My previous work required me to spend a lot of time in casinos and especially Vegas. It reached a stage where I started getting really tired of those visits. The very thought of walking through those long rows of slot machines, the typical sights, sounds, blinking lights and smell of a gaming floor made me sick and tired. However, there is one thing that always fascinated me and that was talking to the professional poker players, who make a living playing poker. Initially I used to wonder how someone can make a profession out of a pure random outcome of any event (cards in this case). After spending enough time and watching some of the cleverest poker players in the world closely, I learnt my best lessons in ‘money management’.I was having a drink with one such pro and he asked me a simple question…”If I ask you to toss a coin and offer you a chance to win $110 for a head but lose $90 for a tail, will you do it?” I always thought I understood math and probability and all that, wanted to answer “yes”. He smiled and said he would not do it. When he explained, it became one of those aha-moments which in a way was also life changing for me.
He said he would do it if and only if:
1. He had a chance of repeating that toss a very large number of times rather than doing it just once.
2. Much more importantly, while the 11:9 win/loss payoff is fine for a coin-toss (with 50% chance of winning), he would prefer to win $1.1 for heads and lose $0.9 for the tails instead of $100 and $90 respectively.
Elaborating on this simple money management principle, he explained that most people tend to calculate the probability and feel that they should jump into the game. However, more than 99% of the people fail to look at this relative to the total money available with them. He had $500 in his pocket, so while he surely had a positive edge in this game, he can easily go broke or lose a large % of his money by tossing for $100/$90, if he ends up with a few tails in a row. However with $1.1/$0.9, he does not need to worry about going broke and would be happy to keep tossing. In fact with $1.1/$0.9 he would look at ways of increasing the frequency of his tossing to make up for the relatively small positive expectation from each toss.
The mathematically inclined would know that Expectation from each event is the sum of the probability X payoff of each possible outcome of that event. So in this exercise, expectation from each toss = 0.5 X $1.1 + 0.5 X (-$0.9) 0r +$0.1.
The larger the number of tosses the closer he moves to 50-50 win-loss ratio, and even during the occasional long losing streaks (which is bound to happen), his total drawdown would be very manageable.
He went on to explain that while, each single toss is an act of speculation, the whole exercise comprising a ‘very large number of tosses’ is not. It is a scientific way of taking advantage of a simple statistical edge, which is defined by the positive expectation. That’s exactly what good poker players would try to do. They would try to keep the losses small and would not worry about a string of losses from bad hands. Their main objective would be to ‘be in the game’ and be there for the occasional good hands where they would make up for the previous losses and even more. The only way they can achieve this is through smart money management. A professional poker player does not depend on luck. Well, if luck is on his side then it’s great, but there will be times when he/she would have no luck at all. The objective is to make money in the long run and he/she realizes that this can be achieved only with sound money management.
The same money-management principles are applicable even outside of the world of gaming. In fact these principles are applicable everywhere but very few take these seriously or even think about them. I know many people who would spend lot of time analyzing companies and can come up with a list of 20 reasons why a stock would go up or go down. However what is staggering is that they don’t even spend 20 seconds wondering about the simple money management principles. Principles of optimum position sizing that would keep the long term equity safe in case their prognosis about the particular investment does not turn out as expected.
In future posts, we would be taking a closer look at these money management principles and see how they can be used smartly for our investments.
You can access our previous post on the topic of money management here – Cashflow: Tiding over rough times