“Is poker more a game of skill or of chance?”
I missed that headline in The Wall Street Journal last August, reporting on a Federal Judge’s ruling that poker isn’t predominated by chance, but is rather a game of skill. However, I didn’t miss the news that Greg Merson, a local Maryland resident, won the World Series of Poker in Las Vegas (with a prize share of $8.5 million). The fact that Merson is a recovering drug addict and a college dropout makes the news all the more fascinating. The return on Merson’s $10,000 buy-in for the tournament was 85,000%, enough to get anyone to consider becoming a poker pro. But before you begin studying the rules for Texas Hold’em, let me introduce you to four players from the tournament that you’ve never heard of.
Dane Lomas, Desmond Portano, Steven Rosen, and David Kelley were also winners, earning $4,806 each. They tied for 666th place and were the last four “winners” to earn any prize money. To put this in context, the buy-in for the tournament was $10,000, not including travel and other miscellaneous expenses. So these four players lost 52% of their money, not including expenses. There were 6,598 entries in this year’s tournament, and some of them were sponsored to be there. But to make the math easy, let’s assume that 5,929 out of the total 6,598 lost everything in hopes that they would take home the big prize. This year’s tournament paid out $62,031,385 — virtually the entire pot — so only ten percent of the players won any money, and 89.9% of the players lost it all (and more).
In the context of investing, losing 52% of your portfolio is a complete disaster, and having a 90% chance of losing all of your wealth is unthinkable. At the end of the day, poker is a game, where most players come to the table with an amount of money they can afford to lose, and then continue until they’ve either lost their stake or won it all. Investing is the very serious pursuit of earning a return on your capital where the players simply can’t afford to lose. Once you consider putting investment money at risk with the notion that you could “lose it all,” that money becomes a speculation and no longer an investment. Both poker and investing involve taking risk, but only one carries the stipulation that you can’t afford to lose.
Because we are in the business of managing investment risk for a living, I thought it would be interesting to compare the game of playing poker to active portfolio management. Here are a few observations about these two risk-taking pursuits, in no particular order.
Know When to Fold Them
Professional poker players know the odds of winning most hands, and often fold without playing a hand for hours (meaning they lose their ante, but limit their losses). In the status quo world of investing, Buy and Hold investors don’t acknowledge that there is ever a time when the odds don’t favor them because markets are assumed to be efficient (or nearly efficient); in their view you should always be playing your hand.
In contrast, active managers like Pinnacle believe that there are many ways to tell if you should limit your betting. Our investment process involves analyzing the market cycle, market psychology, and traditional measures of valuation in order to decide how much we are going to play each hand. We take more relative risk when we think market conditions are constructive and less when we view the world as overly risky. However, we have a pre-defined level of risk we are allowed to take at all times, which is called “benchmark risk.”
Paying to Play
[adrotate block=”4″]One similarity between investing and playing poker is that “the house” is going to make money regardless of who is winning or losing. In the case of playing casino poker, the casino makes money by “raking” the pot and collecting a fee. While experts disagree, the consensus seems to be that the rake is 1% – 3% of the pot. At the recent World Series of Poker, the house take was $3.9 million of the total entry fee of $65.9 million, or a cost of 6% to play. If you compare that to the investment industry, I think the “cost to play” at a casino is nearly the same. (Apparently playing on-line poker is much more expensive.) The typical fee or expense ratio for a managed mutual fund is close to 1.5%, without counting fund transaction costs. On top of the expense ratio for underlying investments, you also pay your financial advisor a fee. Assuming the investment house is taking about 2% – 3% of your funds seems comparable to the cost of playing poker.
[Note: All-in investment expenses and Pinnacle portfolio management fees typically range between 1.5% and 1.9%, depending on how the portfolio is positioned at any point in time.]
Beating the House
Professional poker players will tell you that when you play poker, you are not playing against the house but instead against the other players at the table. With a relatively low cost to play, the overall casino revenue numbers confirm that the chances of winning at slots or other table games where the casino sets the odds are very small.
Interestingly, Pinnacle’s investment philosophy says much the same thing. As an active manager, we don’t have to be correct in our forecasts all of the time. We simply have to beat the consensus of investors, many of whom are folding their hands by always being fully invested in pre-determined asset allocations.
Poker players are always talking about luck, while professional investors have been disagreeing about luck versus skill ever since the efficient market hypothesis was published in the 1960’s. In an efficient market world, investors who beat the market are deemed to be lucky. In fact, both poker players and active money managers are playing probabilities. Poker pros know the odds of filling an inside straight and bet accordingly. Investors buying stocks when the market’s PE ratio is over 40 times earnings know that there is nothing to say the market won’t continue higher in the short term. But there is an overwhelming amount of data to suggest that the PE ratio will regress to the mean over a longer period of time, so investors who remain fully invested in that market environment are playing against the long-term probabilities.
In a post-tournament interview, Greg Merson was asked how he felt when he experienced a losing streak during the tournament. His answer was instructive.
Actually, I drank like four or five Red Bulls just to keep myself jacked up. As Zen-like as I might have looked outside, that’s not really what’s going on inside. But I just tried not to show that much. I felt pretty defeated at some points, and I couldn’t get that out of my head. That shouldn’t be going through your head at that point.
Risk taking is an emotional process, even for professional risk- takers. The winners often manage their emotions better than the other players in both poker and investing. World Series of Poker players compete in a short-term time horizon where the winners and losers will be determined in a structured environment. On the other hand, investors take risk and compete to win over a very long time horizon, often years, or even decades.
We constantly remind our investors to view portfolio results in the context of an investment process. Determining a winning strategy often requires the kind of patience exhibited by… well… professional poker players. Value-oriented investment strategies are notoriously unsuccessful over the short-term, and investors have to understand the underlying process for finding value over time, as well as evaluate whether their portfolio manager is systematically implementing their strategy regardless of short-term performance. When investors begin to think of investing as a game with very short-term winners and losers, they run the risk of exhibiting the same emotions Greg Merson felt on his losing streak. I hope our clients resist reaching for a cold beer after we book a poor quarter of relative performance. Put down that Red Bull. It’s just not helpful.