Game theory: What playing poker taught Manish Dhawan about investing

There is an interesting SSRN paper written by Yan Lu, Sandra Mortal and Sugata Ray titled “Hedge fund Holdem”

This paper claims that hedge fund managers who have won cash prizes at poker tournaments apparently outperform those that have not by approximately 1 percent to 5 percent a year in investment returns and the difference is even wider for few who have won big tournaments.

I do not know if the paper is accurate in its assumptions or not, but what I do know is that both the fields derive heavily from probability, game theory and psychology.

In other words, if you are good at calculating probability, chances are, other things being constant, you would do well in both fields.

In this blog, I will try and share the distinctive similarities, both on upside and down I observed in both fields.

One of the main reasons most people lose money in poker is because they overestimate the strength of their hand without considering probability. Let us say you got a Pocket Rocket (pair of aces). Technically, if you are playing just one opponent, you have great odds (81 percent chance of winning the hand).

But if there are more number of players on table, those odds would reduce. Somebody with a pair of a much lower card may still beat you easily if he or she is able to make ‘three of a kind’

A rookie mistake that people do is that they go overboard in the initial rounds of betting and stretch themselves too thin.

This is where the second bias (sunk cost fallacy) kicks in, once you have committed 20-30 percent of your bankroll on this “sure thing”. It is difficult to bail out even when you know you don’t have a winning hand. Stock market is no different. After burning the mid night oil for three months and doing various channel checks, you conclude that you are onto a sure thing. Once you have bet a big portion and stock tanks, the sunk cost fallacy doesn’t allow you to bail out and you hold on to a loser.

A good poker player, just like a good investor, allows the hand/trade to prove itself. They cut loose their losers and pyramid into their winners.

This disposition works in the opposite direction too. Once you have got a good hand, you should try not to show your excitement. If you over bet and your opponent senses that you have a strong hand, he will simply fold his cards and deny you the chance of making a killing.

The investing equivalent of this would be selling your winners too early. Once you get a winner, as a trader/investor it is your duty to ride/milk it for as long and as much as you can.

If you are a statistics student, you must have heard of Bayes theorem. The reason I am boring you with this technical stuff is that it is relevant in both fields.

The theorem expresses how a degree of belief, expressed as a probability, should rationally change to account for the availability of related evidence.

In simple words, it is calculation of changing probability with addition of “new evidence”.

Let us say you are solving a murder case of a lady. Preliminary evidence suggests that it is a case of attempted burglary gone awry. Later you learn that the deceased was insured for Rs 5 crore just a year ago and her husband owes money to people.

How the new information changes the probability of this being an open and shut case of burglary and accidental death is Bayesian probability.

Stock market is a live beast, it is an unfolding story. Every new piece of information adds to your understanding of a company and therefore Bayesian probability is at play. Poker is a game where the dealer deals you two cards that tell you your initial odds. He then lays three cards (Flop). This is new information that turns the probability on its head.

After more betting, he shows another card (Turn) again changing the probability matrix upside down.

As if this is not enough after further round of betting he unveils a final card (River) which opens up a Pandora’s box of psychological warfare (bluff, deception, body language etc).

And therefore Bayesian theorem of changing probability with changing information plays out both in poker and investing.

Another amazing similarity between poker and trading is that majority of participants are just gamblers and adrenaline junkies and therefore handful of them (1-2 percent) with self-discipline and patience account for all the winnings. This is a winner takes all field or as Nasim Taleb would say, EXTREMISTAN.

There is a famous saying in poker: “If after 30 minutes into a poker tournament, you don’t know who the patsie (sucker) is, it is probably you.”

The same holds true for traders with no strategy, no trading journal to record what they are doing. They all end up losing a packet.

Both poker and trading are games of patience; if your urge to seek adrenaline overpowers your resolve and self-discipline, it is ‘game over’

Both poker and trading allow its players to be flexible. There are many ways to skin the cat. In trading, you can be successful by being an options writer, a trend follower, or a mean reversion trader. The strategy has to suit your personality.

Similarly, the poker world has scalpers, who would play any hand (regardless of its strength), mathematicians who would calculate each and every probability (Chris Ferguson) or a Gus Hansen (my favourite) who plays more on psychology and game awareness.

In both fields, success lies in realising who you are and then playing to your strengths. A trend follower doing mean reversion trades will mess it up and similarly, Gus Hansen playing by maths would be a disaster. Something like Sehwag trying to play like Dravid or the other way round.

Both in poker and trading, you have to learn to embrace losses. You should be aware that this is not a high win-rate game. Just like a trend following trader, on average a poker player would lose 70 percent of his hands and still can end up at top of the table. The entire game is to make sure that losses are small and winnings are windfalls.

I once had a full house and bet everything when there was just one opponent left in the game. I knew that the probability of my opponent having a better hand was negligible. And yet I lost because he had four of a kind.

In stock markets too, luck plays a big role (especially in your early years). A bad streak can end the career of otherwise skilful traders. Watch the Brad Pitt movie Money ball to see what happened to Billy Beane despite all his at figuring out probabilities.

There are a lot of nuances and subtopics within this broad subject. I am sure I have missed many other vantage points. Poker and investing have many more similarities as both derive their success from a potent combination of psychology, probability and a dash of luck.