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Why Poker Players Make Good Investors: Part IV

Poker -- like investing -- is the ultimate "individual's" game.

For example, only you know what kind of hand you’re playing at the poker table. And only you can exercise the appropriate judgement and demonstrate the correct level of patience that’s going to result in your walking away from the table with more money than the other guy.

Of these attributes, it’s patience that separates the great players from the woulda-coulda-shoulda players. Like investing, poker is a game of incomplete information. There are myriad factors in a poker game that you just don’t know and that you can’t control. But the smart poker player doesn’t leave things to chance and divine providence. Nope, you can’t make a living relying on that.

Instead, the champion poker player invests a great deal of time and effort, immersing himself in scenario analysis and probability analysis. If you apply enough examination to the process, and conclude from that analysis that you have the best hand, you can increase your odds of taking a big poker hand

Another infamous maxim of the poker world - -that you can learn the game in five minutes and spend the rest of your life trying to master the complexities of the game -- also applies to the stock market.

It’s not difficult to pick up the phone or plug into your favorite online discount broker and buy 100 shares of ABC Corporation. But is it a good stock to buy? Are you buying it at the right time? Does it fit into your overall investment strategy? At what point will you sell the stock if it rises or if it falls? What weaknesses do you see in the company? What strengths? Are you sure of the decision you’re making?

You see where I'm going here. These questions are exactly the same questions a poker player must ask himself when sitting at a table with five other players and a big pot of money at stake. In that sense, the skill sets for poker are a lot like the skill sets you need to succeed at investing.

If you pull those three key elements together – understanding human behavior; understanding money management; and knowing yourself and your acceptable levels of risk, you’re fully equipped to succeed in poker and in investing. These are the cornerstones of what eventually will become your decision-making process; i.e. deciding whether to raise, fold, buy or sell.

Make no mistake, decision-making goes hand in hand with poker and investing. Nobel prize-winning mathematicians Amos Tversky and Daniel Kahneman produced a decision-making test that goes as follows: In decision number one, you have (A) the opportunity for a sure gain of $240 or (B) a 25% chance to gain $1,000. Which would you rather have? In decision number two, you have (C) a sure loss of $750 or (D) a 75% chance to lose $1,000. Which one of those two most appeals to you?

Given a choice between the $240 and the 25% chance to gain $1,000, 84% of the people choose the sure gain (A). Given the choice between the sure loss of $750 or the 75% chance to lose $1,000, 87% of the people select the 75% chance (D). Overall, 73% wanted the sure gain and the 75% chance of a loss (A and D together) and only 3% selected the 25% chance of gain and the sure loss of $750 (B and C together).

According to Tversky and Kahneman, if you choose both A and D, then 25% of the time you gain $240 and 75% of the time you lose $760. If you choose C and D in aggregate, you have a 25% chance of gaining $250 and a 75% chance of losing $750. In the B and C aggregate, you make more when you win and lose less when you lose, so this combination is the most valuable. Yet, only a very small percentage of people actually choose this. The researchers concluded that because people are risk averse in the domain of gains (they would love to have a bird in the hand or a sure thing), but in the game of losses, they are risk seekers (people do not want to take a loss and they will do almost anything to avoid it). One of the things people do to avoid a loss is take a risk at losing even more in the hopes that luck will favor them. People, therefore, make sub-optimal decisions.

Published Sep 11 2006, 08:42 PM by moneycoach
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