Luck was a servant and not a master. Luck had to be accepted with a shrug or taken advantage of up to the hilt…Bond saw luck as a woman, to be softly wooed or brutally ravaged, never pandered to or pursued…
Casino Royale – by Ian Fleming
Although lifted from a fictional adventure of 007, created by Ian Fleming, the above quote vividly illustrates how a gentleman should tango with Lady Luck; whether you are betting on the stock market or on the green velvet card table in Monte Carlo.
Many people may believe that betting in a card game is risky and highly dependent on the mood of Lady Luck. However, a layman investor may be making the same mistakes as an oblivious gambler.
A game like Poker is in fact a perfect simulation of what goes on in the grand scheme of the investment universe. The same emotional traps set at the card table are very well the same traps that devour many investors.
Let us examine the vices of investors by using the game of Poker as a referential case study.
Vice #1 Future can be predicted
Card players like to predict what cards will turn up next based on cards already shown on the table. This is the same mistake as how investors become overly optimistic based on past information about a stock or a fund.
If a card player is trying to make a flush (five cards of the same suit) and he is holding two hearts with two others showing as community cards on the table, the card player is very tempted to think the next card turning up would be heart. However, hearts are only one of the four suits, and his odds are in reality less than 18.75% (given one deck of cards, and no other players). Four hearts have already turned up, so in the deck of cards, only nine more hearts are present.
Similarly, emotional investors are overly optimistic about past winners and overly pessimistic about past losers. Certain investments, especially mutual funds, are advertised with high historical returns which may not have any impact on the future returns. Certain stocks also meet the criteria of investor emotional bias, e.g common stock of Ford Motor Co. was trading @ $1.43 in 2008, with a recent high of $12.51, and not much has changed in the fundamentals of the company, only the emotions are stabilized.
When investing with a portfolio, one must examine the long term. Examine the 10 year or 8 year history, and not just how the stock or fund performs in the past couple of years. For a fund, examine the fund size, fees, turnover, and manager tenure. For mutual funds, an investor must be diligent in conducting their research regarding the funds that have been closed by the company. Mutual funds with consistent losses are closed and do not show in the historical rate of return as presented in the pamphlets.
For a stock, look at the inherent value of the company, just like good old Mr. Buffett would. Do not invest in a stock just because the price has been rising. “Value Investing”, anyone?
Trying to form a pattern based on random past information is as reliable as a naïve woman trying to predict your future by reading horoscopes. If you still believe in horoscopes, then perhaps you should never be allowed to approach the card table at Monte Carlo or the stock market. Please go back to watching the “Twilight” series.
Vice #2 Over Confidence
In a card game, having a hand of high spades, or winning a couple of hands, may tempt a card player to become more risk seeking. This is a direct result of his confidence being boosted with previous victories.
Overconfidence was also demonstrated in the bubble of technological stocks in the late 90s, when many speculators banked large amounts of money from day trading. As they won more, they reinvested a larger amount. Some speculators even quit their day jobs to sit at their computers daily to make some easy money. When the bubble burst, many speculators got cleaned out because they went “all-in”. One must understand that the gains due to day trading were not because of the good speculation, but the market played a big role in it as well. A gain or positive return by a speculator does not imply that the speculator is smart, it just means that those bets worked out, just like in a card game.
Vice #3 The World Is Not Enough [greed]
Greed, being one of the seven deadly sins, is the primary deadly vice at the card table and in the stock market.
A poker player is most tempted to act greedy when the first two cards he receives are aces. It may appear to be the best opening hand and you have the world in your hands, but it can also be the single hand that causes the most losses.
For example, if he is holding the ace of diamonds and the ace of spades, and the first three community cards turned over are all hearts. Now a flush has a high probability of happening for anyone with hearts in their hand. However, being over-confident with the pair of aces, the Poker player may be tempted to continue betting or even raise the pot.
The next card is turned over after the flop, and it’s also a heart. The probability that one of his opponents has a heart to complete the flush are very high, and now the pair of aces have essentially lost all of its value. If the card player continues to bet on his pair, then he is making a big mistake.
In the world of investments, a “sure bet” stock in your portfolio is equivalent to your pair of aces in your hand. Nothing is “sure bet” in reality. A stock may have sky rocketed in price, and there may positive information or “hype” in the market to support this rise in prices. However, the investor may be so overjoyed with winning that he may fail to take note of any negative information: the presence of a lawsuit, a subjectivity of a product to its competitors, or the company’s high cost of borrowings, etc. An investor has to keep their biases in check and constantly monitor the whole array of information available to them in a non-biased manner.
A good strategy to avoid being blinded by your winnings is to ask yourself: Why would I buy this stock at this price?
If you cannot find a reason, then you might consider walking away after you have already gained large amounts of winnings.
If the world is not enough to you, you might be in trouble.
Vice #4 Ego
Ego is the greatest asset and the greatest flaw of the great man. It has led to the rise of many emperors and rulers, and has also led to their fall. Hence, ego must be controlled.
A card player start calling on the opponent after he has bet huge amounts on his hands, which previously looked amazing and declined in huge value as more community cards are being displayed. I’m obliged to see my opponent’s cards, call! So the card player says. Ego has just gained its upper hand.
It is no different when an investor holds onto his losing stock for the longest time before he decides to sell. He is afraid to bruise his ego to admit that he has made a bad decision to begin with. However, the investor should not only reward himself for good results; he should also reward himself for making a good decision.
Selling a losing stock is a tough decision, but it is the right decision. So reward yourself for it, great results can only mean you are lucky, great decisions mean that you are skillful.
Having diagnosed the psychology of investing through the art of card playing, one should come to the senses that luck will always be a factor in this game. However, will you be its servant or its master? It’s your choice.
In this game, there are only three options: Win, lose, or vanish by giving up.
Great players win some, and lose some, but never vanish. Mark my words.