Many of the most famous names on Wall Street count poker as one of their favorite hobbies. David Einhorn, Steve Cohen, Steve Schonfeld and Carl Icahn are among the plethora of top investors who also happen to be card sharks.
Many people think that poker is a game of luck, and that the dealer plays the biggest role in determining a player’s fate. However, evidence points to just the opposite.
At the 2010 World Series of Poker, Steven Levitt of Freakonimics, along with Thomas J. Miles, performed a study on the correlation between a player's level of skill and his or her ROI. The two economists found that high-skilled players averaged a 30 percent return while all others averaged a 15 percent loss. This suggests that poker is not a game of luck, but rather, a test of skill.
In fact, Wall Street firms such as Toro Trading believe poker skills are transferable to trading, and they have incorporated poker into their training program. Pat McCauley, who leads Toro’s training program, says, 'We are trying to teach people how to be good decision-makers under uncertainty. It’s not the stereotypical stuff with bluffing -- it's real science.'
We’ve compiled a list of the poker truths that double as useful advice for investors.
1. You Need To Know Your Own Strategy.
Renowned hedge fund manager (and poker player) David Einhorn gave a speech back in 2006 on the different types of poker players and how their strategies translate over to investing:
Loose aggressive types play lots of hands -- virtually any two cards -- and try to win lots of small pots. They are the day traders of the poker tables. Others play any Ace or any King or any two high cards... I would compare them to long-only closet indexers who trade too much. Then there are the rocks. These folks sit around waiting for premium hands -- high pocket pairs or an Ace, King... Could this be what is becoming of Berkshire Hathaway (NYSE:BRK-A)?
Just like different investors have their own strategies, different poker players play very differently. Some are real math-based like Chris Ferguson while others are more feel-based, like Gus Hansen.
The important part: Identify your strategy, and avoid the temptation of drifting.
2. You Must Keep Your Emotions In Check
Daniel Negreanu, one of the world's best poker players, has said: 'Having emotional stability and emotional control is key to both investing and poker.'
Oftentimes, poker players who have some bad luck react by going 'on tilt' -- playing over-aggressively, often due to anger -- and it costs them dearly.
In the same manner, eliminating emotional investing is a great way to ensure that you are maximizing your returns and avoiding money pits.
3. You Have To Manage Your Chips
In poker, you only have a certain amount of chips at the table. In Texas Hold 'Em, you can get your money in before the flop with a pair of fours facing two overcards and be a favorite to win -- but the race is little more than a coin flip. That's not a smart place to bet a large part of your stack.
For investors, this means that portfolio diversification -- poker's equivalent to playing several hands simultaneously at the table -- is of paramount importance.
4. You Have To Have A Sense Of The Risk/Reward Of Every Pot You Enter Into.
Experienced poker players know the odds of a particular card coming up at any point during the hand. Their knowledge of probability allows them to bet based on the expected value (EV) of their hand. Likewise, most investors allocate assets based upon models which project future growth and cash flows.
5. Be Selective. Know That Most Of The Time, You Should Just Fold.
The best poker players in the world fold over 90% of the starting hands they receive. Likewise, an investor shouldn't necessarily buy a stake in every company he or she researches, but rather ought to carefully discriminate amongst options and wait for the best opportunities to generate a return.
6. Position Matters.
In poker, position at the table determines who you're winning and losing chips from. All things equal, you're most likely to win chips from the player sitting to your right and lose chips to the player on your left -- who has the benefit of acting after you.
In the market, your position in life should play a role in your asset selection. Whether you are a senior who chooses high-dividend stocks for a steady income, or a middle-aged worker with your 401k in mutual funds, the reason why you're in the market should be reflected by your choice of assets.
7. Watch Other People, Not The Board.
After the flop hits in Texas Hold 'Em is an ideal time to pick up information from your opponents. Maybe one might instinctively glance at his or her chips -- a sign of strength -- or stare longingly at the board, which would suggest the opposite.
Unless you're a very clued-in investor, you're better served trying to pick up what experts say about market movements rather than trying to interpret stock movements on your own. Whether it's at the poker table or the NYSE, never miss an opportunity to pick up additional knowledge.
8. Cut Losers Loose.
In the market and at the table, selling or folding after you've already invested money/chips is an admission of defeat. But holding onto a once-hot stock that's in free fall or calling that last bet to see your opponent's hand is just throwing away money -- and money saved is the same as money earned.
9. The Market Can Go On Tilt, Too.
We've discussed how controlling your emotions is a key to success in both poker and investing. There's also a flip side: You can take advantage of others at the table who might be playing on tilt, and investors in the market who invest irrationally.
Consider Facebook's IPO. Many people valued each user as contributing $100 each to the company's market value, and the firm received intense media attention. CNN described the buying frenzy as 'just gambling.' During these times of mass market psychosis, there are opportunities to generate a huge return by betting against the house.
10. Be Patient.
As described in the movie 'Rounders,' a professional poker player generates an average hourly return of one big blind, which is equivalent to the minimum bet. A better performance than that often suggests that a player is involved in too many hands and is due for a correction.
Likewise, any investor who looks to double their money overnight is surely on a fool's errand.
11. Know The Rake!
At the poker table, either the blinds or the portion of the pot taken by the house (known as the 'rake') eats into your winnings. Likewise, fees charged by investment managers reduce an investor's return.
The bottom line: There are costs associated with being at the table or in the market.
12. Beware Of Attempts To Deceive.
While you're at the poker table, opponents will constantly attempt to mislead you with shows of feigned strength and weakness. The top poker players read body language to call bluffs or avoid throwing away their chips.
Deception is also prevalent in the markets. Hedge fund managers often use a technique known as 'doing the reverse desk' in which they strategically sell a portion of a holding in order to scoop up a greater quantity of that very same holding from the hedge funds that copy its initial trade -- but at a lower, more favorable price.
13. Ignore Small Sample Sizes.
Investors can overreact to volatility in stock markets, and often make poor decisions based upon short-term stock movements. Savvy investors base their decisions on market fundamentals and trends, not on headlines.
At the poker table, a 'fish' can win on any given day. But as Mike McDermott said in Rounders, 'Why do you think the same five guys make it to the final table of the World Series of Poker EVERY YEAR? What, are they the luckiest guys in Las Vegas?'
Lucas Kawa is a writer for BusinessInsider.
This article originally appeared at BusinessInsider.com:
The 13 Poker Concepts That Every Investor Needs To Know.
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