How Poker Can Make You a Better Investor by Kiplinger

8/2/2019 How Poker Can Make You a Better Investor by Kiplinger

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How Poker Can Make You a Better InvestorLearn to avoid emotional traps by playing a little

Texas hold em.

By Bob Frick, Senior Editor,Kiplinger's PersonalFinance

January 7, 2010

Ever watch professional poker players calculating the odds, then coolly dissecting their opponents? Manyof the same skills the top players use can help you be a better investor. Success at both investing andgambling, it turns out, has much to do with controlling emotions. And playing a little poker can help yourecognize, and avoid, emotional traps that endanger your most important stack of chips -- your portfolio.But you need to know what to look for.

The psychological issues that drive investing and gambling decisions arent merely similar. They are

identical, says Andrew Lo, director of the Massachusetts Institute of Technology Laboratory for FinancialEngineering and one of the leaders in the field of behavioral finance (listen toour podcast with Lo). Itseasy to find investment professionals and professional poker players who agree. Says poker pro DanielNegreanu, who holds four World Series of Poker bracelets and two World Poker Tour Championshiptitles: Having emotional stability and emotional control is key to both investing and poker.

Can you gain that control at a poker table? Aaron Brown is among many who think so. Brown is aonetime finance professor and former portfolio manager for Prudential Securities who is now a riskmanager for hedge funds. Hes also the author ofThe Poker Face of Wall Street(Wiley, $17). Says Brown:People tell me playing poker is risky. Investing for a financial lifetime without playing poker is risky. Idmuch rather make these mistakes at the table.

And by mistakes, Brown means the common emotional errors that plague investors. The burgeoning

fields ofinvestor psychologyandbehavioral financeare uncovering more about these errors all the time,and they are the subject of a year-long series co-produced by Kiplingers and Nightly Business ReportonPBS.

By playing some poker, you can find out your tendencies to make emotional mistakes, and then you canguard against them, says Frank Murtha, a behavioral-finance consultant with a PhD in counselingpsychology (his dissertation explored the effect of psychological errors in gambling). Murtha helps clientsfrom investment banks, financial-services companies and trading firms to avoid making psychologicalerrors.

Hes also co-founder ofMarketPsych, which offers psychological-training services to traders and moneymanagers and which offers a number of online tests that any investor can take to better understand his orher own psychological makeup.

Most investors make few investment decisions over a year, or even over a lifetime. But experts agree thatjust a few hours of playing poker will take you through literally dozens of financial decisions -- potentially alifetimes worth if you were making those decisions about your portfolio. By playing poker while keeping inmind the psychological errors that are also common to investing, you can get a lifetimes worth of trainingin one evening.


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What are these errors? Weve picked five of the most common, and all can be found both in investing andin gambling. Click on each one below to learn how they appear in poker and investing and to find out howyou can use poker to help train yourself not to make these errors.

Greed

Greed is one of the most powerful emotions that govern our actions. In the context of poker and investing,

greed refers to anticipating a financial gain. When the greed circuitry of our brain kicks in, we fixate onhow great well feel when we cash in those winning chips or investments, and we tend to ignoredevelopments that could cause us to lose the bet.

The best example of the greed effect in Texas hold em is when the first twocards you get are aces. While thats the best possible opening hand, it is alsomaybe the single hand that causes the most losses.

Why? Seeing those pocket rockets sparks feelings of greed, and we startcounting our chips before weve won the hand. The possibility of that bigpayout can blind us to thinking logically about our odds of winning -- just as

people who play the lottery can let the possibility of a multi-million-dollar payout blind them to theirridiculously small odds of winning.

The tunnel vision greed causes can make us ignore even obvious signs that our powerful hand hasactually turned into a loser. For example, suppose were holding the ace of diamonds and the ace ofspades, and the first three community cards turned over (called the flop) are all hearts. Now a flush(someone who has five cards of the same suit) becomes a real possibility. But you keep betting, confidentin your aces.

Then the next card is turned over, and its also a heart. The odds that one of your opponents has a heartto complete the flush are extremely high, so your aces have become virtually worthless. But you keepbetting -- a mistake.

A pair of aces is the most obvious example, but the effect works with any hand you think is a sure winnerand that causes you to ignore the possibility of loss. In poker, seldom do you hold a hand thats a surewinner (called, in poker slang, the nuts).

In our portfolios, the same problem happens when we invest in something we think is a sure bet -- forinstance, a stock with a great story thats recently rocketed up in price. So confident are we that whennegative information about the company is revealed -- the chief executive is indicted, say, or a keyproduct is discovered to cause cancer -- we ignore it.

The way to stop the greed response is to focus not on the joys of winning, but on why you might not win.Test your hypothesis with each new card. The story changes and you have to change with it, says FrankMurtha, a behavioral-finance consultant. Thats why great poker players will lay down great hands.In investing, Murtha says, greed leads us to get emotionally attached to an investment. A good way toshake this attachment basically the investing equivalent of testing your hypothesis with each new card -

- is to ask yourself whether you would buy this stock at this price right now. If the answer is no, not really,then we know that you have some sort of emotional need to hold on to it, says Murtha.

OverconfidenceHumans are overconfident animals. As Jason Zweig points out in his bookYour Money & Your Brain($15,Simon & Schuster), about 75% of people will judge themselves better than average at anything -- fromdriving to basketball to telling jokes to scoring well on an IQ test. Of course, half of any group, bydefinition, must be below average.


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In poker, this plays out in, er, spades -- especially among beginners. The very act of playing a game suchas Texas hold em is a humbling experience that will quickly deflate feelings of overconfidence. But thereal value is helping you recognize situations in which overconfidence leads you into big losses.

Professional poker player Vanessa Rousso says this effect takes place particularly after large gains. Intournaments when Ive won a series of hands, it tends to make me loosen up and take excessive risks,

says Rousso, who holds a degree in economics from Duke University. What could have been a period ofprolonged success is quickly shortened by overconfidence.

In investing, the parallel is obvious. During stock-market booms, many people start boosting their stakesin riskier investments, such as emerging-markets stocks. Or they may simply shift hefty percentages oftheir portfolios from bonds to stocks.

This overconfidence can turn into manias, such as the day-trading phenomenon of the late 1990s.Buoyed by the growing bubble in tech stocks, day traders felt they could sit at their computers and profitby quickly trading stocks. When the tech bubble burst, so did most of these traders fortunes.

Rousso says the key to combating overconfidence in poker is recognizing when youre deviating fromyour game plan. Thats good advice for investors, too. When youre tempted to take more risk, recognize

the effects of overconfidence and methodically think through your plan.

Regret

Poker pro Daniel Negreanu says, The toughest thing for a poker player to do is quit when hes losing.Losing a big hand in poker will often put a player on tilt, which means a player is so twisted up aboutlosing that hes apt to do crazy things. In investor psychology, that same feeling is known as regret.

Imagine being dealt a ten and a jack, then watching as two sevens, an eight, anine and an ace come up in the community cards on the table. You have astraight, and a single player has stayed in the hand, matching your bets chipfor chip. Finally, you flip over your cards in triumph, and your opponent flipsover his. He has a seven and an ace, a full house, and you realize that fat pileof chips belongs to someone else.

Oh, the pain. Literally. A financial loss stimulates the part of the brain associated with pain. A bad beat(poker slang for a tough break) often generates two responses: You bet big on a weak hand to try tomake back the lost money, or you become so fearful of another loss that you play too conservatively.

The same thing happens in investing. A big loss causes regret, which can lead you to take big risks or tounload your securities and stay out of the market for an extended period. We saw both those things afterthe 2007-09 bear market, especially the tendency of investors to sit on the sidelines by holding only cash.Whats at the core of regret? Behavioral-finance consultant Murtha says regret is such a powerful emotionbecause people hate to be responsible for their own pain.

When he counsels people who are frozen from regret, he urges them to take a long-term view and get

back on the horse. I know its hard to make this decision now, but if you want to accumulate this wealthover a lifetime you have to make the hard decisions now, says Murtha. Youll look back someday andsay, Gee, why didnt I have any guts?

Brown, the investment pro and poker player, says that learning to deal with losses at the card table canhelp investors deal with declines in their portfolios. If you made a mistake either playing a hand or pickinga stock, learn from the mistake and resolve not to make it again.

But sometimes, Brown says, bad things just happen. He thinks of it this way: Okay, I bought 20 stocks,and three turned out to be terrible. Thats okay; they were good at the time.


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Seeing patterns

One of my own poker demons is the hot hand fallacy. Humans are wired to see patterns where nonereally exist. A simple example of this is when fans think a basketball player whos made a fewconsecutive shots will sink the next because of a hot hand. In fact, the next shot is no more likely to fallthan the players longer-term shooting percentage would suggest.

Likewise, when playing poker theres a tendency to think you can predict whatcards will turn up next based on the cards already showing. If youre holding aking and a queen, for example, and the flop includes a ten and a jack, youmay be tempted to bet big because the pattern is clear: Ten, jack, queen, king... the next card is likely to be an ace. Right? In fact, the odds of ace comingup are only about one in 13.

And if youre trying to make a flush and youre holding two hearts with two others on the table, the nextcard is likely to be a heart, right? Of course, hearts are only one of four suits, but your odds are even lessthan one-in-four. Four hearts are already accounted for, remember? So the deck holds only nine more.

Another reason why people see patterns may boil down to a feeling of hope. A poker player may want a

card so badly that he or she disregards the low probability of getting that card. The hope and desire to hitthe big hand (emotion) overwhelm better judgment (rationality). As the saying goes, hope is not astrategy.

This compulsion to see patterns hurts our investments in a number of ways. When it comes to stocks, alandmark study by professors Werner DeBondt, of DePaul, and Richard Thaler, of the University ofChicago, showed that investors relying on past information became overly optimistic about past stock-market winners and overly pessimistic about past losers. But the stock-price patterns didnt persist. Overtime, extreme winners underperformed the market, while extreme losers outperformed.

The hot hand works well with mutual funds, too. When it comes to mutual-fund advertising, the warningthat past performance is no indication of future returns doesnt seem to sink in with many of us. We seeads that promote two or three good years of returns, and we buy the funds -- even though that greatperformance is usually a random phenomenon, just like three consecutive heads on a tossed coin.In poker, you can beat pattern thinking by calculating the odds. This kicks your thinking from instinctualand emotional to logical.

With investing, you likewise have to start thinking logically. First, look at the long term, especially withmutual funds. Check the five- and ten-year histories, not just how a fund has done the past couple ofyears.

And do some in-depth analysis. Look at things such as fees, turnover, fund size, manager tenure and soon. And with a stock, make sure a tempting record is based on solid fundamentals of the underlyingcompany, not just investors piling into a stock simply because its price has been rising.

Holding losersOne of the best-known psychological errors in investing is the tendency to hold on to losing investmentstoo long. Why cant we sell?

Its easier to see why if we look at this problem in poker terms. Say youve betbig on a hand that looked great at first, but started to look like a loser as morecards were turned over. In fact, your opponents could have straights, flushesand full houses, but youre sitting with three-of-a-kind.


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To stay in, you have to call one final, big bet. Murtha knows whats going through your mind: I know Ishouldnt call this. I know your hand is better. But Ive got to see it. Ive got to call!

What happens when you fold a bad hand or sell an investment thats gone south? Youre admitting thatyou made a bad decision, and that hurts your ego. True, the bad decision to hold and not to fold earlier isobvious without actually giving up. But folding a hand or selling a losing stock removes the last shred of

possibility that you might have been right.

The solution to holding on to losers is to listen to that voice in your head saying, I know I shouldnt callthis or I know I shouldnt hold on to this investment. Thats your logical self trying to drown out your ego.You can also change your thinking so that your reward isnt about making money, but about making agood decision. Let yourself feel good about doing something difficult, knowing -- as Daniel Negreanu says-- that youre doing the hardest thing in poker, the thing that separates the greats from the rest of us.

We often let ourselves be rewarded for good outcomes rather than good decisions. That is a big mistake.Outcomes are often capricious and beyond our control. You can make bad choices and luck out, and youcan make good choices and get burned. Successful poker players know that the key to accumulatingwealth is relentlessly making the good decisions. If you do that long enough, you will make money ineither game.

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How Poker Can Make You a Better Investor by Kiplinger

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