Money Management is Almost Everything

The ability to manage money effectively is the most imp0rtant skill to have in a capitalist society, yet our education system does little to develop this skill in our citizens.

Notice that the most successful plumbing businesses are not necessarily run by the person who knows the most about plumbing, the most successful painting business are not run by the best painters, etc.  All businesses that survive practice good money management.  I don’t care if you are running a hedge fund, a Fortune 500 company, a small business, or just y0ur own household; you need to know how to manage money.  What does that mean?

I have a gambler’s perspective on money management.  That is, good money management means making sure that your bets are properly sized.  I believe that everything you do with your money is a wager, and sometimes on many different levels.  Even stuffing your money in a mattress is a bet against inflation and against certain types of robbery.

If you buy that big flat screen TV, you are betting that you won’t need that money to feed your family.  If the cost of that TV is a small percentage of all the money you have, that is probably a good bet.  However, you are also betting that you won’t need that money for retirement.   For many people, this is nowhere near as good a bet.

If you view it this way, you are always deciding whether or not to make a bet.  How do you decide whether or not to make a bet?

John R. Kelly of Bell Labs, one of the brilliant mathematicians that made our world-wide communications system possible, came up with a mathematical formula (Kelly’s Law) that is way over my head, but I have read a lot about it and gotten a lot of input from those who do understand the math.  Here is what I have distilled.

Never make any bet in which you do not have a significant edge.   That doesn’t mean that you have to be the favorite to win, but it does mean that the payoff has to be better than the risk.  For example, if you are simply betting on whether a coin will come up heads or tails, the odds of winning that bet are dead even.  However, it is a good bet if the amount you win is greater than the amount you lose, and it’s a bad bet if the the amount you lose is bigger than the amount you win.

Poker players talk about ‘pot odds’.  That means your payoff for a bet is so good that the fact that you have short odds is beside the point.  You might have a hand that has only a five percent chance of taking the pot, but it’s a good bet if the payoff on the bet is a hundred to one.  Note that pot odds do not exiist if you have no chance of winning the bet.

In most cases, deciding whether or not to bet is comparatively easy.  The hard part is knowing how much you should bet.  Here again, Kelly’s Law provides difinitive guidance.

First, never bet more than fifty percent of your bankroll on any bet that is not a sure thing.  Don’t get confused between a situation where the odds are 99 to 1 in your favor and a sure thing.  As people in the property and causualty insurance business will tell you, it’s amazing how these once every hundred years events seem to happen every twenty years.

This implies that you should avoid betting borrowed money on anything less than a sure thing, i.e., no use of leverage.  It also implies that you should not make two bets that may turn out to be correlated inf the total amount you are betting is more than fifty percent of yoour bankroll.

This also implies that you should always know how much you are betting.  For example, you know how much you can win but not how much you can lose when you sell a call option.  Kelly would call this a bad bet because you don’t know how much you can lose.  In order to use Kelly’s math, you need to have the bet amount in order to the calculations.   The math does not work if you don’t have exact figures for the amount at risk and the size of your bankroll.

There are few sure things, and most what is a sure thing is not obvious until the opportunity has come and gone.  If you find a real arbitrage opportunity, that may be a sure thing but beware of what some people call ‘asynchronous arbitrage’.

Real arbitrage happens when you can buy a commodity and simultaneously sell it at a higher price.  The longer the time required between the purchase and the sale, the greater the chance for loss.

Our banking community recently fell prey to the myth of asynchrous arbitrage.  They were buying loans at one price, hoping to turn around and sell them down the road.  Many weren’t interested in the quality of loans because the only purpose of their creation was so that the bank had something to sell down the road.

When customers started realizing that the banks were selling them crap, they stopped buying.  Most banks could have avoided the overwhelming losses they faced later if they simply stopped making bad loans when people stopped taking them off their hands, but they were addicted to the income stream.  That made it easy for them to believe that they would eventually find customers for the bad loans.

The banks simply forgot that every mortgage is a bet, and they stopped looking at each loan as a wager.  A bank is by definition an instituion for making wagers, but they forgot that.

They thought that they were bookies, not gamblers.  Being a bookie is a good business if you are smart and not worried about the law or the competition from organized crime.  A gambler can win or lose while a bookie simply collects a service fee.

For example, if you ask your bookie about the odds on a particular game, he might indicate that it is a six to five pick ’em bet.  This means that you have to bet six dollar to win five. If the bookie gets an equal amount of bets on each side, he makes ten percent of all of the money bet.  The bookie can’t really win or lose if the bets are evenly distributed.

The smart bookie keeps the action evem by changing the odds, moving the point spread, and laying off uneven action to bigger books.  money management for the bookie is simply avoing the chance of losing wherever possible.

Hedging is key to money management.  If possible, you always want to be in the position of the good bookie.  You don’t want to be greedy; you want to make sure that you win no matter what happens.

Nothing in life is without risk, but risks can often be chosen and managed.  To do so is to reduce dependence on luck.

A Few Words in Defense of Gambling

One of the most ridiculed hypocrises in American culture is our treatment of gambling as a character flaw at same time we regard capitalism as a pure and virtuous economic system, and deservedly so!

Capitalism is gambling, pure and simple.  I’ve been an entrepreneur all my life, and every business has been a gamble.  Not all have been good gambles, and most were not a good bet to begin with.  Sometimes you can overcome that, and sometimes you can’t.

But risk is an intrinsic part of the universe.  It permeates every part of the universe and every part of every activity.  Unless you can figure out how to cheat death, eventually the risk is going to dominate.

Our government has chosen time and time again to prohibit gambling.  Of course, they don’t prohibit all gambling.  Most of their purpose seems to be to eliminate gambling on games of chance, but we can’t overlook that they do restrict and eliminate a lot of gambling that is even more vital to the system.

For example, the government did nothing to stop thousands of people making their bets with Bernie Madoff, but a little more than a year ago, they changed the definition of a “qualified investor’.  If you are not a qualified investor, the government will “protect” you by not allowing you to invest in the next Google or Microsoft before they go public, but it will allow you to lose all of your money in Bear Stearns, General Motors, or AIG.

Qualified investors used to have to have a million dollars in addition to their personal real estate.  Now they need five million.  I guess the logic is that millionaires are not as rich as they need to be, and therefore they need to be protected against making bad bets.  Because start-ups are so shakey and you are so likely to lose, you now need five million to play this game.

The whole idea of qualified investor is so wrong on so many different levels.  It is a huge impediment to the development of new businesses, and new businesses are the lifeblood of capitalism.  It says that they government is more qualified than you are as to how to invest your money.

I don’t think the role of government should ever be to protect people against themselves, but rules like this are even more offensive than gross stupidities like outlawing Internet gambling or casual drug use.  The proper role of the government is to ensure that people have access to all of the information necessary to make the best descion for themselves.  You can’t le3gislate risk out of existence, but you can do a whole lot to make sure that risks are not a surprise.

Let’s take playing poker on the Internet for example.  The current approach is to make it illegal.  The logic is that people are ruining their lives by losing so much money playing poker.  That’s not most people.  The purpose of this law is to protect the weakest.

Most people win a little or lose a little.  Smart people who lose a lot are smart enough to stop playing before it ruins their lives.  Most people are at least that smart.  If they lose at poker, they treat poker as an entertainment expense.  They don’t bet the mortgage payment on a poker game month after month.

I not only beleive that Internet poker ought to be legal, I think everyone oght to spend some time and money on it.  Don’t play for too much money, but play for enough so that it means something to you whether you win or lose.  If you are really broke, you can play for pennies or nickels.  Don’t play for enough so that it has a negative impact on your life if you lose, but do play for enough so that you learn about money management and risk.  Pick a budget and stick to it.

There are many good and sound reasons that some Wall Street firms and hedge hunters recruit poker players, but the primary reason is that poker teaches you about risk.  Everyone in a capitalist society should know everything about risk that they can.