How Playing Poker Can Give You An Edge In Investing (and how to calculate risk)
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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.
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…
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.
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|
|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
Financial professionals use standard seviation to compare the volatility between investments.
Essentially the lower the standard deviation the less volatile the asset.
Most stock indexes (which most would call volatile) tend to have a standard deviation of between 0.5% and 1%.
Bitcoins 30-day standard deviation however is currently 3.05%, suggesting a volatility triple that of equities which is an already high risk asset. Furthermore Bitcoins standard deviation has even been known to hit 15%.
Whether you wish to invest at this volatility should be a decision only you can make. Although there are many financial advisers who can help guide you.
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.