Thinking in Bets

Do you know the odds?

C.M. Coolidge, “Poker Game” (1894). Source: Wikipedia. Public Domain.

I remember the first time I played poker with my older brother. He taught me the rules and then proceeded to clean up, not only taking this week’s and next week’s allowance, but all of my birthday and Christmas money as well. I didn’t know the odds very well, but I could predict the outcome. What could I do?

A lot of folks don’t like to think about the odds when they gamble. They’re not considering probabilities and decisions trees – they just want the adrenaline rush of maybe winning, maybe losing. I think that’s what’s behind all the sub-Reddits and meme stocks and sports betting lately. Gambling is a form of entertainment.

Investing isn’t entertainment, though. It’s about managing risk and uncertainty

There lots of times – uncertain times – where we have no idea what the odds are, but the results can have world-changing effects. Technological breakthroughs, war, terrorism, and of course, a pandemic – they can all re-make society. That’s the nature of uncertainty: there’s no way of knowing what’s off the edge of the map. Old mapmakers used to put “TBD” as a label outside the borders, which stood for “There Be Dragons.”

But risk can be calculated. When we play poker, we can calculate the odds that one of the other players had a hand that beats ours. The boundaries are clear, the odds are distinct, and the math is settled. In managing risk, it’s important to settle on a strategy and have a clear plan.

Decision tree for a legal case. Source: Wikipedia

(As an aside, calculating the odds is the easy part. The greater challenge is to know the probabilities ourselves and play against the other player. The even greater challenge is to master our emotions while remaining mindful of the math in a high-stakes contest. In this way, poker is a lot like investing.)

Investors need to manage both risk and uncertainty. In the short run, markets are risky. Sales rise and fall, economies grow and contract, but variables mostly stay within a range. In the short run, probabilities rule. It’s important to invest with probabilities in mind.

In the long run, though, life is uncertain. Change can assert itself anywhere, and we end up using that dreadful word “unprecedented.” We can prepare for uncertain times, but we can never know what’s off the edge of the map. In uncertain times, we need to improvise.

Sometimes, we don’t want to know the odds because it would ruin the mood. But sometimes, we can’t know the odds. At those times, we won’t need any extra exhilaration.