So it goes in poker, one of our most enduring and popular cultural pasttimes, where understanding human emotion and evaluating behavioral management can help achieve success. Let's face it, under pressure, people usually don't make the best decisions and they don't demonstrate the soundest judgment.
That's why, in my opinion, poker and investing have much in common.Allow me to explain.
In the stock market, pressure from having all that money on the line triggers what Wall Street gurus call the "herd mentality." That's when investors buy when everyone else is buying (when prices are usually at their highest), and sell when everyone is selling (usually when stock prices are at their lowest). They say fear is a great motivator and that's true of the average stock market investor and the average poker player. Fear of being left out of a bull market or fear of walking away from a pair of 10's when a face card comes up in the draw. Fear leads to bad decisions on a Wall Street trading floor or at a high-stakes Vegas poker table.
Greed is another human emotion that, left unchecked, can ruin an investor or a poker player.
In his speech, "What Poker Can Teach You About Investing," given at the Mandalay Bay Resort in Las Vegas on November 7, 2003, David Nelson, senior vice president, Legg Mason Funds Management, opined that people make all kinds of bad decisions at the poker table. They get too greedy and they get frightened. They don't analyze things on a probability basis, and they don't know how to control their own emotions.
Nelson, a guy who knows where poker and investing intersect, draws the following analogy on gambling, greed, and the importance of exercising probability scenarios on a poker game.
"In a five-card draw game, with a four flush (four cards to a flush plus one other card) or a four-card, open-ended straight draw (let's say a 6,7,8 and 9) is it correct to call a $10 bet with $50 in the pot? You need to go through a mental process in considering this problem. If you have five cards in a draw game, there are 47 cards that you have not seen. If you are drawing to a flush, there are nine cards out of the thirteen in the suit that can help you and there are 38 cards that are of no help to you at all. Therefore the odds are 4.22:1 against making that flush. In the case of the straight, the four fives and the four tens help you, so there are eight cards out of the 47, and the odds are 4.88:1 against making the straight. The answer is that you are advised to make the call because the odds of making the flush or the straight are less than the pot odds (your $10 in a $50 pot)."
It's Nelson's point that the toughest part of poker, and one of the toughest parts of investing, is that people have a difficult time making decisions on a rational, logical—rather than emotional—basis. "There are a number of behavioral issues: cognitive illusion, attitudes towards risk, mental accounting, over-confidence, at work in a poker game," Nelson continues. "All of these are quirky ways in which people make decisions that cause them to be bad poker players and poor investors. In poker and in investing, 'hope' can be a very expensive word. When you're in a poker game and you start out with three good cards in a seven-card stud and then the next two cards are nothing, you should be out of that hand. You shouldn't be hoping that the sixth card or the last card will save you. That kind of decision process will cost you money. That's true in the investment process as well."