Thursday, June 21, 2007

Know When to Fold 'Em: What Makes an Investor Great

I love poker, particularly Texas Hold 'Em. If you're unfamiliar with the game, just turn on the TV. The chances are, it's on right now - on 37 different channels.

The game provides a great diversion, especially when you make a night out of it with friends, but more than that, it provides valuable self-insights into one's investing behavior -- if you're inclined to look.

Poker, like investing, is a game of decisions made with incomplete and unfolding information. Being good at it requires the same set of skills - patience, discipline, guts, and the ability to filter out our own emotions.

There's an expression in poker; great players lay down great hands. In fact, the ability to accept a loss and get away from a great hand is probably the most important (and difficult) skill to learn. Here's a typical example.

Let's say you've been losing all night when you find yourself dealt a pair of Queens as your starting hand. "Yes! I'm getting paid on this one!", you say to yourself. So you bet. Two people call your bet.

Then the flop comes, revealing a 5, a 7 and a King. You don't like seeing that King, because anyone holding a King in their starting hand has you dead to rights now. But you decide to get aggressive, you bet again. This time one of the bettors folds his hand. The other calls your bet.

Next comes the turn, revealing an Ace. Uh-oh, now you're really in trouble. If the other player is holding either an Ace or a King... you lose. But your opponent bet with that King on the board so you figure that while they may have a King, there's no reason to believe they're holding an Ace. You decide to bluff. You bet again, this time with even more money. They player calls your bet again. Now most of your money is in the pot.

The river comes, it's a harmless 2. You're committed to winning this hand, you decide to put some pressure on the opponent, so you bet half of your remaining money. This time, the opponent, doesn't call. He raises you, forcing you all in. Every bone in your body is telling you, not to call. Even a novice player recognizes he or she is almost certainly holding a losing hand. But you've put so much money into the pot already (financial investment) and you still have a sliver of hope you can win and get your money back (emotional investment). You think, "What choice do I have?" You call.

You show your Queens, and the other player reveals a pair of Kings AND a pair of Aces. Damn. Their starting hand was Ace-King. They had you on the flop and on the turn. Game over.

In behavioral finance parlance this is called the Sunk Cost Fallacy - the refusal to get out of a losing position, because you've already written the money off -- resulting in losing even more money.

Those Queens were one of the best starting hands in the game (the third best actually). But it soon became apparent based on the subsequent cards and betting behavior that it was no longer the winning hand. Information changes, but our emotions sometimes don't get the memo. You know in your head to cut your losses. It's your gut that won't let go. We tell ourselves, in poker and in stock market investing "There's a chance it could come back and, what the heck, it's down so much, there's no sense in getting out now anyway."

The ability to take a small loss to avoid a big one is the hallmark of smart poker player. It's also the sign of a great investor.

So how do you do it? How do you overcome the natural temptation to "dig your way out of a hole".

You have to reframe the situation and retrain your mind. In other words, you have to learn to love to take losses. One way I do this is by using the expression above; "Great poker players lay down great hands" is what I use to do that. I tell myself, "Sure, I lost a little money. But I demonstrated the quality necessary to be a long-term winner." In other words, I pat myself on the back.

Think of it this way; all financial investing is an attempt to meet an emotional need. If you can let the emotional gain trump the financial loss, you've found the secret to acquiring those tough-to-form habits.

Does it always work? Well, no. In the spirit of honesty, I can tell you that sometimes I get frustrated and make a dumb call anyway. I suspect we all do. But the next time your impulsive stock purchase drifts down 10%, remember those two Queens. It may just help you fold that hand, and pick up an even bigger winner on your next hand. It is, afterall, a sign of greatness.

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