Getting rich slowly in the markets is an achievable goal. Just find the risks that everyone else irrationally hates right now. That’s the one that is available at the right price and will yield good returns.
Now, while it’s simple, it’s not easy. Winning the gold medal in the 100 metres is simple – just run faster than everyone else. In hindsight, superior strategies look simple. But they need preparation and 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 very few people can apply them consistently.
I’m going to explore 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 lessons directly applicable to investing. Both are games of analysis and decision-making under imperfect information and uncertainty; psychology and human emotion; and ‘luck’… which in the long run is variance, the winding road to the inevitable fate your skill, preparation, mental toughness or lack thereof have destined you to.
It’s all about understanding value. 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.
If you have four of one suit, that’s like a startup or growth stock. Your hand, in terms of competitors it can beat, is laughable. But it might grow into a monster, so it has a lot of option value. Your goal is to get in cheap enough that it’s worth hanging on to it. 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.
It’s all about using all the information at your disposal. Fundamental analysis is understanding your hand’s value in the context of the flop, the turn, the river and probable outcomes. Technical analysis is trying to figure out how strong your opponents are based on their tells. Knowing their history can give you an idea of what they might have and how they might respond to your play. If all there was to the game was history, there would be a lot of rich historians. But only a fool bets without thinking about how the game has been played until now, who is in the game at what price and how they might feel about that and respond to action.
Grind it out and stay in the game
It’s all about knowing what you don’t know. Once you attain a certain level of mastery, there’s going to come a time when you think you have the game, the market, the other guy player figured out. And then it behaves in a way you didn’t quite expect. You need to accept that it’s a game of imperfect information, and you’re not at the top of the information waterfall most of the time. Not even close.
You make most 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 can be 10-50 times that. The key to the game is to make the right call on the big pot most of the time.
Depending on the type of investor and market you are in, you may make all your profits and then some on a couple of home runs. The rest of the time you are managing risk, trying not to blow up on something stupid, and making sure you are around and properly positioned when opportunity arises.
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 significant positive expected value (EV). If you bet too much, even when you have the edge, variance is going to destroy you. Most of the time, it’s more important to not blow up on something stupid than to make a hero call. You win by not losing.
Be patient – with well-timed aggression
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 billionaire investor and philanthropist Warren Buffett says, there are no called strikes in investing. (There is only opportunity cost in investing, but in poker you have blinds/ante). 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 hands harder to read, makes the opponent 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.
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 favour. Conversely, when something is going south, you have to be able to get out while the going is good. Cut your losses quickly and be all-in on your best hands.
The last thing you want is situations 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 is guaranteed to fold and anybody better 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.
Multi-level thought process
It’s all about context and process. A play that might be terrible at a certain time and in a certain size might be brilliant at a different time or with a different size.
Typical scenario: novice player sees pro and tells him about some big hand where he got knocked out of a tournament and asks what he should have done. Pro asks: “How big was your stack? How big was your opponent’s stack? What were the blinds? Where were you sitting? Where was he sitting?”. 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.
It’s a game that requires thinking on many levels. In poker, it’s something like this:
- 1st Level: What cards do I have?
- 2nd Level: What do my opponents have?
- 3rd Level: What do they think I have?
- 4th Level: What do they think I think they have?
- 5th Level: Yes, you can keep going and going…
In investing, it’s not enough to interpret or predict earnings, you have to understand what other investors are thinking, what is priced in to the market. It’s Keynes’s beauty contest or Oaktree Capital Management’s Howard Marks’s second-level thinking.
You need next-level thinking to win. But if you’re thinking more than one level ahead of the market, you’re overthinking it and you’re going to have hard time. (i.e. if the market is just focusing on the next earnings report and you are focusing on the product pipeline and earnings five years out.)
It’s all about not going on tilt. You have to manage your emotions in the face of inevitable ups and downs and maintain Zen-like concentration on what the game is telling you and the plays you can control. If you can just avoid the big mistake that wipes you out, you will have opportunities to do well.
Also, you can’t bluff the financial markets, unless you’re the axe in a market. In poker, you can bluff successfully, when you have a stack advantage, table image, 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 at the margin, and confuse your opponents more.)
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. They call it no-limit for a reason. 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, demand ante or a big blind, and you can always get all your money in at or near the price it shows.
Stay alert to ‘good’ and ‘bad’ risk
But this really is the most important thing. There is good risk and bad risk and you need to be able to smell the difference.
The really bad risk is the one that hits you out of leftfield because you didn’t know what you were doing. The novice bets with top pair, top kicker (i.e. Ace Jack with a Jack-high flop) , gets raised, and he calls for his whole stack against a pair of Queens. Or, he thinks he’s invincible with a pair on the board giving him three of a kind, and someone has a full house.
If you’re that guy, in investing or in poker, the thing to do is 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 stock-trading pioneer 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 you don’t really 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.
Ensure you can cope – emotionally – with risk-taking
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 and your opponent is good enough that you don’t really know where you stand. Or the player is not that good or has been out for a lot of hands is suddenly confident and aggressive. You’re out of position, behind the information curve, and before you know where you stand you will be committed for a lot of your stack. That’s the time to see if you can buy information cheap, reassess and possibly run away before you get in too deep.
The good risk is where you have an awful knot in your stomach over all the scenarios where 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, you might run into a ridiculous bad beat or cooler, but in the long run it’s a winning strategy. The good risk is the one you are paid well to take, and take in the right size in the context of the game as a whole. Embrace it and learn to love seizing it.
Mathematically, 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.
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.
Image credit: ©Getty Images/Oscar Sánchez Photography