Applying behavioural economics to investment outcomes is an interest that many seasoned wealth advisors share. And while most of us resist the comparison between investing and gambling, there are definite similarities that both pursuits share.
Writing in Kiplinger1, a Washington, D.C. based publisher of business forecasts and personal finance advice, Senior Editor Bob Frick developed an excellent analysis of card playing in the form of a piece called: How Texas Hold ‘em Simulates Investing.
Wrote Mr. Frick: ‘Of all the gambling games, Texas hold ’em best simulates investing. Other gambling games can spark the same errors, but poker is closer to investing because a good player can win consistently (whereas players will lose over time with games of chance such as roulette and blackjack). And Texas hold ’em involves many decisions per hand.’
Incomplete and unfolding information
Mr. Frick quotes Frank Murtha2, a behavioural finance consultant and co-founder of Marketpsych – an investment advisory practice dedicated to distilling the sentiments and emotions of financial markets – who observes: ‘The stock market and Texas hold ’em are games of investing based on incomplete and unfolding information. The goal of each is to accumulate wealth by making decisions based on that information.’
Interestingly, several of the most well known U.S. money managers – including Peter Lynch, Bill Gross, David Einhorn, Steve Cohen, and even Warren Buffett, have observed that one of the most valuable educational tools for a would-be-investor is playing poker.
As a coda to this insight, Mr. Frick reminds us: ‘Researchers have long known about the gambling/investing connection. In fact, gambling is often used in laboratories to test psychological reactions that are also common to investing.
A variation of seven-card stud
Texas hold ’em is a nuanced variation of seven-card stud. Each player receives two cards face down, followed by a round of betting. Three community cards are then placed face up in the middle of the table, followed by another round of betting. Another community card is dealt, followed by more betting. Then the final community card is dealt, followed by the final round of betting.
How does this simulate investing?
How does this simulate investing? Mr. Frick’s answer is clear and concise: ‘Think of your first two cards as a potential investment – say a stock, mutual fund or bond. Your first decision is: Do I want buy it (bet) or pass on it (fold)? If you decide to buy it, you have made an investment, and you’re given the same choices that you get with any investment you own: buy more of it (bet), hold it (check), or sell it (fold). Every time community cards are shown, you get more information about your hand, which is just like getting more information about your investment. And every decision point can be a lesson in controlling your emotions.’
Texas Hold ’em and game theory
Texas Hold ’em has a great deal in common with game theory, which is the study of human conflict and cooperation within a competitive situation. Defining the discipline more rigorously, Investopedia3 adds: ‘In some respects, game theory is the science of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting.’ Sound familiar? It certainly does to me.
More graphically, Texas Hold ’em has been described as a mixture of stagecraft and game theory, in the sense that those it seriously rewards, such as high rolling hedge fund managers and a few successful long-term wealth advisors, have three things in common:
- Ferocious mathematical skills.
- Prodigious intuitive resources.
- Nerves of steel.
Ask Texas Hold ‘em aficionados and seasoned, successful investors. They will likely agree that both are games of subtle skill and exquisite odds. That’s what makes them so much fun.
Michael Fahy, The Michael Fahy Group, CIBC Wood Gundy, 604-691-7207.