Poker is a microcosm of all we admire and disdain about capitalism and democracy.  It can be rough-hewn or polished, warm or cold, charitable and caring, or hard and impersonal, fickle and elusive, but ultimately it is fair, and right, and just.   – Lou Krieger

Have you ever had a chance to play a hand of poker? Did you ever think poker can be one of the best training grounds for wannabe traders?

Increasing number of hedge funds and brokerage houses are looking to recruit from the most unusual of a talent pool – the poker players. There is a growing awareness that a great poker player has all the requisite skills that a successful financial trader needs: a calculated and rational approach to risk, ability to take quick decisions under intense pressure, discipline and a good memory.

Before we get into the litany of how poker helps in honing your skills as a trader, here is a quick snapshot of what poker is. Poker is a set of card games of which the most famous is the No-Limit Texas Hold ‘Em where each player is dealt two cards initially and a set of five ‘community’ cards is dealt on the table which is common to all the players. There are four rounds of betting – first, immediately after you are dealt the first two cards (called the pre-flop), second – after the first three community cards (called the flop) are dealt  and the final two rounds of betting after each of the fourth and the fifth card are dealt (called the turn and the river respectively).  You can either check or bet or raise or call or fold at any point in the game.

Information Asymmetry

There is a substantial element of information asymmetry in a poker game. And that’s precisely the reason why poker is so hugely popular. You have a bit of information on the current hand and you need to solicit or deduce information about your opponents’ hands. The more the information, the more the chances you will win. There are two ways to do it: You calculate the odds, the implied odds, and the probability of making your hand and go about in a logical and scientific manner as to how you play a given hand. The other is deducing information about your opponents – through his playing style, his betting pattern, his body language and the myriad other signals which he might be giving out even without his knowledge – and controlling your emotions. These two ways of eliciting information and taking a decision are never rewarding, when practiced in isolation.

In fact, it would suffice to say, you will never make money in the long run if you are extraordinary in one and come a cropper in the other. This article delves into the psychological issues involved in playing poker and likens it to the real-world trading decisions.

As Frank Murtha, a behavioral finance consultant puts it point-blank, “The stock market and Texas Hold ‘em are games of investing based on incomplete and unfolding information. The goal of each is to accumulate wealth by making decisions based on that information.”

The best way to play a game of poker is to weigh the marginal cost and benefit, without considering past losses and gains and to treat each hand independently. In reality, past results do matter because players reassess the perceptions of their skill levels and outcomes do have lasting psychological effects.

There are five common psychological errors – Greed, Over-confidence, Regret, Seeing patterns, Holding on to losers.

Greed

The best cards to be dealt before the flop in poker are bullets (Two Aces). Probabilistically, this hand will win the most no. of times than any other two cards. The problem arises when you start counting the chickens even before they are hatched. Sure, a pocket aces is a great way to start a hand with. But there are so many ways your bullets could be busted as the hand progresses. A typical instance is when three cards of the same suit, which is not of the suit of one of your aces, open on the flop, and the turn card also is of the same suit as the flop. The chances of a flush busting your bullets are extremely high. But you still keep betting or calling, at a point when you should be folding.

The same happens so often in our portfolio when we bet and bet big on a stock which we think is a sure winner in the hope of a massive kill in a short time period. When there is unexpected negative news about the company, we tend to remain rigid and not change our initial perceptions, popularly referred to as Bayesian Rigidity in behavioral finance parlance. The probability of winning big, even if the chances are ridiculously small, blinds us from the fact that this is the opportune time to quit.

If only that one minute of rationality prevailed, you would have known the most obvious decision in almost all the cases would be to quit. Or rather to fold and look for the next hand. If only, that is.

Over Confidence

Over-confidence – Oh, that most ruining of feelings. Let’s say, you win a series of hands in your table, partly due to your adeptness and partly due to all your lucky stars in place. That’s when most, if not all, players tend to start ‘thinking’ they are better than what they ‘thought’ they were just a few hands earlier. That’s precisely the point when all hell starts breaking loose and you start playing rashly than you would normally. What could have been a great killing, swiftly results in a position where your stack might even become smaller than it initially was. Not letting your emotions take control of you, and steadily playing the subsequent hands based solely on the merit of that individual hand is the blatantly evident ploy that should be employed. But trust me it’s infinitely more difficult to follow that day in and day out. Therein lies the difference between a good player and a truly great player.

In real world, overconfidence results in two tangible implications: Traders tend to make uncalled for and unjustified bets based on their perceived ability to interpret information, when in actuality they do not have all the information to form unbiased projections. Secondly, traders tend to trade more frequently than can be justified by the information.

Regret Minimization

In an investment framework, regret is the feeling in hindsight of making a bad decision. It is that “If only I had done that…” feeling that we get once in every while. In poker, there will be many a hand which you will feel, in hindsight, you should never have got in. You have a marginal hand right from pre-flop and you keep on calling all your opponent’s bet till the river, only to find out to your dismay that he had, as expected, a far better hand from the beginning and you had lost quite a bit of your chip stack in the process. The other case is when you had the best hand from the pre-flop stages till the turn, but your opponent forms a better hand right at the river. You curse yourself, if only I had bet a little more, he would have folded earlier.

Many poker pros concede that the most difficult thing to master is the art of folding in poker. To call it quits when it ought to be quit. When facing themselves in a situation where they have a feeling of regret, a large majority of players do either of the following two: They bet large even on very weak hands else they play so tightly that they don’t win as much as they could have, even on very good hands.

Contrast this to the real world. In behavioral finance, regret minimization framework states that investors, in order to avoid the feeling of regret, tend to be too risk averse and stay put in safe instruments like bonds and bills leading to a lack of diversity in their portfolio. They also tend to stick on to profitable investments rather than sell it. Diametrically opposite is the case of an investor who, in order to reduce his regret levels, harps on to very risky investments hoping that the windfall from the new investments will offset his previous losses.

Seeing patterns

Seeing patterns where none exists is another of the major emotional errors. A famous study by two professors – Werner DeBondt of DePaul University and Richard Thaler of the University of Chicago – showed that investors relying on past information and market return patterns became over-optimistic about past winners and over-pessimistic about past losers. But in reality the stock returns patterns never repeated.

Holding onto losers

According to behavioral finance, loss aversion refers to the individual’s reluctance to accept a loss. And when seen from the loss aversion framework, even though a stock might have come down considerably from its cost price, investors tend to hold it, hoping that it will recover. Relate this to a poker player, who, even though on a losing spree, keeps taking re-buyins and keeps on playing hoping that he will win one big hand which will make up his losses. And, so goes on the search for that one elusive hand like those French searching eternally for that elusive Scarlet Pimpernel.

Another instance in poker is when, even though you know you have a very weak hand, you still call your opponent’s bet for the sole reason that you have already invested so much in the pot in that particular hand. Whereas the logic of economics and sunk cost tells you that you need to fold, that god-forsaken ego of yours doesn’t allow you to admit that you have taken a bad decision and that you are losing. So what ensues? In majority cases, you refuse to accept that you are holding on to a losing hand and you keep on calling.

Conclusion

As poker pros often tell you, you should reward yourself on taking good decisions and not on winning huge pots. There will be times when the pot’s outcome is out of your control. As Stephen Covey would tell you, the pot’s outcome is your circle of concern, but taking good decisions and playing good poker is in your circle of control. ‘Bad beats’ are a way of life. You can’t pick winners all your life. But if your decisions are based on solid research, then you are bound to make money in the long run.

Any smart player will know – the short run never matters. It’s the long run which determines how good a player or trader you are. And remember, in the long run, the theory of probability is always true. Always. And as your Strategy Professor would have it, “Hope is never a strategy.”

About the Author

Sethu Chidambaram is a 2nd year PGP student at IIM Calcutta. He can be reached at csethu@gmail.com

References

1. http://economics-files.pomona.edu/GarySmith/PokerPlayers.pdf
2. http://articles.chicagotribune.com/2010-01-31/news/1001280626_1_professional-poker-players-poker-face-poker-table
3. http://www.kiplinger.com/features/archives/how-texas-hold-em-simulates-investing.html
4. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=alximP6.Eta8

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