It Is Not the Cards You are Dealt; But is How You Play Them

Financial Times

“Any time you make a bet with the best of it, where the odds are in your favour, you have earned  something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favour, you have lost something, whether you actually win or lose the bet.” – David Sklansky, ‘The Theory of Poker’

Over a lifetime, active investors will make hundreds, often thousands of investment decisions. Not all of those decisions will work out for the better. Some will lose and some will make us money. As humans we tend to focus on the outcome of the decision rather than on the process.

On a behavioural level, this makes sense. The outcome is binary to us – good or bad, we can observe with ease. But the process is more complex and is often hidden from us.

One of two things (sometimes a bit of both) can unite great investors: process and randomness (luck). Unfortunately, there is not much we can learn from randomness, as it has no predictive power. But the process we should study and learn from. To be a successful investor, all you need is a successful process and the ability (or mental strength) to stick to it.

Several years ago, I was on a business trip. I had some time to kill so I went to a casino to play blackjack. Aware that the odds were stacked against me, I set a $40 limit on how much I was willing to lose in the game.

I figured a couple hours of entertainment, plus the free drinks provided by the casino, were worth it. I was never a big gambler (as I never won much). However, several days before the trip I had picked up a book on blackjack on the deep discount rack in a local bookstore. All the dos and don’ts from the book were still fresh in my head. I figured if I played my cards right I would minimise the house advantage from 2-3 per cent to 0.5 per cent.

Wanting to get as much mileage out of my $40 as possible, I found a table with the smallest minimum bet requirement. My thinking was that the smaller the hands I played, the more time it would take for the casino’s advantage to catch up with me and take my money.

I joined a table that was dominated by a rowdy, half-drunken blue-collar worker who told me several times that it was his payday (literally: he was holding a stack of $100 bills in his hand) and that he was winning. I played by the book. But it did not matter. Luck was not on my side and my $40 was thinning with every hand.

Meanwhile, the rowdy guy was making every wrong move. He would ask for an extra card when he had a hard 18 while the dealer showed 6. The next card he drew would be a 3, giving him 21. Then the dealer would get a 10 and then a 2 (on top of the  6 that already showed), leaving him with 18. The rowdy guy barely paid attention to the cards. He was more interested in saying “hit me”.

Every “right” decision I made turned into a losing bet, while every “wrong” decision he made turned into a winner. His stack of chips was growing while mine was dwindling. His loud behaviour and consistent winnings attracted several observers. Some were making comments such as: “This guy is good.” Nobody paid attention to me – I was not loud and I was losing.

The rowdy guy had no process in place. He was just making half-drunken bets that had statistical improbabilities of success. And he was winning, at least for a while. I was armed with statistics, making every bet to maximise my chances of winning (actually, to minimise my losses – the odds were still against me) but I was on the losing side of the game.

After a couple of hours, and of consuming more of the “free” alcohol, my rowdy companion was increasing the size of his bets with every successful hand. The law of large numbers caught up with him. He gave up his winnings and his pay cheque as well – two weeks of hard work rightly went into the casino’s coffers.

I was down to a couple of dollars at one point. But then my luck changed and I won the bulk of my money back. In the end I lost only $10. This was a successful deal. I’d had a couple beers, spent a couple of hours gambling and learned a valuable gambling/investing lesson about the value of the process.

What is the lesson? Spend more time focusing on the process than on the end results. If it was not for randomness, every decision we made would be right or wrong based solely on the outcome. If that were the case, the process could be judged solely on the end result.

But randomness is constantly present in investing (as it is in gambling). Though we are drawn to judge our own decisions, and those of others, on their outcomes, that is dangerous. Randomness may teach us the wrong lessons.

Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in Denver