Insights on decision making
Games like Chess, Poker and Seep have always fascinated me. At the age of 12, I started playing chess. Chess is a very simple game of calculations in which the one who is able to think ahead wins, for eg if A can think 10 moves ahead and B can think 8 moves ahead; A would beat B most of the time. Chess like investing is a dynamic process of thinking and reacting to every move of your opponent because every move brings new variations to the game. Personally I admire Indian GM Viswanathan Anand, because he is a world class chess player. Also, I admire Michael Tal, a Russian GM known for his aggressiveness and bold openings. When I started playing chess for Nirma University, I used to play against mostly professionally trained chess players. However, I never had any professional training.
Most trained chess players used to play standard white openings like E4 and D4(to give an analogy it’s like most fund managers betting on Nifty 50 stocks) which still are the most preferred openings by Grand Masters(GM) in world chess championships. Against which I used to play Budapest Gambit as black, an opening which requires sacrifice of pawn in the very first move to gain attacking advantage after 7-8 moves. Surprisingly, it used to work like a charm at University level against most players because most coaches don’t teach these openings and their training and preparation couldn’t help them much. My edge was I always stick with the openings I know!
As a grown up, I was drawn to Poker and still enjoy playing it. What professional poker players teaches us
- What a bet is: a decision about an uncertain future.
- In poker, the result of each hand provides immediate feedback on how your decisions are faring. However, it’s tricky feedback because winning and losing are only loose signals of decision quality. You can win lucky hands and lose unlucky ones.
- We don’t have the luxury to know what our opponents are holding, thus position sizing (bet size) becomes an important component in poker.
Poker is a game where decision making factors are bet sizing, odds of our hand, pot size and on every turn the odds, pot size and the position size varies, thus making it an intellectually stimulating and challenging game.
Seep is a game generally played between four players(2 teams), in which the team which crosses 100 points by collecting spade cards wins. Each player has 13 cards and there are 13 hands played in which the highest bidder or one with a triumph card wins. Every hand reveals information about what kind of cards every player is holding and which cards they are not holding. In the initial hands we don’t know what our opponents are holding, however, as the cards are dealt we get a probabilistic picture of what kinds of cards other players are holding in the later hands.
These games involves
Chess : No hidden information, no luck, skill
Poker : Hidden information, luck, skill
Seep : No hidden information, luck, skill
Passive Investing like disciplined investments in Index(Nifty 50, Sensex) and Smart Beta is similar to playing chess where there is no hidden information, no luck, and the skill is in asset allocation.
Active Investing and trading involves hidden information, luck and skill. Thus, it is similar to playing poker, and not chess. However, in the long run skill will dominate over luck.
The crux is
One of the most important aspects of skill in Poker refers to gauging the likely outcome.
- How likely is your hand to win?
- How many paths do we have to winning and losing?
- How good is your current position?
- To what extent would we require good luck on the draws of the card for winning, or what’s the probability your opponent will enjoy good enough hands to win?
The job here is to handicap the likely outcome. Which poker player has the best hand?
To put it simply, Who is the favorite?
However, figuring out the favorite is not the only thing you have to do in poker. Figuring out how someone is likely to win is just the first part, perhaps the far more important part is
Assessing the proposition.
There’s no mystery in identifying the favorite. But in gambling and investing, information that’s available to everyone isn’t likely to produce big winnings. Everyone might like to bet on a favorite, but that means it’s unlikely that they will find someone to take the other side of the wager – to bet against the favorite without an inducement.
The inducement takes the form of a proposition. For example, India is playing against Sri Lanka. India is considered twice as likely to win against Sri Lanka. If it’s common knowledge that India wins two out of three games played against Sri Lanka, then the fair odds are 2:1. Now, if Krishna bets Rs 100 on India and Arjun bets Rs 50 on Sri Lanka. Assuming the outcomes go as per expectations, Krishna wins Rs 50 two times and Arjun wins Rs 100 one time. So, in 3 matches both of them even out. That means the odds 2:1 are fair here.
The bottomline here is to figure out who the favorite is and whether the odds are fair or not?
- If the odds are fair 2:1, there is no need to bet.
- If the odds are 6:5, then we should bet on the favorite India, as we will win Rs 500 twice and lose Rs 600 once, giving us an edge.
- Now, if the odds are titled against favorite 4:1, then we should bet on underdog Sri lanka, as we will lose Rs 100 twice and win Rs 400 once, the payoff will compensate our bet.
Sometimes it is a good idea to bet on an underdog, even though doing so is expected to result in loss most of the time. It all depends on the proposition.
Success in gambling doesn’t go to those who pick winners, but to those with the ability to identify superior propositions. The goal is to identify whether the odds are generous to one side or other, favorite or underdog. In other words, a mispricing!
It’s exactly the same in investing. While investing, the value of the proposition is determined by the price of the asset, the potential payoff against the amount risked and what we perceive to be the chance of winning versus losing.