The Odds are Not Immutable

Some people grow up with the idea that the odds are the odds even though it turns out that this is rarely true.  In almost every situation there are ways to adjust the odds.

Let’s look at a situation dominated by the odds, a single-table poker tournament.  A coomon form has nine players.  The winner gets fifty percent of the purse, the second-place finisher gets thrity percent, and the third place finisher gets twenty percent.  The house usually collects a fee of around five to ten percent for running the game.

If the odds dominate, every nine games on average you will have one first, one second, and one third.  If you are playing for one hundred dollars, you are out ninety bucks at this point if the house is taking a ten percent cut.

Obviously some people lose far faster than this and some people make money.  Both the big losers and the big winners have changed the odds.  The difference is that the winners know how they are changing the odds; the losers don’t.

Aggression and lack of aggression is part of the problem in a no-limit or pot limit tourney.  In the early part of the tournament, you want to be aggressive when you have the best hand, and you want to fold when you don’t.  The most important way to change the odds in this kind of event is to make sure that you are almost always one of the final six.  If luck dominates from that point on, you will get one first, one second, and one third out of every six games.  Now you should be making a few hundred dollars every nine games.

Note that this doesn’t always work.  Sometimes you can’t be in the final six because you run into bad luck.  Bad things can always happen, but if you play only the very vest hands when everyone is still in the game, you are going to fold most of the time.  In most of these events, there are usually some people with no patience.  Show a little yourself, and you should be in the final six ninety percent of the time.

Once you are in the final six, your next goal should be to change the odds of finishing in the final three.  If you have acquired a lot of chips, you can get to the final three by continuing to play only the best hands, but that is not always the best strategy.  Sometimes you want to raise with mediocre or even relatively poor hands.  This actually increases your odds.

Take a game like Omaha High Low, for example,  Some hands have significant advantages and some have serious deficiencies, but most hands are almost even bets against almost almost all other Omaha hands.  If you have a hand that is only forty percent against one other hand and only twenty percent against two other hands, you don’t have a calling hand.  However, depending on your opponents, you may have a raising hand.

When you raise, you win one hundred percent of the hands where your opponents do not call.  If you get them to fold half of the time, and win forty percent of the time when they call, you are going to win seventy percent of the time.  If they reraise, that’s another proposition.  If you call, you are usually up against a better hand.

The odds are also changed by who your opponents are and how they play.  Sometimes you are up against oppoents that always fold if you raise.  Raise these people often.  When they finally call, it doesn’t matter because they don’t have any chips left.

Sometimes you are up against people who always call.  When you call a raise, you need to win the hand with your cards.  That means that callers will only win as many hands as their cards allow.  That demonstrabbly is the path for a slow steady losing pattern because of the house fees, but it changes your odds too because it limits the effects of those raises.

You have to be a lot more selective about the hand syou raise with when you face a calling station.  Raising against them has the same odds as calling, but your odds on winning the tournament are increased dramatically when you know hwo is a calling station and who isn’t.  When you know you have the best hand, bet.  Don’t try to slow-play these players.  They won’t bet into you.  You make the most when you make them call.

As you can plainly see from these examples, two simple risk management procedures can transform a mediocre losing player into a mediocre winning player.  The game offers hundreds more.  Discover and apply them.

Real life and those gambles we call investments are much more complex than a game of poker.  That complexity means that there are far more opportunities for you to institure simple risk management procedures that tilt the table in your direction.  You want the chips to fall towards you, don’t you?

Common Sense Risk Management

Taleb is right when he talks about risk management failing so dramatically in part because of its reliance on statistics, but the problem is neither statistics nor statisticians.  That’s a lot like blaming car manufacturers because people have auto accidents.  They might be the cause sometimes, but most of the time they are the fault of someone who bought the car and misused it.  Statisticians know the difference between ninety-nine and one hudred percent; non-statisticians muddy the line between four to one and a sure thing.

Most of the real problem was really that common sense was not applied.  Basic risk management is almost all common sense.  It begins with asking what can go wrong.  Next, list each risk clearly and completely.  Third, develop a plan to prevent or at least mitigate each risk.

I can’t believe that this is new information to anyone, but it is apparent that this process was either skipped or sabotaged in case after case.  This failure was most spectacular in banking and insurance, i.e., risk management professions.  Since it is hard to believe that they skipped the process entirely, we need to understand where they sabotaged it.

I think statistics was used to sabotage the process.  Many people looked at statistics that said that a bet would win ninety or even ninety-nine percent of the time, and said “That will never happen.”  I heard it myself dozens of times, and what may be most surprising, that same people who were burned by that leap of faith continue to be the same people who are still uttering those words.

If you are a risk manager of any kind and ever say that something will never happen, you are not the guy for the job.  If you can imagine it happening, it almost certainly can happen.  That doesn’t mean that the the fantasized disaster can or will happen, or that you can do anything to prevent the disaster or mitigate the effects.  However, it is certain that you cannot come up with a plan ot deal with the disaster unless you treat it as a real threat and make a plan.

Note that you can recognize a catostrophic risk and still do nothing about it.  At some level that is okay.  For example, if you sell property insurance in Florida, you should recognize that it is a possibility that one hurricane could wipe out Florida — take it right off the map.  Obviously, that would oxer-extend the resources of all of the insurance companies in Florida, and they would almost certainly fail without stunning balance sheets and geographical diversification.

You can’t stop such a hurricane, at least with our present technology.  If the hurricane cuts a wide enough swath through your customer base, geograhic diversification will help a little.  The insurance industry has withstood some major blows, but so far the hurricanes have remained small enough so that only a few companies actually failed.  If the U.S. got hit with a 250 knot storm that hit the country for ten days, insurance companies wouldn’t be the only organizations to fail.

Has it ever happened?  To the best of our knowledge, it has not happened on this planet.  However, similar events do occur constantly on both Venus and Jupiter so that we know that physics isn’t standing in the way.  There is a non-zero chance of it happening here, but when the chances are small enough and the possible remedies are so ineffectual that you simply have to accept that risk.  A financial disaster at that point would probably be insignificant given the scope of the natural disaster.

Many people recognize risk know how to mitigate that risk, and do nothing about it.  People who drive without insurance and people who do not back up the work they’ve done on a computer are two examples that spring immediately to mind.  The issue here is cost.  They don’t want to spend either the money or the time.

Again, deciding not to spend the money or the time to mitigate any risk may still be a valid decision, but if you are a risk manager, you need to document the risk as well as the reason why the mitigation plan was too expensive.  You should review each risk categorized this way regularly because conditions change.

An obvious example of this is buying stocks on margin.  If you buy stocks on margin at ten bucks a share, it is very expensive to buy ten dollar puts to cover them.  Prohibitively expensive, in fact.  However, if the stock moves fifty dollars a share, puts with strikes of twenty dollars or less will be extremely cheap.  If I was forced into a position where I had no practical option but to buy stocks on margin (usually a good position, I would review the cost of puts on a monthly and maybe even weekly basis.  But I digress …

Risk management is almost never about statistics.  Statististics are used to justify risk management decisions,  but no risk management plan should need statistics as a defense.  Ask the question:  What can go wrong?  Answer the question.  Deal with the answers.  That’s all it takes.

Budget or Bankroll?

Are you on a budget or a bankroll?  Knowing this is the difference betweeen sanity and insanity if you are investing or gambling.  Do you know how to tell the difference?

For most people, the test is easy.  If you are taking money out of your income stream to fund your gambling or investment, you are (or at least should be) on a budget.  The purpose of such a budget is to ensure that you are not spending money on these activities that you need to pay the rent or eat.  If you like to play poker, but lose consistently, you need to be on a budget.

It’s perfectly fine to play poker and lose if you enjoy spending your time that way and can afford it.  When you are figuring out whether or not you can afford it, make sure you assess the value of the time spent.  For example, if you are a mediocre poker player (as most people are by definition), you can limit you financial budget by playing for lower stakes.  Let’s say, five dollars is all you think you could afford to lose every week.  If you found tournaments that cost a dime to enter, five dollars would last a whole week even if you never finished in the money.

In fact, there are enough tournaments that are free to get into so that you could easily spend two hundred hours of your time playing in them every week without spending a nickel.  The real cost of your activity is the cost of your own time.  If you could make as little as fifty cents an hour, you would have effectively spent a hundred dollars on your gambling habit.  If you live in the U.S. and get minimum wage, the alternative use cost to you is about fifteen hundred dolalrs for each two hundred hours you spend at the table.  If you’ve got a skill that earns you fifty dollars an hour, each one hundred hours you spend on the tables is five grand that you could have had in your pocket.  True that time has more value than the money you get for it, but you have to budget your time to make things work in this worl.d.

Very few people, comparatively, are working on a bankroll.  A bankroll consists of other people’s money that you have made in this activity.  Your investment fund only becomes a bankroll when you take out all of the money you originally put in.  Budgeting is still important after you have reached this point, but how much of my bankroll can I afford to bet is a different question than whether this game and these stakes fit within your budget.

If you have a bankroll, you should be guided by past history and Kelly’s Law.  Kelly’s Law says that you need some kind of evidence of an edge before you take any bet or make any investment.  If it’s a stock, you need a reason to believe that it is going in the idrction you are betting on.  If it’s a poker game, that means that you need a past history of making money playing poker.

If your past history says that you lose in poker, playing poker is an amusement decision, not a gambling decision.  If it is a gambling decision, the other implications of Kelly’s Law need to be followed as well.  One of these is that you should never bet more than half of your money on less than a sure thing.  Think of it as a scale where you can bet half of your money on a bet you are 99.99% certain to win, but only one percent of your cash in bets where you have a five percent edge.

It is important to keep in mind as so many people recently have not, that every time you bet all of your money on less than a sure thing, you risk losing all of your money.  It doesn’t matter how smart you are or what you think you know.  The unknown can strike at anytime.

This of course also implies that you should never use leverage except in the case of a sure thing.  Leverage is betting all the money you have and all of the money you can talk your broker into lending to you.  This clearly violates the principle of never betting more than half ofd your bankroll on less than a sure thing.

Sure things are incredibly rare, but ninety-nine percent things are available most of the time.

Insurance executives will confirm that these once a hundred year storms come far more often than that.  Poker players can tell you how often they get beat by a draw that could only lose to a single card in the deck.  If it can go wrong, it will far more often than it looks like it can.  Stay within your budget if you are on a budget and inside of Kelly’s guidelines if you have a bankroll, and these events will not wipe you out when they inevitably happen.

The Economic Impact of the Star Trek Transporter

Did you ever think how many people would lose their jobs and lose their fortunes if a transporter like the one on Star Trek was suddenly introduced?  We soon wouldn’t need cars, airplanes, trains, or boats.  The ripple effect from the failure of these industries would bring down banks and governments.  It might be a good thing in the long run, but it might well cause a world-wide depression in the meantime that would dwarf anthing we have seen before.  The whole world would change.

The Internet is having a similar impact, but it isn’t putting businesses out of business overnight.  It is putting them out of business slowly and painfully.  Among the most excruciating deaths are the newspapers.  Beloved newspapers all over the world are dying at an unprecedented rate.  Many have alreadydied, and many others, including the Boston Globe and the New York Times, are losing money at an unsustainable rate.

Other businesses have also taken a beating from the Internet.  Manufacturers have found that they don’t need retailers in some cases, while others, like Apple, find they are useful but that doesn’t stop the manufacturer from competing with their own retailers.  Retail was never an easy way to make a living, but it has gotten much harder now.  This is a huge boon to manufacturers, particularly new manufacturers, because the cost and difficulty of getting their goods to customers has dropped dramatically.  At some point, this should cause a rise in manufacturing start-ups.

Service businesses also are having to adapt to a new playing field.  Travel agencies are just one example of a business that is nothing like it was twenty years ago or even ten.  Travel has changed from top to bottom, and the Internet is just part of that.

The whole world of middlemen has become very, very different, but service deliverers have had to change too.  Ten years ago we went to Williams, Arizona for a family vacation.  I did the research on line, but I did not book a place because we were not sure what day we would arrive.  I took my list of motels from the Internet to Williams.  We found a nice place with no trouble, but every place on my list was booked solid.  Most of the other places were less than half full.

Interent communications are one of the  the most important factors for almost any service company.  If you run a motel, a golf course, a skating rink, or almost anything else you can think of, you have to bring customer in through the Internet.

In short, the Internet is just like the Star Trek transporter.  It is a big train taking over the station.  You can get on board or get out of the way.