Tuesday, February 3, 2009

Financial Lessons from Poker

Common advice about controlling spending is to track all your purchases and add them up each week or month. I believe that this is effective, but have been fuzzy on why it seems to work so well. Why can’t people just spend less without the constant reminder of how well they are doing? I got some insight on this question from, of all places, poker.

For poker players there is a certain thrill to dragging in a pot of chips. The thrill is there whether it is a $1 pot or a $10 pot. The $10 pot gives a bigger thrill, but not 10 times bigger. Similarly, losing a $10 pot feels worse than losing a $1 pot, but not 10 times worse.

This leads to some players playing in such a way that they maximize happiness by taking in many small pots, but losing some big ones. As long as they don’t count their dwindling chips, they can actually be happy playing this way.

Counting your chips is a lot like adding up your spending at the end of the month to see what happened. You may feel good about having saved small amounts of money several times, but if you wasted a big amount just once, you’ve had a bad month. If you don’t add up your spending you might actually feel good about all the times you saved money even though you’ve had a bad month overall.

Ignorance can be bliss for a while, but when the debts finally start catching up to you, there won’t be much happiness. The worse your financial trouble, the more often you should be adding up your purchases to take stock of your financial situation.

Some people can get along by assessing their finances monthly, and others have to do it weekly to keep a lid on spending. Then we have the families who appear on Gail Vaz-Oxlade’s television show Til Debt do Us Part who have to assess their financial position with every purchase by abandoning debit and credit cards entirely and using cash.

9 comments:

  1. Riddle me this:

    Can you think of an instance where it is actually painful to win a poker pot?

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  2. Gene: Sure. When you have a monster hand and everyone folds leaving you with a tiny pot.

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  3. I play poker with the boys and there is almost a direct parallel between poker playing styles and investing styles.

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  4. Thicken: I don't tend to talk investing with poker buddies, but your observation sounds right to me. One guy I play with likes to be in every pot and raise big. He also used to gamble with stock options until he lost enough money that he figured out he had to stop.

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  5. The value function is steeper for losses than for gains.

    So, a gain of $10 is about 1.5x as pleasurable as a $5 gain (the 2nd $5 is worth 50% of the first $5). This is simple diminishing marginal utility.

    However, it's steeper for losses. A $10 loss is about 2x worse than a $10 gain is good.

    I both play poker professionally and do neuroeconomics.

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  6. Anonymous: Thanks for the comment. It made me think of expressing the main idea of my post in different terms. The utility function you are talking about could be called short-term pleasure utility or emotional utility. However, the long-term impact of wins and losses on your net worth has different utility (rational utility). As you point out, based on emotional utility, a $10 loss is about twice as bad as a $10 win is good. However, based on rational utility (the impact on net worth), the $10 gain and loss (nearly) offset each other. I say nearly because of the law of diminishing utility. However, this effect is very small for net worths in a normal range.

    So, what makes some poker players play poorly is that they are optimizing their emotional utility at the expense of their rational utility. The same is true for many people in the way that they spend their money.

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  7. Nice parallel to poker, Michael. I actually just played a Texas hold 'em tournament for the first time last week. Nothing serious - just a buddy's birthday party where we threw in $10.

    Like gambling, there are many addictive traits to personal finance, too. The connection between investing and poker styles has me replaying how (and how quickly!) I lost my $10, LOL!

    I'll definitely keep that connection in mind when I become a more serious investor with discretionary income - and the next time I decide to give money away at another poker night with the buddies :O)

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  8. Playing online poker for a living is absolutely doable, but it takes a combination of talent, dedication, patience, discipline and disposition to succeed.
    http://www.championofpoker.com/

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