Know when to fold ’em: what investors can learn from poker players

For one thing, don’t be more willing to walk away when you’ve won money than when you’ve lost it.

In poker and investing, don’t be more willing to walk away when you’ve won money than when you’ve lost it.

Some of the biggest investors on Wall Street are known to be ace poker players. Are there things we small fish can learn from Texas Hold ’em that will make us better investors?

Researchers on the subject say the answer is yes.

Kevin Zollman, an associate professor of philosophy at Carnegie Mellon University who studies game theory, notes an oddity of behavioural finance called the disposition effect, in which investors tend to sell assets that have increased in value but hold on to those that have decreased. Why? Investors dislike losing more than they like winning.

This same behaviour manifests itself in poker, Dr Zollman says, when players, to their detriment, more often walk away when they’ve won money than when they are losing, or when they take too many quick small gains and unrelentingly try to recoup losses. Small investors, he says, often ­defeat themselves by doing the same things.

A similar behaviour is referred to as hedonic framing, which is thinking about one’s money — gains and losses in particular — in ways that maximise pleasure and minimise pain. In poker, this is seen in players who fold often and quickly, and who play lots of relatively low-risk, low-stakes hands, says best-selling author and corporate-decision strategist Annie Duke. They might often win, she says. But when they lose, they lose just a little bit more than they win, and it adds up.

Likewise traders, Ms Duke says, can worry too much about how often they have winning trades and not enough about how much profit they are making overall. Ms Duke was a Ph.D candidate in cognitive psychology at the University of Pennsylvania before joining the professional poker ­circuit.

Luck, Ms Duke says, plays a big role in poker and investing. Poker, she says, is a better proxy for investing than chess, bridge or backgammon, because of the similar balance of known and unknown information. To deal with uncertainty, she says, traders and poker players must develop resilience and learn not to be guided too much by “results-based behaviour”. Put another way, they must learn that it is possible to do everything right and have a bad outcome; and it is possible to do everything wrong — maybe by throwing a dart at a list of stocks — and win big.

Dr Zollman notes that a related cognitive bias, the Dunning-Kruger Effect — which is, essentially, extreme overconfidence — also tends to exist in small-time investors but less so in high-level poker players. “You have to straddle this line,” Dr Zollman says. “You don’t want to react too strongly to each individual hand, which would be like reacting too strongly … to each trade.”

Less esoteric criteria come into play as well when judging the abilities of investors and poker pros. For example, experts say that an ability to “read” people is found in both groups. To wit, good poker players can sense a bluff; good investors know when an investment pitch is mostly hyperbole.

Also, the player or trader with more knowledge — enhanced by a good memory and computational ability — will usually win. Some “day traders”, in other words, are at a distinct disadvantage to pros with high-speed algorithms.

Other mathematical analogies found in poker and investing, Dr Zollman says, include the “gambler’s ruin” problem which, to simplify, means that over-betting can cause a card player to run out of chips. If that sounds obvious, there are obvious solutions as well, at least in investing. “The gambler’s ruin problem is why people diversify portfolios,” Dr Zollman says.

A common trait in successful investors and poker players is an ability to accept regrets. How often has a small trader muttered at a party, “I should have bought Microsoft in 1986 or ditched Enron in 2001, or gone all-in on the S&P 500 ETF in March 2009”.

It is no different in poker, where players sometimes miss an opportunity by folding too soon. But, as Ms Duke observes, the only way to avoid those kinds of regrets is to play every hand until the end.

“You would lose your money incredibly quickly,” she adds.

The Wall Street Journal