Wall Street quant analyst and top-drawer poker player Aaron Brown looks at how some basic logic and the application of your risk brain can help traders and gamblers alike.
About 20 years ago, I wrote an article criticizing poker analogies in business and finance. The problem is that most people are bad poker players, so those analogies would only, I argued, transfer bad habits from one arena to another. Non-poker players are an even bigger group, and they usually have even worse ideas about how to play. While a decent analogy could potentially help the few good players in the world, any of them who also cared about business already understood how to apply poker principles.
That was then, this is now. I’ve been playing serious poker since the 1970s. In those days card play and money management were only a part of a poker player’s education. You had to know how to get into good games, how to deal with cheating, how to collect debts and how to avoid legal troubles. To be successful both at the table and away from it, you had to acquire most of the skills required for dealing with people and money.
Today there is a vastly larger number of good players, from all over the world. Most learned online, an environment which teaches card play and money management, but not the other old-school skills. Thus it’s possible to become an excellent poker player without knowing how to apply poker skills in other arenas. So I officially change my opinion.
Every three years, the University of Reno hosts a conference on Gambling on Risk Taking. It attracts professional gamblers, casino executives, psychologists, academics and policy experts; people who otherwise seldom gather in the same room, which makes it fun. at one session in 2009, a psychiatrist gave statistics showing that no matter what the treatment, there was almost no recorded success for problem gambling. I suggested that it was a lot easier to turn a problem gambler into a successful gambler than into a non-gambler. This caused a bit of a ruckus. It seems most people who treat gamblers think successful gambling is impossible (which may explain why their treatments don’t work). And furthermore, that gambling was bad for you, win or lose.
One of the few people who took my side was a behavioural psychologist named Dylan Evans (he has a book coming out soon, risk Intelligence: How to live with uncertainty that anyone who wants to be a successful gambler should pre-order). He has been interviewing successful gamblers for years and studying their skills. He developed a test to measure “risk IQ,” and discovered it correlates very well with gambling success, and not at all with general intelligence.
Dylan and I agreed that financial betting sites offered a good way to study risk IQ. Jacob pastor gathered some data from the sites. He discovered that between 8% and 17% of on-line bettors could beat the market, and the rest appeared to be betting randomly (and thus paying the spread). However up to 25% of the market-beaters lost money. How was that? Well, they bet larger amounts when they were wrong than they did when they were right. They knew something – they could predict short-term moves in a financial index with better-than random success. But they didn’t know what they knew. When they were most confident of being right, they were wrong. among the 75% of money-making bettors, most won less than they could have if they had bet equal amounts every time. poor bet sizing cost the group about half their potential winnings. only a tiny minority of bettors were more likely to win when they bet more money. There was some evidence that people learned, however, because losses from perverse bet sizing for some individuals decreased over time.
Any successful gamble starts with an edge. With financial betting, that edge is an ability to predict some financial price movement better than the random-walk model used to set the payouts. consistent success requires more than an edge, however, it requires an accurate estimate of how big your edge is. That allows proper bet sizing.
Suppose, for example, you make even money bets on whether the S&p500 will go up or down from close today to close tomorrow. You are lucky enough to have a hint; every day before the close your fairy godmother will tell you tomorrow’s opening price. If the price goes up between tonight’s close and tomorrow’s opening, it’s likely that tomorrow’s close will be above today’s close. Similarly if the price is down on tomorrow’s opening, it’s a smart bet that tomorrow’s close will be down from today’s close.
However, you have no information on how big your edge is. Suppose you assume you will win 80% of the time. In that case you do best in the long-run by betting 60% of your bankroll each day. If you did that bet over the last year (ending August 13, 2010, as I’m writing this), you would have turned €1,000 into €11,456. However, it would have been a wild ride. You would have had a loss on 59% of the days and been down to as little as €0.60 at one point. at the end of July you would have been down to €104 before ten straight wins to end the year multiplied your bankroll by over 100.
The problem was not your edge – you won a healthy 67% of the time. The problem is you were overconfident, and thus over-bet. Had you instead been under-confident, things would have been smoother, but you also would not have extracted full value from your edge. It you had thought you would win 52% of the time you would have bet 4% of your bankroll each day and ended up with €23,609.
Now suppose instead your fairy godmother gave you only the information that the S&p500 would be up 142 days over the year, no information about tomorrow’s opening price. That seems like almost no information by comparison. If you always bet the market will go up you do get an edge, 57%, but smaller than the 67% you get from the opening price information. However the key is that you know exactly what your edge is. That allows you to bet an average of 12% of your bankroll and be up to €199,815 by the end of the year, without ever being below your initial stake. To be a successful gambler, it’s not what you know, or who you know. It’s what you know about what you know.
Aaron Brown is the author of The Poker Face of Wall Street. He has been involved in trading, risk management, and portfolio management for Morgan Stanley, Prudential Insurance, JPMorgan, Rabobank, and Citigroup. He is also a serious lifelong poker player who has played with Wall Street tycoons and world champion poker pros.
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