Going All-In: Investment Strategies from the Poker Table

A Good Decision Can Bring a Bad Outcome

Investors formulating investment strategies can learn much from expert poker player Annie Duke’s book, Thinking in Bets. In it, she explains that one of the more common mistakes made by amateurs is the tendency to equate the quality of a decision with the quality of its outcome. Poker players call this trait ‘resulting.’

The quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (since those who succeed attribute their success to the quality of their decision).

Common Mistakes and Inaccuracies

This inaccuracy confuses the ‘before-the-fact strategy’ with the ‘after-the-fact outcome.’ In either case, it is often caused by hindsight bias: after an outcome is known, the tendency is to consider it inevitable.

Writer Nolan Dalla provides another lesson from the world of poker in his February 12, 2014, Poker News article: “Talk to poker players who have been around for a while, and most will tell you the money isn’t as easy as it used to be. The games are getting tougher.”

Dalla explained that this is due to players learning more. The first serious books on poker strategy were published in the late 1970s, with more sophisticated versions being introduced by each new generation of players (just as academics have brought value, size, momentum, profitability, quality, and low beta strategies to individual investors). As a result, the level of competition increased rapidly.

The Paradox of Rising Skill Levels

Many fail to comprehend that in various forms of competition, including poker-playing and investment strategies, the relative level of skill, not the absolute, plays the more important role in determining outcomes. My co-author, Andrew Berkin, and I explain the paradox of skill in our book The Incredible Shrinking Alpha.

What is referred to as the ‘paradox of skill’ means that even as skill level rises, luck becomes increasingly important in determining outcomes if the level of competition is also rising.

Charles Ellis, one of the most respected thinkers in the investment industry, noted the following in the Financial Analysts Journal: “Over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition…They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”

Legendary hedge funds, such as Renaissance Technology, SAC Capital Advisors, and D.E. Shaw, hire Ph.D. scientists, mathematicians, and computer scientists. MBAs from top schools, such as Chicago, Wharton, and MIT, flock to investment management armed with powerful computers and massive databases.

For example, Dimensional’s Co-CEO and Co-CIO Gerard O’Reilly has a PhD in aeronautics and applied mathematics from Caltech. Andrew Berkin, head of research at Bridgeway Capital Management, has a BS from Caltech and a PhD in physics from the University of Texas and is a winner of the NASA Software of the Year award. According to Ellis, the ‘unsurprising result’ of this increase in skill is that “The increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees.”

A Zero-Sum Game Needs Victims

The paradox of skill, from competitive sports, helps explain this. Today’s baseball players are more skilled than those before 1941. Yet, we have not had a .400 hitter since then. However, this had been done 12 times between 1903 and 1941.

There is another important lesson we can take from poker. Dalla notes, “Most profit at the poker table comes not from our own brilliance, but rather from the mistakes of others.” In other words, you need victims to exploit in a zero-sum game (and investing is a negative-sum game after expenses). As Robert Stambaugh points out in his study “Investment Noise and Trends,” there was a substantial downward trend in the fraction of US equity owned directly by individuals (dumb retail money). In other words, the pool of victims to exploit is shrinking. The less sophisticated investors are leaving for passive investment strategies.

Stambaugh notes that households held more than 90% of US corporate equity at the end of World War II. By 1980, US corporate equity directly held by households had fallen to 48%. By 2008, it had dropped to around 20%. The financial crisis certainly did nothing to alter this trend. With 90% or more of trading done by institutional investors, the sharks have fewer fish to feed on.

Investment Strategies: Further Evidence

The study “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri provides further evidence of a declining ability to generate alpha. The authors found that:

• Since 1989, the percentage of managers who evidenced enough skill to match their costs (showed no net alpha) ranged from about 70% to as high as about 90%.
• The percentage of unskilled managers ranged from about 10% to about 20%, leveling at about 16%.
• Skilled managers ranged from 10% to 20%, falling to just 1.6%.

Lubos Pastor, Robert Stambaugh, and Lucian Taylor, authors of the 2015 paper “Scale and Skill in Active Management,” provide further insight into why the hurdles to generating alpha are getting higher. The authors studied over 3,000 mutual funds from 1979 to 2011. They concluded that fund managers have become more skillful over time:  “We find that the average fund’s skill has increased substantially over time, from -5 basis points (bp) per month in 1979 to +13 bp per month in 2011.”

However, they also found that the higher skill level has not translated into better performance. They reconcile the upward trend in skill with no trend in performance noting: “Growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack.”

Even Buffett Has Had Trouble Outperforming

As one of the greatest investors of all time, Buffett has always been considered a value investor. To determine if the shrinking pool of victims and the increasing skill level have impacted his ability to generate alpha, we can compare his recent performance to that of a large-cap value passive fund. Morningstar data provides us with the returns for the last 15 years. Berkshire Hathaway Inc. B shares (BRK.B) returned 14.01%, compared to Vanguard Value ETF (VTV)’s return of 20.35% and the 10.21% return of DFA US Large Cap Value Fund (DFLVX). This is not the stuff of which legends are made.

Buffett’s failure to outperform was not due to declining skill. It was because his competition was getting better and his victims were fewer.

Market Efficiency Continues To Rise

As trading costs have fallen, markets have become more efficient. It has made it easier for sophisticated investors to fix mispricing and generate alpha. What’s more, the pool of victims is shrinking. The competition’s skill is rising. They let the ’wisdom of crowds’ set prices and allocate capital. This will be true as long as investors think independently and avoid thinking in herds, which can allow bubbles to form.

The bottom line is that winning the game of active management is becoming increasingly difficult. And that is the explanation for the massive movement to passive, low-cost funds. Are you still playing the loser’s game of active investing strategies? If so, who exactly are the victims you will be able to exploit successfully?

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Structuring and Planning the M&A Transaction
2. Raising Capital: Negotiating with Potential Investors
3. Valuing Your Brand and Other “Soft” Assets

This article was originally published on October 21, 2022. This article was most recently updated by the Financial Poise Editors.]

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