A Dozen Lessons about Business and Investing from Poker

You can’t write about the relationship between games and investing without quoting Michael Mauboussin. I will do so often in this post. He is the master. Read his books. All of them. Then read them again.

Set out below are the usual dozen lessons you can learn from poker:

“Poker is a game where you don’t have to have the best hand to win. Poker is really reading other people and reading human emotion, which certainly comes into play in business.” Charlie Ergen

One of the stories people tell about Charlie Ergen is how he was a blackjack card counter before he created the DISH satellite television business. One part of the lore about his poker playing is this anecdote:

“In 1980, a few months before Charlie Ergen co-founded the company that would become Dish Network, he and a gambling buddy strode into a Lake Tahoe casino with the intention of winning a fortune by counting cards. Ergen, then 27, had bought a book called Playing Blackjack as a Business and studied the cheat sheets. Unfortunately for him, a security guard caught his pal lip-syncing numbers as the cards were dealt. The two were kicked out and subsequently banned from the casino.”

Ergen knows the smartest business people and investors don’t really “gamble” (a net present value negative activity) since their intent is to bet only when the odds are substantially in their favor (i.e., a net present value activity). Ergen understands this distinction since he has the same outlook as Steve Crist of the Daily Racing form:

“A good litmus test for someone being a liar and an idiot is if someone ever tells you, ‘I am really good at roulette,’ or ‘I win at craps,” or ‘I have a system for beating the slot machines.’ There is no such thing. These are games with fixed percentages. The casino might as well attach a leach to your forehead when you walk in the door because the longer you stay, the more you will lose, except for short-term, meaningless fluctuations. The exceptions to [the previous] rule are blackjack and poker. If you count cards diligently in blackjack, you can get a 1.5 percent edge over the house. Casinos, of course, don’t get built by players having edges, so the casinos will eject you if they figure out that you’re counting cards.”

The best example of what essentially was poker playing I have even seen in business is how Bill Gates managed Microsoft’s relationship with IBM and took them to the cleaners. Gates said in 1993:

“We would have been glad at sometime to sell IBM part of the company. We even proposed to IBM that they buy part of Microsoft– I think it was 30%– and they turned us down. At every stage of our relationship, they had project groups doing work to wipe us out. We stayed ahead, but it wasn’t simple.” Computerworld, May 24

This story has never been properly told. If someone does write an accurate account someday, it will convey poker playing skills at the highest level. The relationship wasn’t just a dumb lumbering IBM not understanding software (although there were elements of that). IBM was actively engaged in a campaign to “wipe out” Microsoft. Gates played hand after hand against IBM in this business poker game and won every time. The OS/2 era alone is worthy of an entire master class in business strategy.

2. “If there weren’t luck involved, I would win every time.” Phil Hellmuth

There is no substitute for a sound process in an activity like investing. When playing poker you can make a wise decision and still lose or make a terrible decision and still win. As Michael Mauboussin writes: “If you compete in a field where luck plays a role, you should focus more on the process of how you make decisions and rely less on the short-term outcomes. The reason is that luck breaks the direct link between skill and results—you can be skillful and have a poor outcome and unskillful and have a good outcome. A good process can lead to a bad outcome in the real world, just as a bad process can lead to a good outcome. In other words, both good and bad luck can play a part in investing results. But the best investors and business people understand that over time a sound process will outperform.” Over a shorter period of time, luck can fool you into believing that someone has skill or good judgement. On this point I have always liked this 1993 quote from Bill Gates on luck: “The notion that people who have been lucky enough to make a lot of money know something or are worth listening to is a risky proposition.” Chicago Tribune, October 24.

Luck of course is at the root of what poker players calls a bad beat. There are many stories one of them is:

poker

3. “On any given day a good investor or a good poker player can lose money.” David Einhorn

Mauboussin tells this story about poker: “Jim Rutt, who used to be the CEO of Network Solutions. He talked about playing poker when he was a young man.By day, he would learn about the different probabilities, and look for poker tells and pot odds, and all this stuff, and by night he would play. He played in progressively tougher games, and won some, lost a little. Eventually, his uncle pulled him aside and said, “Jim, it’s time to be less worried about getting better, and more worried about finding easy games.”

Mauboussin tells another story to illustrates this point:

“[A baseball executive] was in Las Vegas sitting next to a guy who has got a 17. So the dealer is asking for hits and everybody knows the standard in blackjack is that you sit on a 17. The guy asked for a hit. The dealer flips over 4, makes the man’s hand, right, and the dealer sort of smiles and says, “Nice hit, sir?” Well, you’re thinking nice hit if you’re the casino, because if that guy does that a hundred times, obviously the casino is going to take it the bulk of the time. But in that one particular instance: bad process, good outcome. If the process is the key thing that you focus on, and if you do it properly, over time the outcomes will ultimately take care of themselves. In the short run, however, randomness just takes over, and even a good process may lead to bad outcomes. And if that’s the case: You pick yourself up. You dust yourself off. You make sure you have capital to trade the next day, and you go back at it.”

“Ain’t only three things to gambling: knowing the 60-40 end of the proposition, money management, and knowing yourself. Any donkey knows that.” Puggy Pearson

This statement from Puggy Pearson is one of the favorite quotes of Michael Mauboussin who wrote one of his many essays specifically on Pearson.” In that essay Mauboussin explain’s what Pearsin means:

“Pearson’s message may be colloquial, but that in no way undermines its power. We can express the ideas more formally, and readily draw out critical investment concepts. Taken together, Pearson’s points indeed provide a strong foundation for investment success. The core of Pearson’s point is that investors should seek financial opportunities that have a positive expected value. A positive expected value opportunity has an anticipated benefit that exceeds the cost, including the opportunity cost of capital. Not all such financial opportunities deliver positive returns, but, over time, a portfolio of them will. So how should investors seek such opportunities? First off, investors must understand their source of competitive advantage. Markets reflect the collective expectations of investors, and embody more information than any individual can hope to have. An investor with a competitive advantage knows something that the market doesn’t—based either on superior information or on superior analysis of known information. An investment is attractive if it trades below its expected value. Expected value, in turn, is a function of potential value outcomes and the probability of each outcome coming to pass. Investing is fundamentally a probabilistic exercise, and leading investors always think in probability terms. In Pearson’s words: ‘I believe in logics. Cut and dried. Two and two ain’t nothing in this world but four. But them suckers always think it’s somethin’ different. I play percentages in everything.’ Investing is the constant search for asymmetric payoffs, where the upside opportunity exceeds the downside risk. Ben Graham described margin of safety as buying an investment for less than what it is worth. The larger the discount, the greater the margin of safety. That’s knowing the 60-40 end of a proposition.”

My blog post last weekend on Ed Thorp has loads of great material on the Kelly criterion. I win’t repeat that here other than to repeat two sentences from Thorp which make the key points: “If you bet too much you’re likely to be wiped out. If you bet too little it takes forever to make any money, so there’s a happy medium.”

“Coming out ahead at poker requires that I win a lot on my winning hands and lose less on my losers. But insisting that I’ll never play anything but ‘the nuts’ – the hand that can’t possibly be beat – will keep me from playing lots of hands that have a good chance to win but aren’t sure things. For a real-life example, Oaktree has always emphasized default avoidance as the route to outperformance in high yield bonds. Thus our default rate has consistently averaged just 1/3 of the universe default rate, and our risk-adjusted return has beaten the indices. But if we had insisted on – and designed compensation to demand – zero defaults, I’m sure we would have been too risk averse and our performance wouldn’t have been as good. As my partner Sheldon Stone puts it, ‘If you don’t have any defaults, you’re taking too little risk.’” Howard Marks

My blog posts on Howard Marks are here and here. In his book Margin of Safety, Seth Klarman writes:

“Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.”

Sometimes the right result is found through trial an error. At other times intelligence and observation are the key factors. There is also luck involved of course and a keen understanding of human nature. In their famous book In Search of Excellence Tom Peters and Bob Waterman write:

“There is a quality in experimentation as a corporate mind set that resembles nothing so much as a game of stud poker. With each card, the stakes get higher and with each card, you know more, but you never really know enough until the last card has been played. The most important ability in the game is knowing when to fold.”

As an example of business people making big bets, here are Bill Gates and Steve Jobs talking about a big bet made by Apple and a simultaneous big bet by Microsoft:

“Bill: One of the most fun things we did was the Macintosh and that was so risky. People may not remember that Apple really bet the company. Lisa hadn’t done that well, and some people were saying that general approach wasn’t good, but the team that Steve built even within the company to pursue that, even some days it felt a little ahead of its time–I don’t know if you remember that Twiggy disk drive and…

Steve: 128K.

Bill: The team that was assembled there to do the Macintosh was a very committed team. And there was an equivalent team on our side that just got totally focused on this activity. Jeff Harbers, a lot of incredible people. And we had really bet our future on the Macintosh being successful, and then, hopefully, graphics interfaces in general being successful, but first and foremost, the thing that would popularize that being the Macintosh….We made this bet that the paradigm shift would be graphics interface and, in particular, that the Macintosh would make that happen with 128K of memory, 22K of which was for the screen buffer, 14K was for the operating system.

Steve: What’s interesting, what’s hard to remember now is that Microsoft wasn’t in the applications business then. They took a big bet on the Mac because this is how they got into the apps business. Lotus dominated the apps business on the PC back then.”

“It’s very important for most people to know when not to make a bet, because if you’re going to come to the poker table, you’re going to have to beat me, and you’re going to have to beat those who take money. So, the nature of investing is that a very small percentage of the people take money, essentially, in that poker game, away from other people who don’t know when prices go up whether that means it’s a good investment or if it’s a more expensive investment.” Ray Dalio

Many people agree with these points made by Dalio, including these three famously successful people:

Warren Buffett: “The important thing is to keep playing, to play against weak opponents and to play for big stakes.” “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

Charlie Munger: “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.” Charlie Munger was once asked who he was most thankful for in all his life. He answered that he was as most thankful for his wife Nancy’s previous husband. When asked why this was true he said: “Because he was a drunk. You need to make sure the competition is weak.”

Tony Hseih of Zappos: “An experienced player can make ten times as much money sitting at a table with nine mediocre players who are tired and have a lot of chips compared with sitting at a table with nine really good players who are focused and don’t have that many chips in front of them. In business, one of the most important decisions for an entrepreneur or a CEO to make is what business to be in. It doesn’t matter how flawlessly a business is executed if it’s the wrong business or if it’s in too small a market.”

“One of the best antidotes to this folly is a good poker skill learned young. The teaching value of poker demonstrates that not all effective teaching occurs on a standard academic path.” “Part of what you must learn is how to handle mistakes and new facts that change the odds. Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much loved hand.” “Playing poker in the Army and as a young lawyer honed my business skills. What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often. Opportunity comes, but it doesn’t come often, so seize it when it does come.” “And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It’s just that simple.” Charlie Munger

A simple point Munger makes again and again is that understanding probability and statistics is essential in both card playing and investing. Munger bets big when he sees a situation that is “net present value positive” over time after fees and expenses. Bets that are net present value negative are avoided. Amarillo Slim has a view that is similar to Munger: “I like to bet on anything—as long as the odds are in my favor….there are people who love action and others who love money. The first group is called suckers, and the second is called professional gamblers, and it was a cinch which one I wanted to be.” Here’s a story about Slim putting that principle to work:

“Bobby Riggs, the 1939 Wimbledon Tennis Champion tried to hustle Amarillo Slim in Ping Pong. Riggs was looking to bust Slim’s skinny ass. Slim tells the story, “I told Riggs I would play him in Ping Pong straight up with one stipulation: that I got to choose the paddles. “We both use the same paddle?” Bobby asked. “Yessir.” “So when you show up with two of the same paddles, can I get my choice of which one of them?” “Yessir, so long as I can bring the paddles.” Bobby thought I was pulling a schoolboy’s scam—that it was a weight thing or that one of the paddles was hollow or something. But once I told him that he could choose whichever of the two paddles he wanted to use, he couldn’t post his money fast enough. We bet $10,000 and agreed to play at two o’clock the next day. Before I left, just to avoid any misunderstanding, I confirmed the bet: We were to play a game of Ping Pong to twenty-one, each using the paddles of my choosing. I showed up the next day at the Bel Air Country Club ready to wage battle. When Bobby asked to see the paddles, I reached into my satchel and handed him two skillets, the exact same weight and size, and told him he could use either one. Now, Bobby was about as coordinated an athlete that ever lived, but he was swinging that skillet like a fry cook on speed. It wasn’t until I had him buried that he started to get the hand of that skillet, but it wasn’t soon enough. I won the game 21-8, and it could have been much worse. Once again I proved that you can make a living beating a champion just by using your head instead of your ass. The easiest person in the world to hustle is a hustler, and Bobby had taken the bait like a country hog after town slop. You see, I had been practicing with that skillet since I saw him in Houston.”

“Poker is a lot like sex, everyone thinks they are the best, but most people don’t have a clue what they are doing.” Dutch Boyd

Overconfidence is one of many behavioral biases that can trip up a poker player or investor. Charlie Munger likes to use this example to explain this bias: “A careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives.” Munger is talking about investing here but he may as well have been writing about poker: “The primary problem with this bias is that people who should be buying index funds think they can be successful active investors. Munger has said: “Most people who try don’t do well at it. But the trouble is that if even 90 percent are no good, everyone looks around and says, ‘I’m the 10 percent.’”

“In poker, a player collects different pieces of information—who’s betting boldly, what cards are showing, what this guy’s pattern of betting and bluffing is—and then crunches all that data together to devise a plan for his own hand.” Bill Gates

When Bill Gates was a student at Harvard people he went to school with quickly found out how hard he works to learn and how persistent he can be:

“He took up poker with a vengeance. The games would last all night in one of the common rooms of Currier House, which became known as the Poker Room. His game of choice was Seven Card Stud, high low. A thousand dollars or more could be won or lost per night. Gates was better at assessing the cards than in reading the thoughts of his fellow players. “Bill had a monomaniacal quality,” Braiterman said. “He would focus on something and really stick with it.” At one point he gave Paul Allen his checkbook to try to stop himself from squandering more money, but he soon demanded it back. “He was getting some costly lessons in bluffing,” said Allen. “He’d win $300 one night and lose $600 the next. As Bill dropped thousands that fall, he kept telling me, ‘I’m getting better.’ ” He was known to be an aggressive player,” says C. Greg Nelson ‘75. “But in the crowd at Currier House where we played, he was about the median—definitely not in the top quartile.” According to Nelson, the group usually played with six people and allowed participants to buy into the game for $100. As the year went on, the pot would grow until some hands were being played for over $1,000.”

Gates is also very practical. When the Altair computer came out Gates “decided that I better buy one. I thought it was a better use of my money than losing at poker.” The process did have some significant befits according to Steve Ballmer who has said that Microsoft’s success in business was “basically an extension of the all-night poker games Bill and I used to play back at Harvard. Sometimes whole divisions would get moved just because someone bet two pairs against an inside straight. People were always wondering why [co-president] Jim Allchin ended up with so much power. What can I say? He bet big and won big.”

The pattern recognition and bluffing part of poker is fascinating. Tom Schneider, a four-time World Series of Poker bracelet winner once said:

“I pick up clues immediately. If you come in, and all your bills are 20s, it means you don’t have casino chips and you don’t have 100s. It means you went to the bank, and money is probably more important to you. You’ll be a little tighter with it than somebody who comes in with $20,000 in $5,000 casino chips, which means they’re probably a gambler in the pit and money won’t mean as much to them.”

But poker requires skills that transcend simply knowing the odds of completing any particular hand. It requires a split-screen ability to read the other people at the table while maintaining an awareness of how they are reading you. It requires what is called “leveling”: the ability to move fluidly and accurately in one’s imagination from the hands that all the other players are representing, to the hands that they probably have, to the hand that they think you have, to the hand that they think that you think that they think you have. The acute awareness and processing ability required to quickly go through a complex checklist and get it right—while controlling your thoughts and behavior so that others can’t read you with any equivalent degree of accuracy—is what separates poker pros from casino operators and other crude types who profit from the fact that large numbers of people are dumb or drunk and can’t do math.”

The number of possible “tells” that can potentially be exploited in poker is gigantic:

“Because poker is a game of human interaction, we sometimes receive clues from other players, based on changes in their betting patterns or their physical demeanor, which indicates the strength or weakness of their hand. These are called “poker tells.” A player gains an advantage if he observes and understands the meaning of another player’s tell, particularly if the poker tell is unconscious and reliable. Sometimes a player may even fake a tell, hoping to induce his opponents to make poor judgments in response to the false poker tell. After all, poker is a game of deception. Poker tells come in two forms: (1) Betting patterns and (2) Physical tells.”

“Nobody is always a winner, and anybody who says he is, is either a liar or doesn’t play poker.” “The over-under, is just another example of how the bookmakers are always looking for more options to give the guesser an opportunity.” Amarillo Slim

Charlie Munger’s best essay and arguably the one that made him most famous is entitled: “A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management and Business” and it can be found here. In this wonderful essay is a long passage which includes this language:

“The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack… Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market. Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal….”

My essay on Steve Crist discusses the meaning of this point so I won’t repeat that here.

“If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.” Peter Lynch

If you are going to win at poker you need to have an edge of some kind. That means doing things like acquiring skill and finding better information. Howard Marks writes: “The investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the great the likelihood you can learn things others don’t.” In addition to having an informational edge, outlook is important. Poker professional Doyle Brunson once said: “Poker is not a game where the meek shall inherit the earth.” If you don’t do the work, understand probability, manage your bankroll well, manage your emotions and understand the emotions of others, you are going to get your clock cleaned in poker and in business.

Somtimes the best way to learn the importance of something is to go without it as an experiment. This link tells a story about a famous player winning without looking at their cards:

“This fricking donkey stuffs $15,000 in with king-jack. I mean, the guy can’t even spell poker.” Phil Hellmuth

Humans love stories and part of the fun of playing poker is the ability of a player to tell a story like Hellmuth just did. Business for me is the same way. Part of the fun of this blog is telling stories. A great story told well is one of the best ways ever invented to teach people about a topic. Before the invention of written language stories were the only way that culture and history were conveyed from generation to generation. As an example, I edited two books of stories collected by my Great Grandfather Judge Arthur Griffin that he used to help establish native American treaty rights since there was no other written record that they could use to make their case. The best business people and founders are great story tellers. Some of the best story tellers like Mark Twain were also poker fans as was the great sportswriter Grantland Rice. Twain once said: “There are few things that are so unpardonably neglected in our country as poker. Rice said it better: “It’s not whether you won or lost, but how many bad-beat stories you were able to tell.

Maybe the best way to end this post is with a Puggy Pearson story. It is sort of long (about six minutes) and you will probably enjoy it most if you are a poker player: