How to Increase Your Odds of Winning at the Investment Game

Summary

• Stock market strategy can be understood using game theory.
• The players in this game have widely different skill sets.
• Profits flow from low-skilled players to those with better skills.
• Every investor has a strategy, even if that strategy is “I just go by gut instinct”.
• Investors and their strategies compete against each other in the marketplace by taking opposite sides on every trade. They can’t both win.
• Capturing Alpha is therefore a zero-sum game, where players with sharp skills and superior strategies profit at the expense of everyone else.

“We need to protect ourselves both from our own self-deceptions

And the deceptions visited upon us by others.” – Dan Ariely

All investing involves a gambling component. Even a conservative, buy-and-hold low-cost index funds investor is gambling, although they may not realize it. This type of investor is making a bet on an unknown future. In a severe bear market, the index funds will likely get hammered along with everything and everyone else.

Game Theory

Game theory is the examination of how a rational person makes decisions under conditions of uncertainty.  Game theory was created as a method for finding the best strategies for games where luck, or the skill of your opponent, or both play a key role in your ability to win.

One of the key findings to come out of Game Theory is that players who understand how to correctly calculate the odds of the game, and use that to inform the moves they make, have a great advantage over players who simply go by the seat of their pants. To illustrate this point, I turn to the most famous gambling mecca of all – the casinos of Las Vegas.

Most everyone knows that the majority of gamblers in a casino will eventually lose money. The house has an edge in every game, unless the player cheats. Smart players, such as professionals and highly-skilled amateurs, stay far away from the games where the house edge is large. Instead, they choose to play the games where the house edge is small, and their superior skills can even reduce that edge to zero.

Words of advice from The House

In a 2013 interview by a Cleveland television news crew, Jay Bean, a Caesar’s floor manager, had this to say about the casino games with the best odds. He said many people don’t realize that table games have much better odds than slots. They are intimidated by thoughts of card sharks taking their money, and so they stick with the safe games: the slots. But they are doing themselves a disservice, he said.

Bean’s advice? After you’ve spent some time on the slot machines, move on to the Blackjack table, and start by just observing.

Blackjack

Blackjack has the best odds of winning, with a house edge of just 1.4 percent in most casinos, Bean said. If you know how to play a perfect strategy, which isn’t nearly as hard as you might think, you can cut the house advantage to 1% or even less. And if you can keep a running tally of the cards that have been played, you can tip the advantage in your favor. (Card counting is frowned upon by casino management, for obvious reasons.)

In blackjack, you are playing against the dealer, not some cigar-chomping pro who knows that the weaker players rattle easily.  It’s easy for a pro to cause an amateur to make mistakes.

But the same is not true with poker: You should practice the game with your friends first, at home, Bean said, until you are comfortable with it. Bean said novices are best off passing on the poker tables, where the competition can be tough.

Craps

After getting comfortable at the Blackjack table, he suggests moving on to the dice game Craps, the game with the second best odds, also nearly 50-50.

The Craps table can be a bit intimidating for the beginner with all the boxes on the table, Bean admitted. But it’s really not tough, and it has one of your best chances of winning. In the end, all you are really doing is betting on a dice roll.

And taking advantage of the ability to get paid the “true odds” on a secondary bet can cut the house advantage to 1% or less.

Roulette

Bean said your next stop should be the Roulette wheel. It’s simple, and pays fairly well. If you stick to betting on just Red or Black, you have nearly a 50-50 chance of walking away a winner. If it lands on red when you choose red, you will double your bet, Bean explained.

While it may seem you have an even chance of winning by simply choosing a color, there is one catch that gives the house its edge: the extra green 0 and 00 position on the wheel. It’s on all American roulette wheels. It changes the odds of winning enough to make a difference. The house has an advantage of 5% or more in roulette.

Sucker games

Wheel of Fortune, Big Six, and the ever-popular slot machines, have the lowest odds of winning, with a house edge in double digits.

Where the Pros make a killing

So which game do professional gamblers overwhelmingly prefer? Poker. Why? Because it’s a game of skill, strategy, intimidation, and money management. Most amateurs don’t stand a chance.

It takes skill to win at blackjack. There is a correct play for every combination of cards that are dealt. But even a perfect strategy only brings the house advantage down to 1% or so.

Poker is very different. Since you’re not playing against the house, the only edge you’re giving away is the rake, or the commission the dealer takes for dealing the cards.

You are playing against the other players. Skill levels vary widely. Skill accounts for as much as 80% of success in poker, and luck the other 20%. A skilled player will beat a less-skilled one nearly every time.

If all the players are highly skilled, as is the case in tournament poker, the luck element becomes more prominent. But skill still dominates the outcomes.

One of the critical skills a poker player must have is the ability to calculate the odds of winning a given hand, based on several factors. If she is dealt two aces, she knows her odds are very good, but not foolproof. As each card is dealt, she must recalculate her odds of winning. She must also calculate the payoff she will earn for each additional bet she makes.

She must also be aware of how many of which cards are still in the deck, and how they will change the odds. It’s a heavy lift for even the most gifted math pros.

The other skills that influence poker success are things like the ability to “read” your opponents, to “represent” a hand that you want other players to think you have, and to use aggression when called for, but timidity in other situations.

The skill set required to be successful at poker is not very different from the skills that a successful investor needs. Chief among them is the ability to calculate changing odds on the fly as new information comes in. Humility is extremely important, because few things will sink a player as quickly as overconfidence.

Money management is also critical. In poker, you must manage your bet size in a way that keeps you in the game, while being aggressive when it’s called for. In investing, managing position size is similar. The best investors know when to bet big, just like the best poker players.

The moral of the story for investors

This is an over-simplification, but investing is closer, in terms of game theory, to poker than it is to any other form of gambling. (With the possible exception of pari-mutuel betting.) So let’s review the skills that all highly successful poker players have in common, and apply them to investing.

• Ability to calculate the odds of winning a given hand
• Ability to recalculate the odds on the fly as new cards are dealt
• Situational awareness, or the ability to read the strength or weakness of the other players
• Willingness to fold when the odds turn negative
• Money management, or the ability to strategically control bet size
• Emotional control, or the ability to remain calm in the face of a bad beat

Remember that every trade (bet) you make has someone who is willing to take the other side. Is that someone a pro? Does she know more than you do? If you’re buying a stock because it looks cheap to you, do you really understand why it’s so cheap? Is there some bad news about to come out?

These are the kinds of questions that pros ask themselves constantly. So should you.