Gamblers Profit From Holding A Strong Hand

Financial Times

By Stephen Schurr

March 20 2006

There is a hedge fund manager so secretive that few industry veterans know he exists, yet he ranks among the world’s 10 best investors. A former emp­loyee says: “When it comes to investing, [this manager] is the world’s greatest poker player.”

Equating one’s investment acumen with gambling may seem the quintessential back-handed compliment. But in the mind of the former colleague, he is giving his old boss the highest praise.

This anecdote gets to a reality about investing and gambling that may shock academics and individual investors, but is understood by professionals. Investing and poker are two forms of gambling that are separated by a thin thread. Individuals who recognise this link – and recognise that both involve taking uncalculated risks and favour those with a keen knowledge of self – will be the most profitable.

Individuals have drawn comparisons between gambling and the stock market for decades but the observations were an attempt to knock the art of investing down a peg. However, in recent years a combination of factors – behavioural finance, the rise of quantitative analyses of investing and gambling, and the collapse of the stock market bubble – and has led to a more serious investigation.

A new book by Aaron Brown, Morgan Stanley’s quantitative expert, aims to have investors (and poker players) apply the connections for profit. The Poker Face of Wall Street, to be published next month by Wiley Finance, embraces the link and explores how lessons from each craft can inform the other.

“Gambling lies at the heart of economic ideas and institutions, no matter how uncomfortable many people in the financial industry are with that idea,” Mr Brown states near the beginning of the book. “Poker has valuable lessons for winning in the markets, and markets have equally valuable lessons for winning at poker.”

While the book may be the first attempt to help individual investors profit from a better understanding of the art of gambling, behavioural finance professors have employed gambling and investing decisions to explore how individuals behave when it comes to financial decisions.

Richard Thaler at the University of Chicago has explored the “house money” effect – how people take additional risks when they perceive they are gambling money they have won from the house – and found parallels in how investors acted in the late 1990s. Justin Wolfers at the University of Pennsylvania has shown that betting markets are about as efficient as the financial markets, yet they suffer from the same inefficiencies and biases. And a study in the journal Psychological Science employed a gambling game of coin tosses to find that individuals with a form of brain damage that impairs their ability to experience certain emotions are better investors.

Some professional investors have embraced the links between gambling and inv­esting. For instance, Legg Mason’s Bill Miller believes gambling is investing in a non-judgmental way. He cites the poker great Walter Clyde “Puggy” Pearson’s gambling maxim: “Ain’t only three things to gambling: knowing the 60-40 end of a proposition, money management and knowing yourself.”

Likewise, Mark Cuban, the Dallas Mavericks’ owner and money manager, recently wrote semi-facetiously that he planned to start a gambling hedge fund, since effectively better information can be gleaned from betting markets than stock and bond markets. “It’s not unusual to hear people refer to trading stocks as no different than going to Vegas,” he wrote on his blog. “They are right. Gambling is gambling.”

While the professionals may understand this, most individual investors have not embraced the notion – something Mr Brown aims to rectify with his book. There may be few individuals better suited to take on such a controversial argument. The Harvard and University of Chicago-trained quantitative strategist has helped top-tier Wall Street firms manage uncertain risks for more than two decades. Mr Brown is also a life-long poker player who has shared the table with Wall Street bigwigs, Nobel Prize-winning researchers and world champion poker players.

In exploring the intrinsic links between gambling and investing, Mr Brown mines a rich vein of economic history and draws conclusions that may surprise. He demonstrates how gambling was at the centre of economic development in many river-network societies – explaining how the highly leveraged “soft banks” in the American frontier are much like modern poker houses and why it is no coincidence that futures markets and poker were invented in the same time and place, the American west of the 19th century.

More important than his historical research, however, are his explanations of the inner workings of poker hands and trading. Many casual players may feel poker is about intuition and trying to get a gut feeling from the player across the table. But Mr Brown’s book leaves the impression that poker might be considered a type of quantitative investing where rapid processing of statistical probabilities can greatly enhance one’s long-term returns. He also shows that while hand to hand and trade to trade markets may be random, the cumulative effect of previous trades (or hands) weighs heavily on future outcomes.

In his explanation of stud poker, he analyses how to bet on each hand by breaking down the statistical odds of what other players are holding and what other cards may come up. In one example, you hold a king and hope for another, knowing that the odds of landing another king are three in 35 (the number of cards you have not seen), or 8.57 per cent. There are 17 chips in the pot and you need to put in one to call, you need a 1 in 18 chance of winning, or 5.56 per cent, to justify a call rather than a fold.

Similarly, Mr Brown provides many examples of how investing involves a careful application of uncalculated risks. These include George Soros’ massively successful bet that the British pound was worth less than the amount the central bank was aiming to set against the D-Mark. He also offers more analysis of how to make money from the spreads in various dated options.

The bigger impact of Mr Brown’s book is to get investors to rethink how they view placing bets with their money. Our understanding of the markets may be moving further away from the comforting notion of efficiency and steady returns and more toward an acceptance of uncertainty and incalculable risks.

Investors who recognise this will hold the stronger hand.