Monday, October 10, 2005

The Tao of Risk

"The general who thoroughly understands the advantages that accompany variation of tactics knows how to handle his troops. The general who does not understand these may be well acquainted with the configuration of the country, yet he will not be able to turn his knowledge to practical account." - Sun Tzu, The Art of War
After the overwhelming response from last Monday's post called Empiricism, Kierkegaard, Catholic High School Girls, and Poker, I realize that anything I write today will not be as good or meaningful so I decided to just go for it again. I'll be taking a risk today trying to mix half-baked pop culture references, with Wall Street investment strategy and my tweaked perspective of Shakespeare.

Yes, the word of the day is risk.

The best thing that I liked about Wall Street were the high priced hookers that looked like supermodels. The second best thing was being able to risk your entire client's bankroll on a single trade. That's the equivalent of moving all in for your chips, however, there's zero emotional attachment because it's not your money. It's fairly easy to risk everything when you have nothing to lose.

For most of you who are invested in the financial markets, I hope that you have a competent broker who's going to look out after your interests instead of either churning and burning your account for more commissions to pay for his girlfriend's spendthrift habits or someone who is going to treat your money like it's his Mother's nestegg instead of recklessly putting your entire savings at risk on a single trade. Now that rarely happens only in Hollyweird movies or in really awful anecdotes that you'd overhear at one of those gaudy New York City cocktail parties on the Upper East Side. The stiff suits on Wall Street despise rogue traders.

One of the key essentials to investing and accumulating wealth is money management. There are many similar traits that you would undertake for bankroll management. Over the long term, the poker players with the most money should be those with the best money management skills. Due to the high variance of poker and the -EV of playing in a lot of poker tournaments, you need to be careful about your bankroll. How many times have you made a big withdraw for an unnecessary personal expense and discovered that you went on a losing or cold soon after? Did you freak out because your bankroll was not sufficient to handle that bad streak? What happens if another bad streak comes along a few weeks later? Then another? And another? A competent money manager would foresee those possible disasters and be able to compensate for any fluctuations in your bankroll.

Another key to investing is diversity. It's easy to simply play NL tournaments if you are running well. But what happens when you are off your game or stuck in a cold run of cards? That's when you need to play other types of games. Perhaps you should switch from Limit to No Limit or from Omaha Hi/Lo ring games to NL SNGs. It's essential that you are able to vary the types of games that you play. You are taking a step back without walking away from the tables altogether. Playing a different game will give you a different perspective and does wonders for your damaged psychological nature. It's a proven fact that even the best players in the world succumb to depression after multiple losing sessions. A quick win in another game can boost your frail ego out of the doldrums. And sometimes when you play something different, you rediscover the simple joy of the game of poker.

Another big key to investing is risk assessment and management. I used to ask prospective clients what their safety level was. How much are they willing to risk? The general rule was that the older you were, the more conservative your investment approach had to be. The younger clients with money could afford to take chances and bigger risks since they were still 30-40 years away from retirement age and did not need to be careful about blowing their entire savings.

Back to the opening Sun Tzu quote...
"The general who thoroughly understands the advantages that accompany variation of tactics knows how to handle his troops. The general who does not understand these may be well acquainted with the configuration of the country, yet he will not be able to turn his knowledge to practical account."
That quote reminds me of something that one of the partners in my old firm used to talk to us younger brokers about. He preached that we should be spending more time reading Sun Tzu than the Wall Street Journal. He reminded me of Ben Affleck's character in the film Boiler Room. He was a big swinging dick and everyone on the trading floor knew it. I never played poker with him, but I imagined that he'd be one tough son of a bitch at the poker tables. He often spoke to us about: Opportunistic Flexibility in Adapting Strategies and Tactics to Situations.

Basically the Wall Street veteran was saying that although it's important to have a game plan, it's far more important to be flexible and make decisions on the fly regarding changing your strategy based on the information you have gathered in front of you. The hardest part about working on Wall Street was the pressure to make snap decisions that could affect every single client in your "book." You never know when those decisions are going to come up. You can only prepare yourself with the most information possible and based on prior experiences, assess the risk that is involved with your decision. The best poker players, and more specifically, the best NL tournament players in the world all seem to consistently make great decisions. They are all also skilled in looking at a situation and being flexible enough to change their style of tactical play to gain an advantage, even in the middle of a hand!

In William Shakespeare's epic play Hamlet, the main character is Hamlet, a Danish prince who's really just a spoiled rich kid who's slacking off in France drinking and banging French broads while his Uncle Claudius kills his father, the King of Denmark. Hamlet's mother weds his Uncle Claudius who takes the throne. Upon his return to Denmark, Hamlet finds his world all fucked up and even his love Ophelia is being manipulated by Claudius. Hamlet draws a ton of criticism because he lost his shit and went crazy spiraling into the madness of his own twisted mind, while others cite his incestual love for his mother, the Queen of Denmark, as the reason for his dementia. For me, Hamlet's biggest downfall was his inability to act quickly and make decisions on the fly in order to avenge his father's murder. He should have whacked Claudius upon his return home and everything whould have been settled and his Mother and Ophelia never would have died. That's what Michael Corleone would have done. Even in Shakespeare's time, taking risks and making quick decisions were an integral part of society and failure to do so would result in the worst of consequences.

Another Sun Tzu quote comes to mind...
"Therefore the clever combatant imposes his will on the enemy, but does not allow the enemy's will to be imposed on him."
The winning poker player/investor is able to adjust their tactics and implement them without any difficulties. More importantly, a player needs the psychological capacity, mental strength, and discipline to adapt their implementation tactics and adjust to the patterns or the volatility of the other players/markets. Winning players are also able to adapt to situations beyond human control. That means minimizing tilt.

When assessing risk at the poker table or in investing, you will discover that in every advantageous situation, there are equally inherent potential disadvantages. In order to be successful, you need to quickly identify the potential disadvantages, undertake any precautionary measures to combat the potential disadvantages, and at the same time focusing on pursuing the advantage and maximizing your edge.

Conversely, in every disadvantageous situation, there is an inherent potential to capitalize on a developing advantage. That's a way to minimize or eliminate your loses.

Over the long term, the most successful investors and poker players engage in constant ongoing and conscious risk taking. Players who play a lot of pots sometimes win frequently because they are constantly putting their chips at risk. I'm not suggesting that you play more hands, but I am suggesting that you need to take more disciplined risks, especially in tournaments.

We would love to have control over the weather, but we can't. We also have no control over how the stock market is going to perform, and we sure as hell cannot control what cards fall on the river. We can however, create a forecast on tomorrow's weather or what the bond market is expected to do when it opens tomorrow. We can also do the same with poker. Although you cannot influence the outcome of the hand, based on the information in front of you (betting patterns, player's style, and the flop), you can make a probability forecast for the remainder of the hand using your best risk management skills assessing your exposure while implementing the proper tactical adjustments. The key thing to remember is not whether or not your forecast is right or wrong. Rather, did you maintain the flexibility to adapt your strategies and tactics based on the realities of the situation? If you did, then you are one step closer to being a winning player.
"It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another." - Gordon Gekko, Wall Street
The most fearless players are not afraid of risking their stacks. The most fearless investors are the ones who are willing to go broke on a single deal or trade. You have to determine the level of risk you are most comfortable playing with and then maximize your fearlessness at the tables.

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