Betting in poker is very much like building a portfolio: each hand you chase you are placing capital at risk and—unless you are trying to be aggressive—you want to spread your bets around to lower your risk.

I have a rule in poker that (unless it is late game) I never go all in.  Basically the same rule I apply to investing with my “5-to-10” rule.  Basically my 5-to-10 rule states that I limit myself to investing between 5% to 10% of my portfolio in any one company.  This forces me to have between 10 to 20 different shares in my portfolio at any one time, which means that I am neither under nor over diversified and I’ve minimised my brokerage costs.

In Texas Hold ‘Em poker has various rounds of betting as cards are revealed on the table and the strength of your hand becomes more accurately calculated.  It is almost always worth buying a look at the Flop (the first three cards) because you are paying one sum to see three cards.  On the other hand, if you aren’t bluffing then paying for the River (the final fifth card) is almost never worth it.

Unless you were dealt pockets (pairs) then this is essentially “averaging” (buying a share as it is dropping that lowers your average cost).  Averaging is a very dangerous game and could lead to good money being thrown at bad.  For good reason I’ve heard it being referred to as “catching knives”.

I protect myself from this through strict adherence to my 5-by-10, but in the case where I invest 5% I can average down until I reach a 10% weighting in the company.

Still, as you are averaging down you must be very aware of whether or not the return is worth the risk. Is that final amount of capital you are putting at risk and that brokerage you are incurring worth the potential return…or is there not a fundamental reason the share price is declining?

When a company’s share price is steadily dropping then the “bluffing” I referred to in yesterday’s article starts increasing (especially on Internet forums where some have over exposed themselves).  This simply adds to the confusion and makes the price even more volatile.

So where am I going with this…?

There are two core concepts that are involved in both poker betting strategies and in building portfolios: intelligent selection of capital at risk and correct diversification.  Although this sounds like the same thing, there is a subtle distinction…allow me to illustrate this closing point:

I believed that if Chrometco’s directors made a successful deal within a couple months of their previous cautionary then the share price should have risen significantly…but if they didn't then the company would flounder.  I identified that CMO was worth allocating capital to because of its significant potential.  Because CMO is extremely risky, though, I decided to purchase a stake that was 5% of my portfolio.  This is correct diversification.  Subsequent to this decision CMO has since withdrawn the cautionary that I was investing in favour of, hence I exited my position as a loss.  The loss was small because I applied diversification to my capital allocation decision.

Like I said above: it is almost never worth buying a look at the River.

I’ve played poker for a number of years and across different tables, groups, and formats.  What I’ve always found interesting is the common perception that this game of chance can be “mastered”.  In other words some poker players can be consistently good at winning.

I agree with this perception and firmly believe that one can master a game that on the surface appears to be one of chance…but is actually a game of skill.   Despite volatility between individual hands a good player will consistently walk away from the table with positive winnings due to superior strategy and playing tactics.

Now if we view the stock market as poker then individual hands would be short-term single stock volatility and the tables would be the long-term portfolio returns.  Taking this metaphor further we can make the poker format the individual’s investment strategy and other players at the table as the other market participants.

Despite the fact that you cannot choose the other market participants you can decided which poker format you feel the most comfortable with.  I tend to favour Texas Hold ‘Em given that it encourages relatively higher cross table participation by players (and this is the “fundamentals” of reading hands, calling bluffs, and bluffing).

After this deceptively simple choice you begin playing…hand after hand.  The trick with poker is to distinguish between early game and late game: early game you fold more often than you call or raise, while late game (once you’ve built up your chips) you begin to play more aggressively…but that is a little off the point…

Getting back to the point, the short term market volatility gives the illusion of chance to the casual observer of the stock market.  But in the long-term with the correct strategy an investor will be rewarded with real returns…the better his strategy the higher his returns.

Each individual hand the poker player picks (excluding some bluffing strategies) should have or should appear to have the odds weighted in his favour.  For example, unless you have the nuts or are sitting as one of the blinds the chances of you playing on a differing suites 2 - 7 hand are very slim, as this is the hand that has the worst odds in the whole game.

There is nothing different in the market.  Just like in poker you can choose which hands to play, investors can choose which companies to invest in.  Each company you invest in should have a higher chance of making you money than it has of loosing you money.

In finance we don’t speak of weighted odds, but of the risk:return ratio.  The riskier an investment is the higher the expected return should be to offset the risk.

A famous trader once said the following words that ring true both in poker and investing: “I do not believe in fate or destiny, but I believe in weighted odds.”

Continued tomorrow with "Poker & Investing: Bluffing"