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How Playing Poker Can Give You An Edge In Investing (and how to calculate risk)

By Samuel Jefferies
Money Nest does not provide financial advice in any form. Contact a licensed professional before making any decision. Investments can go down in value as well as up. Post may contain affiliate links.

Professional Poker players use a term called EV or Expected Value to judge whether they should bet on Poker hands. The idea is bets are only ever placed on positive expected value (or EV+) outcomes.

Whilst in the short-term these EV+ outcomes may produce losses, over the long-term the EV+ outcomes should add-up putting the Poker player in a long-term profitable position.

If you’re familiar with Poker an EV+ outcome could be Player A opening the game with a pair of Aces, compared to Player B who opens with two odd numbers from two different suits.

Even though Player A doesn’t know Player B’s cards at ‘pre flop’ he is in a statistically EV+ position.

A real-life EV+ could be betting only ever on heads in a coin flipping scenario where a landing on heads triples your bet whilst a tails means you lose your single bet.

If you keep betting on heads in the short-term you stand to lose multiple bets, however, if your wallet can take it, probability tells us you have the chance to end up far wealthier than you began.

So what does this have to do with investing?

Take equities for example…

Using expected value to calculate whether you should invest in equities

Between 1915 and 2014 after taking into account inflation equities outperformed Bonds by a factor of 2.7x.

Equities averaged out an annual return of 8.3% whilst Bonds produced a measly 1.1% return.


Source: cibcwg.

However, equities have also been far more volatile than bonds, crashing beyond 30% multiple times and wiping out many bull traders in the process.

Each time this has occurred just about every major media outlet has blasted the crash all over the headlines, propagating the myth that ‘investing is always risky’.

Yet the truth is whilst an amount of chaos does exist in the financial markets over the long-run equities have and continue to outperform just about every other asset class.

With a long enough time horizon then, investing in equities could be viewed as an EV+ decision.

This is why I’m always keen (in my twenties) to ensure my pension is purely in equities, since I can’t touch the money for 30+ years, it makes no sense to dampen my return with fixed assets, gilts or company bonds.

What happens to volatility in the short-term is certainly not my business when my money is locked down for such a long time, so if more volatility is a side effect of higher returns, I personally jump at the chance.

Yet most if not all default workplace pension plans put at least some of your cash into these low volatility (likely low return) assets.

These small difference really add-up over the long run, take the following example…

[sociallocker id=”1660″]

40 years of monthly pension deposits of £200 at 8.3% (the average return for equities above) nets us a retirement figure of £767,081.84…pretty respectable!

Now lets say we invest the same amount but add a percentage of bonds which reduces our annual return from 8% to 3%. Crunching the numbers this plummets our final pot by 76% all the way down to £185,835.98. Just imagine what would happen if your average annual return was, as in our Bonds example only 1.1%![/sociallocker]

Cryptocurrencies – The Marmite of the investing world

Crypto! What!? Right now you’re either getting a little excited I just dropped the world Cryptocurrencies for the first time or upset to the point you probably cracked your laptop screen when you slammed it shut so hard.

But here’s the thing…

Why be so black and white? Andrew Craig’s book How To Own The World taught me to put 80-90% of my investments in long-term stable venues and keep 10% back to invest in assets that had the chance of generating high returns from a potential high risk scenario (I do not know the authors viewpoint on Crypto so the following doesn’t represent his views in anyway).

Whilst in most cases you may lose a good chunk (or even all), if the damage is limited to 10% but the upside is 10X, wouldn’t that too become a +EV decision?

What we do know from the (albeit shady) historic returns of the world of Bitcoin is that the market is both extremely volatile and potentially…extremely rewarding. Since collapsing from its peak around Christmas time the world of Crypto has once again slipped back from the light of the mainstream.


Source: Coinmarketcap

With a market cap down from $813 billion to $294 billion and Bitcoin down to £6,771 could this is be a smart time to take a closer look?

Figures as at early June 2018.

Should I invest in X? Calculating expected returns

Lets now take a look at calculating the expected return of an investment. In our example we’ll attempt to figure out the expected return for Bitcoin over a two year period.

First we need an approximation for the worst, likely and best case scenarios…

For our examples lets take a worst case scenario of $531 – approximately the cheapest it costs to mine, a likely case of $9,949 – the 3 month high and a best case of $19,783 – the all time high.

Now we add in the probability of each event occurring.

To keep things simple I’ve added an evenly weighted 33%. You could argue this is either insanely conservative or insanely aggressive depending on your viewpoint on Bitcoin.

Either-way keep in mind these are example figures, so shouldn’t be used as the basis for an investment decision.

Finally we add in a row to show the percentage difference of each outcome from the current price. This is used in our calculations.

Our example table looks like this:

Asset name Worst Case Likely Case Best Case
Bitcoin $531 $9,949 $19,783
Percentage difference from $6,771 -92.2% +46.9% +192.2%
Probability of occurring 33%% 33% 33%

To calculate the expected return we multiply each of the percentage differences by their probability of occurring then add each of the three results together. Still following? If not here’s the working for this calculation:

(-92.2%*33.33) + (46.9%*33.33%) + (192.2%*33.33%) = 48.99%.

In this case, our expected return over two years equates to 48.99%.

Of course, this number is certainly open to interpretation and before making any decisions you should be completely aware of the risks which in this case literally means losing all your investment.

As you may have noticed from our figures Bitcoin is extremely volatile, but just how volatile is it?

Calculating the volatility of an investment

Using second and third level consequences to determine EV+/EV- decisions

Saying no to an impulse purchase may reduce your short-term pleasure but the second level consequence could be a clutter free home and a chance to retire slightly earlier, whilst third level consequences could be a more relaxed living experience and more time with your family. Clearly this leads to an EV+ decision.

Armed with knowledge on Expected Value and considering multiple layers of consequences, we can hope to guide our decisions to be more EV+ and less EV-, which over the long-run can pay huge dividends.


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Reader Interactions

Comments

  1. Hey Sam,

    Interesting way of thinking about things – I guess a lot of us subconsciouly do some mental maths along the lines of EV+/-.

    You’re also dead right that crypto divides people. I’ll lay my cards on the table up front and say that for my money it’s folly. Your maths works, but only if we accept the assumption of an equal chance of going down a bit, up a bit, or up a lot. Change the assumptions and you change the conclusion. My main reasons for mistrusting crypto are:

    1) The old “you know it’s time to sell when shoeshine boys give you stock tips”. Too much hype around cryto, especially to get to the highs you’re calculating for best case. Time will tell if the subsequent bust is more tulips or dotcom bubble-esque.

    2) FOMO (“What if I miss out on 10x”) isn’t necessarily a logical reason to invest.

    3) Even if you call the success of cryptos in general, it won’t necessarily be Bitcoin (MySpace and Yahoo! Search examples of once-powerful names which have been usurped by newcomers).

    4) They don’t really have intrinsic value except to facilitate transactions, so their value relies on trust as to their ability to be used as a medium of exchange. Without government or major corporate backing (which would slightly defeat the point for many people), I can’t see people trusting them enough to keep their value high.

    For those reasons, and a couple of others I won’t go into right now, I mentally park crypto in the “speculation” camp rather than the “investments” camp. I’m not saying that to give you a hard time. I’m not against anyone putting their money wherever they think best. Just not convinced enough to follow suit!

    • Thanks, absolutely and I would also reiterate that I’m not a financial advisor so no decisions should be made following this post!

      As you said, change the maths and you’ll change the outcomes. Interesting point on the shoeshine boys, at the peak I remember an article in The Sun on investing in Ripple. Not something you see every day!

      Again good point about Bitcoin, of course, you could create your own ‘mini-portfolio’ of multiple cryptos to mitigate the risk, also the point on no intrinsic value, could the same be said for Gold or US dollars?

      I do agree it’s speculation and as mentioned in the article your money could go to zero so be warned! I think in the long run all money will be crypto (or at least some of it) but likely it’ll be government created crypto in the meantime lets see what happens!

      Sam

      • Hi Sam,

        Yeah, that’s it. I was getting Uber drivers enthusing to me about cryptocurrency, which to me suggested it had gripped the public imagination to the point of over-hyping.

        True, diversification should reduce both the likely upside and the likely downside in theory. Though if I were being cynical, I might say that diversifying between blackjack and roulette doesn’t make you more likely to beat the house at a casino.

        As for the intrinsic value, again I broadly agree, but with a couple of minor counters. With US dollars, it’s true they don’t have intrinsic value. On the other hand, they’re backed by a strong government. Sure, there are cases like Zimbabwe where a government backed fiat currency has basically folded through hyperinflation, but governments do tend to have more trust than cryptocurrencies, which for me makes their chosen currencies more solid.

        As for gold, it’s not government backed in the same way, but I’d argue there is at least some intrinsic value e.g. “it’s pretty”. I do accept that’s a fairly weak argument, though, and would accept that most of the value of gold is the value it’s been imbued with as a medium of exchange, rather than its intrinsic value. Then again, I don’t invest in gold either, so maybe not the man to defend it!

        All of which is to say in a very longwinded way, yep, you’ve gone a little bit of the way to convincing me. I’m still sticking with index funds personally for now, but I hope the crypto works out for you. Fortune favours the brave…

  2. Very good Sam.

    I think this is a bit like playing roulette!
    You can bet ‘safe’ and keep going a long time but you don’t make much – and it gets very boring!! Or go high risk – you could win a lot or lose the lot! Worth a ‘flutter’ though – as long as you keep to a budget! (High risk high return, low risk low return). Defo. going to put a bit into cryptocurrency!

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