Peter Lynch – one of the most well known US money managers – has written that one of the most valuable educational tools for a would-be-investor is playing poker. Other investment titans also have great regard for the skills that an investor can learn from playing Texas Hold’em.  These include Bill Gross, David Einhorn, Steve Cohen, and even Warren Buffett.  Buffett has preached his investment wisdom using the medium of poker more than once.

However, many investors feel that poker is simply a form of gambling where there is a significant element of luck involved.  They find it hard to believe poker is similar to investing and can be used to teach investing. As I will demonstrate below, these two beliefs are untrue.

Note: In the title and the rest of this post you will see references specific to Texas Hold’em poker. This type of poker is generally regarded as one of the most complex forms of the game.  Therefore, Texas Hold’em is one of the best poker forms to teach investing concepts.

There are many similarities between Texas Hold’em poker and investing:

1. Solo Occupations: Both investing and poker are ultimately solo occupations.

People are well aware that poker is a solo occupation because only you can sit down at the table and start playing.  Ultimately, investing is essentially a solo occupation too.  There is only one person who finally pulls the trigger on making an investment or a trade.  Yes, that person may have support from a team of researchers, but when it comes down to putting the money on the line there is only one person who can make that decision.

Another way of demonstrating how investing as a business is a solo occupation can be shown by comparing investing with other types of businesses.  Granted, many businesses can be operated by a sole trader. However, in most cases they won’t scale up well.  You can’t manage a company like GE without a support cast of thousands.  However, Warren Buffett can control the entire wealth of Berkshire Hathaway from Nebraska, simply making investment decisions on his own (well okay he gets some help from Charlie Munger).

2. Business Plan Required: If you want to invest, trade, or play Texas Hold’em successfully, you need to develop a business plan and learn the patience to adhere to this plan.

This is one of the most important parts of good investing and poker play, yet it is probably the piece of work that is ignored most often by both investors and poker players.  A business plan for Texas Hold’em poker should outline the following aspects of your poker strategy:

• The type of games you will play (e.g., limit, pot limit, no limit, cash games, or tournaments);

• The game strategy you will use which should tie in with your chosen game type, skills, and mentality (i.e., tight or loose aggressive);

• The bankroll you will need to start playing with — both at an overall level and for each game you play;

• Your “limit movement” strategy (i.e., how you will increase/reduce your limit levels based on your results); and,

• How you will record and analyze your performance.

The similarities with an investment business plan are remarkable. Such a plan must incorporate the following elements:

• The type of securities in which you will invest (e.g., stocks, futures, options);

• The strategy you will employ when investing which should be based on the type of security you are investing in, your investing abilities, and your emotional capabilities;

• The starting capital you will need to have before beginning to invest — both for each investment and at an overall level;

• Your investment sizing strategy which would be based on your overall capital level, risk strategy, and ongoing performance; and,

• What tools you will employ for recording and analyzing you investment track record.

3. Serious People Make Money: When practiced properly by serious people, both activities are done with the objective of making money.

Many professional poker players have become famous since the mass promotion of the World Series of Poker: Doyle Brunson, Phil Hellmuth, and Chris Ferguson (and don’t forget the Texas Hold’em Investing hedge fund supremo David Einhorn).  These players all focus intensively on their poker and it is often their sole source of income.  No Friday night games with the friends for these players.  And it isn’t all glamor either – sitting out long runs of bad hands in half empty casinos isn’t exactly Hollywood.  Unfortunately the non-serious players typically lose all their money with the exception of the rare big win which keeps their interest.

The difference between the serious and non-serious people in investing is much more tragic than in Texas Holdem Poker.  The serious investors also generally support themselves fully with their gains from investing.  They focus fiercely on the markets and concentrate on analyzing them as much as possible based on their various strategies.  The names are well known – George Soros, Warren Buffett, Ken Griffin, Peter Lynch, and we can also look to the example set by the various traders interviewed here on Wall St Cheat Sheet by Damien and Derek.  However, at least the non-serious poker players aren’t in it to help secure their retirement.  The non-serious investor tries to put money to work in the markets without sufficient preparation, research, and determination.  This typically leads to inadequate relative returns, or even worse, complete losses of capital.

4. Element of Luck: There are elements of luck in both fields in the short-term, but in the long-term the skill of the player/investor should be expected to result in financial gain.

Short-term luck in poker and investing cuts both ways – good and bad.  In Texas Hold’em Poker good luck can come by being dealt AA pocket cards, which then helps to win a big pot. Or, luck can come when the river card completes a flush to beat the opponent with three of a kind.  On the other hand, the bad luck can come when the AA pocket cards with a third Ace on the flop is beaten by the amateur who started with 27 offsuit and ends up with a poker of 7s.  But in the long-run, the good player will maximize the benefits of good luck and minimize the damage of the bad to produce an ultimately positive return.

Luck in investing is based on the fact that despite endless analysis and research about a company, a security, or a market, something unexpected can always happen that causes an investment to perform better or worse than expected.  BP can find new oil in the Gulf of Mexico. Ebay can sell Skype for nearly the purchase price. These are both examples of good luck.  On the other hand, Washington Mutual can announce it has run out of funds not long after one of the smartest private equity managers invested billions of new capital. Or, Bear Stearns can go nearly to zero out of nowhere before being acquired by JP Morgan.

The intelligent investor will ensure that the portfolio is constructed in such a way that it can survive such incidences of bad luck by sizing investment positions appropriately. At the same time, good luck can be taken advantage of by letting the profits from a position run as long as possible after the good news has emerged.  Thus, the strong investor will never be immune to the effects of luck, but can manage the portfolio in such a way to benefit and protect from luck where possible and help achieve long-term positive returns.

5. Knowledge of Probability Needed: Investing and poker both require a knowledge of probability and statistics for the actor to perform well.

Poker requires players to evaluate approximately the probabilities of winning a game based on the player’s pocket cards, the cards on the table, and the likely cards held by the other players.  The key concepts are:

• Pot Odds – comparing the amount expected to be won in a game with the probabilities of winning based on the current situation;

• Implied Odds – adjusting the Pot Odds to incorporate the likely future betting which will occur in the game; and,

• Expected Value – the long-term value of the current situation for your hand based on how effective the hand is over a large number of hands, which would smooth out the effect of bad beats and good luck in the short-term.

Statistics knowledge is also important for poker when analyzing the results of your play, determining how effective you have been, and where are your weak points.

Investing requires knowledge of probability in order to calculate the expected value of your planned and actual investments based on the probability universe you have developed for the investments according to knowledge of the situation.  This way of thinking allows you to compare the risk and reward elements of each investment in a rational way which prevents emotion from overtaking your thoughts process.

Part 2 of this series continues the description of similarities between poker and investing with the final five key elements. This post was originally posted at Texas Holdem Investing on September 9, 2009.

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