Tuesday, December 18, 2012

What Investors Can Learn By Playing Poker

I’m a great believer in the idea that much of investing is actually about keeping the right mental approach. That’s partly why I write these articles. It’s always a good idea to crystallize some of your investments and rationale by writing them down. In this way, you can objectively analyze what you are doing. Another way to make sure you are on the right track is to understand an analogy with another popular activity, so you can anchor to some solid truths contained within it. I’d argue that good poker players have much to teach investors, and here is why.

Fold Weak Hands/Don’t Buy Everything You Research

Any decent Texas Hold’em player will tell you that you should probably fold over 90% of your hands at the pre-flop stage. Investors should take the same approach with the stocks that they research. It can be interminably frustrating sitting hour after hour waiting for a decent hand, but sometimes it just works out like that. Don’t play with rubbish, it will only hurt you in the end.

It’s exactly the same with stocks. Let’s put it this way. If Warren Buffett told you only to buy a stock if you were willing to hold for 20 years than this doesn’t imply much turnover does it? It certainly tells you that you should be rejecting nearly everything you look at. Unfortunately many private investors fall in love with much of what they research. In addition, many journalists love ‘making a splash’ by constantly and confidently advocating buying stocks willy nilly. My suggestion would be to look at the disclosure section below the article. I don’t take anyone seriously unless they have skin in the game. That would be like taking earnest poker advice from a guy who only plays for play money on Google+.

Play Strong Hands Early/Balk With Too Much Action Later

This is not gospel, but in general if you are dealt a high pair in Hold’em you should play it aggressively early on. However, if there is too much action later with raising and re-raising later (and your pair hasn’t hit anything) you should strongly consider folding and walking away. In my humble opinion, the mental approach with investing is much like this. A good example can be made when investors find a sector that they find favorable (a high pair) with which they should try to then be overweight. Hit home when you have the advantage.

Now consider what happens when the price of investing gets higher (stock price rises/other players raise); the correct thing to do is to stick to what you think is value. I’ve been very vocal throughout this year on the rationale for a US housing recovery. However, I recently took profits on Beacon Roofing Supply (NASDAQ: BECN) because it hit my target price. I like the company and hit home when I thought it was value but sold when the risk/reward calculation was no longer as favorable for me (Original article on Beacon linked here). Similarly, investors in house builder Lennar Corp (NYSE: LEN) will be entitled to start taking some money off the table after its 80%+ rise this year. Even if you still like the company and sector, any stock that has this rise is likely to be a much larger part of your portfolio and thus increases the risk from any one stock.

Be Greedy When Others Are Fearful and Fearful When Others Are Greedy

Ok, I am going to quit with the Buffett quotes now. I just happen to think it’s a great way to express another key analogy with poker and investing. With poker, when the table goes on ‘tilt’ most good players suggest starting to play tighter and not bluffing because your opponents will be playing all sorts of drawing hands that can bury you in late play. It’s the opposite situation when everyone is being tight on the table. You can afford to bluff a little and play a little looser.

In investing terms, when the market is piling into stocks on high evaluations then it is time to walk away. I have no idea how anyone could rationally argue that Microsoft (NASDAQ: MSFT) was value on 60-80x earnings.

MSFT PE Ratio TTM data by YCharts

Similarly, when Facebook (NASDAQ: FB) went public there were many people who thought it was value even as it valued every Facebook user at over $100 each.  No stone was left unturned in talking about this company, and the ludicrous attempts to link every single global event to Facebook by the media became ever more risible. For example, the idea that the Egyptian revolution was inspired by a Facebook page is promptly dismissed by a cursory look at the facts. According to the International Telecommunications Union (ITU), Egypt’s Internet penetration rate was only 24% in 2009.

Performance Measurement and Money Management

I’m going to conclude with the two most important analogies.

The first is money management. All poker players need to remember is that position sizing is critical because outcomes are uncertain. It is exactly the same thing with investing. A lack of diversification or over-reliance on one stock or sector can be crushing to an investor, and the investment world is littered with ‘one trick ponies’ that shone brightly then collapsed in future years.

Finally, any decent poker player will be able to tell you what he has earned and his strengths and weaknesses. It is a constant effort to calibrate and try to understand what has happened and why.  Investors need to do exactly the same thing. It is no good trying to fool yourself that you had a good year and losses will be made up, etc. Subjectivity has little to do with it. Most serious investors will know exactly what they are making and at what time while positing a reason why.

And, again, that is part if my point in writing these articles!

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