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Why Poker Players Make Good Investors: Part II

What can investing teach you about poker - - and vice versa?

Plenty, if you know where to look.

Primarily, there are three keys to expert poker playing that translate well to Wall Street and playing the financial markets. And all three themes are critical to successful investing. Let's tackle them one at a time.

Understand Behavioral Management

Remember the line from the old pogo cartoon “We have met the enemy and it is us”?

So it goes in poker, where understanding human emotion and evaluating behavioral management is the clearest path to success. Let’s face it, under pressure, people usually don’t make the best decisions and they don’t demonstrate the soundest judgement.

In the stock market that character trait is manifested in what Wall Street gurus call the “herd mentality”. That’s when investors buy when everyone else is buying (when prices are usually at their highest), and selling when everyone is selling (usually when stock prices are at their lowest). They say fear is a great motivator and that’s true of the average stock market investor and the average poker player. Fear of being left out of a bull market or fear of walking away from a pair of 10’s when a face card comes up in the draw. Fear leads to bad decisions on a Wall Street trading floor or at a high-stakes Vegas poker table.

Greed is another human emotion that, left unchecked, can ruin an investor or a poker player.

In his speech, “What Poker Can Teach You About Investing”, given at the Mandalay Bay Resort in Las Vegas on November 7, 2003, David Nelson, senior vice president, Legg Mason Funds Management, opined that people make all kinds of bad decisions at the poker table. They get too greedy and they get frightened. They don't analyze things on a probability basis and they don't know how to control their own emotions.

Nelson, a guy who knows where poker and investing intersect, draws the following analogy on gambling, greed and the importance of exercising probability scenarios on a poker game.

“In a five card draw game, with a four flush (four cards to a flush plus one other card) or a four-card open-ended straight draw (let's say a 6,7,8 and 9) is it correct to call a $10 bet with $50 in the pot? You need to go through a mental process in considering this problem. If you have five cards in a draw game, there are 47 cards that you have not seen. If you are drawing to a flush, there are nine cards out of the thirteen in the suit that can help you and there are 38 cards that are of no help to you at all. Therefore the odds are 4.22:1 against making that flush. In the case of the straight, the four fives and the four tens help you, so there are eight cards out of the 47, and the odds are 4.88:1 against making the straight. The answer is that you are advised to make the call because the odds of making the flush or the straight are less than the pot odds (your $10 in a $50 pot).”

It’s Nelson’s point that the toughest part of poker, and one of the toughest parts of investing, is that people have a difficult time making decisions on a rational, logical, rather than emotional basis. “There are a number of behavioral issues: cognitive illusion, attitudes towards risk, mental accounting, over-confidence, at work in a poker game. All of these are quirky ways in which people make decisions that causes them to be bad poker players and poor investors. In poker and in investing, "hope" can be a very expensive word. When you're in a poker game and you start out with a three good cards in seven card stud and then the next two cards are nothing, you should be out of that hand. You shouldn't be hoping that the sixth card or the last card will save you. That kind of decision process will cost you money. That's true in the investment process as well.”

He has a point. In poker and investing, you have to have a game plan and the patience and discipline to stick to it. You have to minimize your losses and maximize your gains. You must understand the probabilities involved. You must understand human nature, especially your own. And you must be able to control your own emotions.

If you can’t, you’ll wind up the type of risk taker who confuses luck with skill, and who doesn’t know when to leave money on the table and walk away.

Published Sep 07 2006, 10:56 PM by moneycoach
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