Monday, July 12, 2010

Can Poker Save Your Portfolio?

A fairly common investing personality I see among my high-tech colleagues is the investor who needs action. While most investors tend to be overly conservative, action junkies need risk to make things interesting. Those who need some risk are likely better off finding some avenue other than investing for finding action.

When the topic comes to investing and I mention buy-and-hold indexing, others often complain that this is too boring for them; they prefer to make big bets on hot stocks. However, when I press for details of their results, invariably their incomes prop up their portfolios rather than the other way around.

How can investors like this save their portfolios from themselves? Maybe one possibility is to find risk elsewhere and keep the investing boring. I don’t think of myself as an action junkie, but I guess I have at least a small risk-seeking streak. I enjoy a few poker games each year. A typical game will see me ahead or behind less than $100. This is much better than betting the farm on a high-tech start-up and losing $100,000.

Unfortunately, there are pitfalls with this approach as well. I know a few people who play far too much poker and play badly enough to lose money consistently. Further, a couple of them take unreasonably big gambles with their investing as well.

So, playing a little poker works for me but not for everyone. I’d be interested in hearing from others who have found an effective outlet for their gambling instinct to keep them away from losing their savings.

11 comments:

  1. Interesting and good advice to seek your thrills elsewhere. I tell my clients if they need to trade/gamble in the market to limit it to 20% of their investable assets. Take the remaining 80% and invest it in well diversified low cost/low turnover/indexed exchange traded funds.
    Many times when they experience one good blow up ( ex. GE, Fannie Mae, Enron) they give up the trading. I consider it as a sort of tuition many people have to pay.

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  2. When I read the title of this article, I thought you meant something else entirely. Getting good at poker (which I'm not claiming to have achieved) requires learning patience. You can sit at a table for two hours between playable hands. Same for investing. You also need to learn the odds, and risk versus reward: consider the pot odds you are being offered versus your actual chances of winning the hand. Finally, you also need to learn to trust that little voice in your head not only when it tells you to bet big, but also when it tells you to fold.

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  3. @Robert: As long as the gambling part of the portfolio is lost only once, the lesson isn't too expensive. I'd be worried that someone might just "borrow" more from the boring side of the portfolio to seek more thrills.

    @Patrick: You're right that patience is the number one thing to learn at a poker table (particularly for a Hold'em game with many players). I've been in weak games with poor players where others just fold to my reraises because I play so many fewer hands.

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  4. Gamblers anonymous may disagree with you on this one (but then again, they wouldn't want one of their recovering gamblers playing the investment game either).

    You want excitement take up roller coaster vacationing, or possibly sky diving?

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  5. If you like to trade, but don't want to risk your retirement savings, you could allocate a very small percentage of your portfolio for active investing. Robert's 20% threshold seems reasonable, but even less would be ideal. Like poker, however, I guess it depends on your skill level. If you're just learning to trade, keeping your position size small can be the key to risk management.

    Any money in the stock market is money at risk. There is always the potential for significant drawdowns. You can manage that risk by adjusting your equity allocation.

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  6. @Big Cajun Man: I suspect that doing physically exciting things would work for younger people. Baby Boomers are more likely to seek excitement by destroying their lifetime of savings by making some big investing bets. Somehow people who need excitement have to find an outlet that won't destroy their bodies or savings.

    @Balance Junkie: Having a percentage of "play money" isn't my thing, but I can see it working for some people if they can keep it to a fixed pot. But, if their results are bad, I suspect that many of these people will just pull in another chunk of their savings to risk on the latest high-flying stock. This is the danger that investors with a need for excitement should stay away from.

    @Larry: That's a very interesting idea. I'd have to say that the best things I've done to further my career we things I poured a lot of my time into without any certainty of a payoff.

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    1. The last reply above is to Larry MacDonald's comment:

      I guess I take risks with part of my human capital. I'm willing to be entrepreneurial, like the time spent writing books (back in the early 2000s), which had a wide range of pay-offs. My financial assets are rather conservative as an offset.

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  7. I'm still learning to play poker. No-one can read my bluffs because I don't know when I'm bluffing. :)

    It doesn't really interest me that much. I'll play when invited, but don't particularly look forward to it as much as the socializing.

    I actively manage 20% of my portfolio, mostly for the reason of satisfying that "itch", but for the most part the bulk of that 20% is buying and holding certain stocks that I can and want to monitor over time. Only rarely do I engage in trading.

    Sometimes that 20% outperforms the 80% and vice versa. The 20% might even outperform the 80% over the long term, but that would be attributed to luck as opposed to skill... :)

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  8. @Preet: You definitely fall into the category of someone who isn't likely to fall into the usual traps when stock picking. For example, you know the difference between revenue and profit. When I meet someone who talks excitedly about stocks, but has no idea of the companies' financials, I shake my head. Even if you lack stock-picking skill, it's plausible that you can expect your active part to lose only a small amount due to lack of diversification. On top of that you can add or subtract the luck component. If you have skill, you can then add some alpha. Good luck.

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  9. I was an avid online poker player for a few years and made a lot of money by sticking to low stakes (where the players are bad) and playing four tables at a time!

    I don;t hesitate to say that studying poker has made me a better investor, but not because it's an outlet for a gambling instinct. If you want to win at poker, you have to be extremely disciplined. You have to out the odds in your favor. You raise when you're likely to have the best hand, and you fold when you think you're beat. You don't play by gut feeling or make random bets with weak hands because you feel lucky, or because you folded the last ten hands and you're bored.

    Investing is the same way: you stick to a strategy that's proven to work and you do your best to remove emotion from the equation. Yes it hurts to fold pocket kings when an ace comes on the flop. Yes, it hurts to load up on beaten down asset classes when you rebalance your portfolio. But in both cases it's the right thing to do!

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  10. @Canadian Couch Potato: You're right about the qualities that make a good poker player. Of course, these qualities are only profitable if your opponents don't have these qualities. The same thing happens with investing. When investing actively (trading), you have to be better than your opponents. This is a tough game. It's much easier to win by being disciplined with a mostly passive approach to investing, like the rebalancing approach you mention.

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