deliberate non-action. Because you never know when a favorable betting opportunity will occur, you must be mentally alert and ready for action at all times—even though not taking action is an integral part of the game and essential to your long-range goal of making money.
I always say doing nothing is an active decision—but this doesn’t apply to teenagers.
2. Know what you don’t know.
Poker players are required to make betting decisions based on incomplete information. Without knowing the cards in their opponents’ hands or the community cards yet to be revealed, they must decide whether to bet, call, raise or fold.
Investing also requires decision-making in the face of incomplete information. The future direction of interest rates, stock prices and many other factors which affect investment returns. These can all be analyzed but, in the end, they’re simply unknowable. Given imperfect information, the key to success in poker and investing is to assess what is most likely to happen and base decisions on the most probable outcome.
What some poker players—and some investors often ignore— is their own behavior.
3. Understand human nature.
Human behavior is an important part of poker: You are constantly trying to determine what is in your opponents’ hands based on how they act at the table. An opponent who leans back in his chair or immediately reaches for his chips after looking at his hole cards can help the watchful player determine that the opponent has a good hand.
But what some poker players—and some investors often ignore—is their own behavior. People tend to underperform their investments. It’s not uncommon for a mutual fund to go up 10% to 11% a year on average, yet the average investor in the fund makes just 2% to 4% per year on average.
Why? It is human nature to buy when the market is up and people feel good and to get frightened and sell when things are bad.
Understanding human nature means understanding our own behavior as well as others, such as staying in a bad hand or a bad investment out of hope—and not because the mathematical probabilities tell us it’s the right thing to do.
4. Minimize losses and maximize gains.
There are four styles of poker players—and this I love, this is important.
- Loose-passive players: They call just about every bet.
- Loose-aggressive players: They play lots of hands and raise frequently.
- Tight-passive players: These folks are careful with their money. They seldom bet, rarely raise, and call only when they have a great hand.
- Tight-aggressive players: These are the best kinds of players. They are careful with their money, but when they do play, they seize the initiative. They enter few hands but, when they do, they bet and raise aggressively.
So, what type of investor/poker player is Warren Buffett?
He’s tight-aggressive. He’s careful with his money, but when he sees things that are in his scope of knowledge and the price is right, he bets heavily and most often makes a fortune…if there’s time.
5. Control emotions.
Losing your cool in poker is called “going on tilt” and leads to irrational play. Likewise, investors who let emotions interfere with good strategy also make bad decisions. As the experts say, the most important decision in poker (and in investing) is always “what is the right thing to do next?”
A client who has a bad investing experience must be careful not to let the emotional fallout affect his next decision. If he finds that hard to do, a temporary retreat to cash—the equivalent of sitting out a few hands—may be the best strategy. And, of course, poker players and investors should never risk money they can’t afford to lose.
This analogy between poker and investing is fun and helps to illustrate some fascinating points. But remember, that to create real wealth, you have to treat your money seriously. Poker is just a game. Investing is serious business. It’s a lifelong process that determines whether or not you will live in peace and comfort. This is the most important financial stuff you can know.
Learn more at StevePomeranz.com