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The Hardest Part of Investing: Discipline
Posted by: rozer (IP Logged)
Date: November 19, 2009 11:50AM

I recently came across this brief poker anecdote referring to the necessity of discipline. While I don’t usually draw a parallel to gambling and investing, the lesson regarding emotional intelligence and discipline is an extremely valuable one. While the focus of the following exert is purely on the art of poker, the similarities are just too good to ignore. Most of us understand that discipline is a key component, and yet most of us fail this test at some point along the way.

You hold pocket aces in late position, put in a raise at the first opportunity, and find yourself against a small enough field to feel like your aces have a chance. The flop comes 8-4-2, a safe enough flop, you figure, since your foes are unlikely to be in there with 8-4, 8-2 or 4-2, and while small sets are a possibility, you judge that to be a remote possibility -- especially when just one subsequent player calls your bet. You're not scared, nor should you be.

But here comes the turn, an offsuit 7. He checks. You bet. He raises. Now you have that familiar sinking feeling: You've been trapped by a slow-played superior hand. Could he really have been lucky enough to hit his set or second pair? Could he have been boneheaded enough to call your initial raise with two disconnected low cards? Maybe he played a 5-6, drew to an inside straight and got there. In any case, you are now in the midst of a familiar situation: You're stuck on the hand and there's no way out. You're going to call his raise on the turn because you might pair up or ace up on the river to beat him -- unless your pair gives him a boat, or unless he's already on a made straight. In any case, you're committed... committed to losing two more big bets because you feel, fatalistically, that there's no way out.

Is this true? Is it really true that you can't escape further damage? After all, why not fold? Why not save those two bets for a time when they'll do you more good.

Sure, he might be bluffing. But for the sake of this example, let's assume that you know he's not. You've never seen him check-raise bluff, but you have seen him check-raise trap many times. Nor is he the kind of player who might put you on overcards and think that his eight is the best hand. No, he's just another straightforward, unimaginative player who just barely knows how to check-call the flop and check-raise the turn. For the sake of this example, let's assume that you're 100% certain he has you beat. Yet you call. Why is that?

Could it be that you feel you're owed? We all know how rarely pocket aces come around. When they come our way, we naturally anticipate winning with them. Why not? They're the best possible hand, and we're good people. We deserve to win. Thus burdened by this feeling of entitlement, we tend to underestimate the strength of our foe's hand, and overestimate the chances of beating him on the redraw. Our thinking is skewed by the emotional attachment we have to those beautiful bullets. We want them to win. We need them to win. If they don't win, it's a tragedy and a shame, but not so big a tragedy and a shame as folding now. That would be just unfair...

You see this sad rationalization in at least one other circumstance: when a player holds pocket kings and there's an ace on the flop. He raised pre-flop, driving off (he assumes) all hands except premium ones. Well, what's a premium non-pair hand? A hand with an ace, of course. But when that ace hits the flop, our holder of king-king suddenly loses all perspective. He puts his foes on underpairs or draws, even when his foes start raising like flags. Why? Because pocket kings come along as rarely as pocket aces, and he feels like he's owed!

Discipline in the skill of investing (like poker) means more than having rigorous starting requirements. It also means staying away from a potential investment when the risk / reward is unfavorable. Discipline is acknowledging when a mistake has been made and make the necessary adjustments. If you can't fold aces when you know, with every fiber of your being, that they're just going to cost you bets upon bets, then you don't have discipline or common sense.

While some are more naturally disciplined then others, I do believe there are some guidelines to follow which may improve results. First, focus on the process of investing, not the results. If the process is sound, results will ultimately follow. Second, keep it as simple as possible. The more complex the design, the more things can break down along the way. Lastly, develop some pre-defined set of rules to take the emotion out of the decision process and provide a reference point. When temptation to stray calls, refer to the list- it may keep you out if trouble.

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Re: The Hardest Part of Investing:...
Posted by: MaskedFinancier (IP Logged)
Date: November 19, 2009 05:31PM

Great article William,

As the promoter of the Texas Holdem Investing I'm a huge believer in the ability of using poker as both a medium and tool for teaching investing.

The "entitlement" issue is indeed a great example of one of the major psychological problems that affects poker players and investors.

Also, the inability to fold a good hand that has been dominated is also very similar to the "anchoring" problem that investment behavioural psychologists have described i.e. investors get attached to the price at which they initially acquired an asset.

Keep up the good work.

John (aka The Masked Financier)

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Re: The Hardest Part of Investing:...
Posted by: cm1750 (IP Logged)
Date: November 19, 2009 07:20PM

Liked the article.

The Kelly Formula is basically saying the same thing - bet big when the risk/reward is in your favor.

Using expected return probabilities and downside risk, the formula attempts to give you a % of your portfolio that should be in a specific stock. However, if you aren't good at assessing business model risk, the formula inputs will be wrong.

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Re: The Hardest Part of Investing:...
Posted by: buffetteer17 (IP Logged)
Date: November 19, 2009 09:04PM

CM, one can still use the Kelly Formula even with an uncertain estimate of risk. You just have to plug in a very pessimistic risk estimate, and then put up only half as much as the formula says to. Alternatively you can cap your risk, e.g., by buying a put option along with stock. That's what I chose to do with my WellPoint stake (with 25% out-of-the-money puts), in view of the great uncertainty of how the national health care debate will sort itself out. I am not willing to risk a 100% loss, but I will cheerfully risk a 25% loss on a 5%-of-portfolio bet.

Bill, it occasionally turns out to be rational to call with the Aces. Even the tightest players sometimes bluff. Harrington says you should assign a 10% probability to a bluff, even against the tightest players. You calculate the pot odds and call with a positive or even slightly negative expectation value. In limit hold-em, for example, you likely have the pot odds required for a call, even if you are pretty sure you are beat. Besides, the information you gain by seeing the opponent's cards has some value, which is why you might call with slightly negative expectation value. I'll grant you that you should mostly fold, but don't just panic, and do take time work out the odds.

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Re: The Hardest Part of Investing:...
Posted by: cm1750 (IP Logged)
Date: November 19, 2009 10:28PM


I agree, but hedging or buying 0.5 of the amount Kelly suggests is kind of watering down the idea IMHO. If you follow enough companies closely, at least 2-3 should call for 20% positions.

Einhorn played in the WSOP main event and was interviewed saying that poker is similar to investing as you have to deal with incomplete information. I think poker is a good proxy for discipline as well. Makes one wonder who would do best if there was a GuruFocus group that played on :-)

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Re: The Hardest Part of Investing:...
Posted by: buffetteer17 (IP Logged)
Date: November 20, 2009 06:29AM

The half Kelly bet has some interesting mathematical properties. For risk management purposes, the nice property is that it cuts your risk of temporary loss (i.e., volatility) by a large amount while reducing your return expectation only a little. The other important property of the half Kelly bet is that it gives a large margin of safety in the risk estimate. If you are off by a factor of two on your risk of loss estimate, a full Kelly bet will reduce your return expectation to zero. But a half Kelly bet will leave you with 2/3 of the return expectation. Not surprisingly, underbetting is far, far safer than overbetting.

With the full Kelly bet, your probability of temporary loss is a linear function of the amount of loss. For example, you stand a 90% chance of losing 10%, an 80% chance of losing 20%, a 50% chance of osing 50%, etc. Not many investors are comfortable with the prospect of a 50% probability of losing 50% of their money. With the half Kelly bet, your probability of temporary loss is a quadratic function of the amount of loss. For example, you stand a 81% chance of losing 10%, a 64% chance of losing 20%, a 25% chance of losing 50%, etc.

Your expected gain with the half Kelly bet is reduced by 25%. For example, if your expected gain is 40% with the full Kelly, it is 30% with the half Kelly, if your expected gain is 30% with the full Kelly, it is 22.5% with the half Kelly, and if your expected gain is 10% with the full Kelly, it is 7.5% with the half Kelly.

The quarter Kelly bet is even safer. You cut your volatility by a quartic factor while reducing your return expectation by half. For example, you stand only a 6.25% of losing half your money. If you can find enough uncorrelated bets to get all your money invested, you can still invest 100% of your stake with a high safety factor with multiple quarter Kelly bets. The rub, of course, is that it is hard to find truly uncorrelated bets during a market crash like 2008.

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