Ever wonder how the same set of poker professionals always seem to rise to the top in tournament after tournament? The World Series of Poker frequently includes repeat faces at its final tables. There is a reason why Doyle Brunson, Johnny Chan, Phil Hellmuth and other poker heavyweights show up over and over again.
In the short term, all poker players experience successes and failures. An experienced poker professional expects to lose some hands and even entire games.
In the long run, however, the skilled players continually come out ahead of the rest. Those players have mastered long-term strategies for success—many of which directly apply to investing.
1. Know your odds
To a novice, professional poker players seem to have a magical ability to calculate their probability of success with any given hand. These math skills are a crucial foundation for any serious player.
Serious Texas hold ’em players, for example, can determine with mathematical precision the probability of success based on their two private “hole” cards, position at the table and number of players.
They can then revise that calculation based on other cards that are revealed, as well as the betting strategies and behavior of the other players. This information gathering process provides a more complete story that allows for better decision making.
In investing, a focus on the numbers and information gathering is equally important. In both poker and investing, the goal is to identify opportunities with attractive chances of success, and then take as much advantage of them as possible.
“Know when you have the 60/40 end of the proposition. Know when the odds are in your favor and bet, or know when the odds are not in your favor and get out of the way,” David Nelson, senior vice president of Legg Mason Funds Management said in a November 2003 speech.
Investors can determine mathematical probabilities as well, although they often have even more factors and unforeseen costs to take into consideration in their calculations.
Experienced investors, like experienced poker players, are better at judging the factors that could affect their odds.
Of course, there is always a degree of unpredictability and unknown information in any poker or investment deal, particularly in the short term.
“You don’t know what’s going to happen a lot of the time, but you do enough analysis so that the probabilities are in your favor when you make a particular investment,” Nelson said.
Over time, a strategy that seeks attractive probabilities will show positive long-term results, even though the player or investor will experience occasional disappointments.
“From the strategic standpoint, all you can do as a poker player is to make the most well-informed decisions possible, based on the information available. For an investor, it’s all the same,” poker player and investor Corwin R. Cole said in his article “Poker and Investing: Two Roads to Profit.”
2. Weigh risk versus reward
A successful poker player can’t focus solely on probability, of course. The amount that must be risked for a chance at the potential returns is also a crucial consideration in both poker and investing strategy.
“A focus on probability is sound when outcomes are symmetrical, but completely inappropriate when payoffs are skewed. Consider that roughly 90 percent of option positions lose money. Does that mean that owning options is a bad idea? The answer lies in how much money you make on the 10 percent of options positions that are profitable,” Michael J. Mauboussin said in his book More Than You Know: Finding Financial Wisdom in Unconventional Places.
“If you buy ten options each for $1, and 9 of them expire worthless but the tenth rises to $25, you’d have an awful frequency of success but a tidy profit,” Mauboussin said.
In poker, some bets have a small chance of paying off, but they only involve a relatively small outlay in proportion to the potential payoff. This means it is sometimes still worth betting if the buy in is low relative to possible returns.
For example, a hand that has a 20 percent chance of winning is still worth playing if the pot is $100 and only requires $5 in outlay. Over time, this strategy will be favorable even though the hand will lose 80 percent of the time.
“Some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis,” Mauboussin said.
A savvy poker player or investor will take into account not just probability of success, but the level of risk required for the potential reward.
Successful poker players and investors diversify across many different deals. “Players of probabilistic games must examine lots of situations,” Mauboussin said. Probability becomes more predictable as the number of deals increases.
Poker players “overcome variance by playing large amounts of hands,” Cole said, and “the investor’s analog is diversification.” Poker players and investors seek diversification across many different advantageous opportunities.
Diversification across a variety of investments ensures that “any single loss is not a large one,” Cole said. Diversification allows poker players and investors to spread the risk out over many deals so that a single deal won’t make them or break them.
For example, even if you have a 90 percent chance of hitting it big, if you put all your eggs in that basket, you also have a 10 percent chance of losing everything.
Investors can participate in many smaller deals rather than one large deal in order to maximize the end result and minimize risk. They can also spread their investments across different markets, such as stocks, bonds, real estate and alternative investments.
A professional poker player knows that many hands and many games must be played in order to maximize the chances of encountering advantageous opportunities.
Even poker players who go “all in” and risk all of their chips are only at risk of losing the particular hand or of being eliminated from a tournament—not of losing their life savings.
Professional poker players and professional investors will never risk their entire savings on a single hand or deal.
4. Be selective
In casual, friendly poker games, players tend to play many hands that they really shouldn’t if their goal is winning. It is simply more fun and exciting to be actively participating, even if the chances of success are not necessarily ideal.
A serious poker player, however, knows better than to play every hand.
“One of the simplest principles of winning poker is to selectively choose hands with a high probability of showing down the greatest strength,” Cole said.
Likewise, investors must have the discipline to be discriminating about the deals they participate in. Those who participate in every deal that comes along will waste money on mediocre deals and be unable to participate in better deals that come up later.
Those who are selective know that over the long run, their good decision making process will lead to success. Rather than trying to make a bad hand or a bad deal work, they wait for the most advantageous situations and make the most of them.
Conversely, a savvy poker player or investor doesn’t allow an unlucky streak to dissuade them from participating in deals that do offer attractive odds.
Even in the middle of what may feel like an unlucky streak, professionals know that “the only way to succeed is to continue to bet as long as they have a positive mathematical expectation—no matter how bad their luck is going,” Brian D. Pacampara said in his Motley Fool article “Poker Wisdom for Investors.”
“They have faith, because the ‘law of large numbers’…dictates that they will be profitable over the long run, as long as the odds are consistently on their side,” he said.
5. Know when to fold
Good poker players are willing to fold a strong hand and cut their losses when the odds are no longer in their favor. This requires a level of emotional discipline that most average people have not developed. Most amateur poker players—and many investors—allow their emotions to influence their decisions.
For example, a Texas hold ’em hand of two aces, or “pocket rockets,” is not an easy hand to fold, since it comes along so rarely. Even so, there are times when the likelihood of that hand coming out the winner becomes very low, and the aces should be folded.
Many amateur players will ride out those aces through the end, even when it is clear mathematically that they should fold.
“You can save a lot of money in poker and investing if you know when to say adios. But the thing that works against us is that people want to hope and they hate taking losses. They are willing to seek risk to avoid losses. They will not sell their losers…they’re not making decisions on a rational basis,” Nelson said.
Likewise, investors must avoid the temptation to fall in love with a particular investment.
Developments mid-way through an investment may change the numbers and make the investment less attractive. For example, a building’s foundation may crack, and it may be better to walk away and cut the financial losses than to sink more money into the project.
Even when the project is clearly no longer a smart financial move, many investors don’t want to admit that an investment isn’t working out. They get emotionally attached to an investment or an outcome and want to stick with it until the end.
“With nearly 30 years of investing experience, I have a hard time making decisions all the time on a rational basis as opposed to an emotional basis,” Nelson said.
Getting emotionally tied to a certain outcome is dangerous. An investment or a poker hand is a number, and when it doesn’t make sense, the player needs to be able to walk away.
“Control your emotions….If you get angry and you start feeling sorry for yourself, you better get up and walk away because you’re getting ready to give somebody a lot of money,” Nelson said.
“As investors, we need to be completely aware of when our emotions are getting the better of us, jeopardizing our ability to make sound investment choices,” Pacampara said.
Those with the self control to separate their decisions from their emotions can keep themselves focused on the correct decisions.
“Poker professionals know that unrestrained nerves are the biggest roadblock to sound decision-making, so they make it a habit to regulate their own emotions. As a result, professionals can, in a sense, step outside of themselves, doing whatever is necessary to make the right decision most of the time,” Pacampara said.
“The most important decision in poker and investing is always ‘what is the right thing to do next?’” Nelson said.
Naturally, there are some major differences between poker and investing. The simple fact that there is a limited number of cards in a deck controls the amount of possibilities that exist in a poker scenario.
Math allows poker players to find percentages and statistics about how likely they are to win or lose a hand, while investing has a wider variety of factors to consider.
“In poker, you can count your outs and do some arithmetic to determine exactly how likely you are to win the hand. Investors have no such luxury,” Cole said.
Potential costs in investing are also more difficult to predict. “Poker players have only one simple cost to beat when playing—the rake [the fee taken by the house]. And it sits right there next to the dealer, completely transparent and always the same. Unfortunately, investors have some more complicated and severe costs to fight,” Cole said.
However, investors do have an advantage in that they are not required to put money toward every deal that comes along. Although poker players must pay out small amounts just to stay in the game, investors have no such ongoing financial commitment required to view opportunities.
“In investing, on the other hand, you need not participate when you perceive the expected value as unattractive, and you can bet aggressively when a situation appears attractive (within the constraints of an investment policy, naturally),” Mauboussin said. “In this way, investing is much more favorable than other games of probability.”