The Poker Face of Wall Street

Aaron Brown

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470127315, 9780471770572
• eBook ISBN: 9781118161104
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Wall Street is where poker and modern finance?and the theory behind these "games"?clash head on. In both worlds, real risk means real money is made or lost in a heart beat, and neither camp is always rational with the risk it takes. As a result, business and financial professionals who want to use poker insights to improve their job performance will find this entertaining book a "must read." So will poker players searching for an edge in applying the insights of risk-takers on Wall Street.

CHAPTER 1

The Art of Uncalculated Risk

This book is about how to gamble and win.

Gambling lies at the heart of economic ideas and institutions, no matter how uncomfortable many people in the financial industry are with that idea. Not surprisingly, the game most like the financial markets—poker—is hugely popular with financial professionals. Poker has valuable lessons for winning in the markets, and markets have equally valuable lessons for winning at poker.

This book will give you insight into both kinds of gambling. We’ll begin with basic information about poker and finance, then delve into the psychology of finance and the economics of poker. We’ll review elementary and advanced tactics for winning. Along the way, we’ll see how America’s passion for gambling at poker and in the markets has shaped the country’s economic success and national character, and spilled over to make the globalized world we live in today. I’ve stuck bits of my autobiography in the Flashback sections to make the points personal. Finally, we’ll look at some of the cutting-edge work being done in these fields and some of the dangerous nonsense to avoid.

RISK

My first point is obvious but often overlooked. In order to win, you must take risk. Therefore, to someone who wants to win, risk is good. However, I have great respect for risk. It is real. Trying to make a living at poker or trading, or anything else that involves risk, means you might fail. You might end up broke or friendless and miserable or dead. Or worse. If you don’t really believe that, if you think that God or the universe or a Hollywood scriptwriter guarantees a happy ending for a shrewd, good-hearted adventurer—or that nothing really bad ever happens to people like you—this book will do you more harm than good. Of course, since God’s looking out for you, you don’t have to worry about that.

It’s easy to say that there’s no alternative to gambling, that you take risk by getting out of bed in the morning or crossing a street. That’s true enough, but you can try to avoid unnecessary risk. More important, you can avoid uncalculated risks; you can always look before you leap. It’s hard to win much that way, though. Other people snap up the riskless profits pretty fast and bid the price of calculable risk opportunities to near their fair values. Things get a lot less crowded if you go for the incalculable risks, leaps of faith that cannot be inspected carefully before takeoff. So that is where you find extraordinary opportunities.

If you can tolerate what life offers in low- and calculable-risk opportunities, you should take it. That is the defining strategy of the middle class, but it can be adopted by anyone, rich or poor. Choose a career in a low-risk field, and get plenty of good training. Be nice to everyone. Select sound investments; make conventional choices; pay your taxes; obey the law. Do a little better every year than the year before, and raise children who will do a little better than you. For many people, this is the American Dream. For others, it’s the only sensible choice, the only kind of life that allows happiness without achieving it at the expense of someone else.

This book is for the rest of us, the ones who cannot imagine living that way. For some of us, conformity is the problem. We are sexual, political, or religious deviants, or uncategorizable eccentrics who just cannot fit into polite society. For others, born in war zones or under horrific governments, or abused as a result of caste or genetic aberration or other prejudice, the rewards of the limited safe choices on offer are too meager to merit consideration. Still others among us are just bored: Conventional comfort is too dull. But the most common reason for embracing risk among people I know is pure egotism. We believe we have some talent that must be nurtured and allowed to flower. We must write or act or research or explore or teach or create art or just be ourselves as an end in itself. This obsession puts us above the rules and justifies any risk or action. I’ve never met a successful poker player or trader who didn’t believe he or she was better than everyone else. Some make it obvious, but for most it is a quiet article of unexamined faith. If you have it, it’s impossible to settle for what everyone else gets, however comfortable that is in absolute terms.

To me, that’s the real American Dream. For most of history, there wasn’t a big middle class. There were rich and poor, life was risky for both, and everyone gambled. The growth of the middle class began in seventeenth-century Holland. Europeans who achieved middle-class security generally stopped gambling and soon afterward tried to get everyone else to stop. But in the United States, the middle class grew so large by the nineteenth century that a sizeable population began to try to escape it. Europeans were shocked to see the western frontier populated not only by drifters and refugees, but also by prosperous eastern farmers who wanted more land, who risked ruin and death for the chance to get rich. Other successful people moved west to escape conformity—social, religious, or otherwise. Traditionally in world history, mines were worked by slaves or oppressed peasants. In the United States, college graduates, clerks, and men with property flocked to mining camps all over North America (to dig and play poker). Even more surprising, these same kinds of people often volunteered to serve as foot soldiers in wars (to fight and play poker). All of them threw away middle-class security to bet their lives and fortunes for wealth or freedom, and many of them found both. This unprecedented combination of opportunity and anarchy produced both poker and modern finance.

That some risks cannot be calculated does not justify ignoring careful strategies or acting on blind hunches. In the last 15 years, the field of risk management in finance has developed sophisticated mathematics to transmute chaotic profits of traders into valuable revenue streams. For the first time, there is a legitimate science of uncalculated risk. The key is not minimizing risk, but managing it. A trading desk with good risk management can take on risks that would blow up an unmanaged desk. The same techniques can be used in poker and other risky endeavors. Poker players who understand risk management principles can play more aggressively in larger-stakes games with smaller bankrolls and have a better chance of succeeding.

RISK RULES

Here are four rules for taking incalculable risks. They apply to poker and trading, to getting married, to hitchhiking to New York to become an actress, and to devoting your life to developing a new theory of physics that everyone thinks is crazy.

1. Do your homework. Think like a middle-class person. Is there a safe way to get the same result? Can any of the risks be calculated? You don’t stop figuring just because there’s one aspect about which there is no useful information. Can you learn anything from people who have tried this before? Caution follows from my respect for risk. You must avoid unnecessary risks and, just as important, avoid taking risks blindly when they can be calculated. In traders’ terms, you must take risk only when you’re getting paid enough for it. In poker terms, you must extract all the value you can as a cardplayer before you start relying on your poker skills.

2. Strike for success. As Dickson Watts wrote in his nineteenth-century classic Speculation as a Fine Art, risk taking requires “Prudence and Courage; Prudence in contemplation, Courage in execution.” If you do decide to act, act quickly and decisively. Go for maximum success, not minimum risk. Remember Macbeth’s resolution after he decides to attack Macduff’s castle: “From this moment, the very firstlings of my heart shall be the firstlings of my hand.” If you want to learn to ride a bicycle, you have to get on and pedal. You might crash, but you might learn how to ride. If the risk is too great, don’t get on the bike. Going slow guarantees both not learning and taking a fall.

3. Make the tough fold. A popular method for losing at poker is to become “pot committed.” After deciding to put a large bet in the pot, a player refuses to give up, even when subsequent events make it wiser to fold the hand. To be even an average poker player, you must often throw away good cards, regardless of how much you have bet on them, even when there is a good chance that you could have won the pot if you kept betting. And you must learn to fold as early in the hand as possible. Traders know well: “Your first loss is your least loss.” As you attack incalculable risks, you learn things that help you calculate. If the result of that calculation suggests that you are not getting sufficient odds to justify further investment, give up just as quickly and decisively as you began. By the way, being willing to fold too soon rather than too late is one reason poker players sometimes make bad leaders. There are situations in which the leader should strive until all hope is gone, even dying on the battlefield or going down with the ship. That can be good for the cause, but it’s bad poker and deadly sin for traders.

It should be obvious that application of rules 2 and 3, even moderated by 1, will leave you in a lot of tight spots. Rule 2 tells you not to hold anything back as you strive for success, and 3 tells you to give up often. If you keep anything in reserve, if you bet only what you can afford to lose, if you insist on a good plan of retreat, you should stick to risks you can calculate. But if you do choose to embrace incalculable risks, there is a safety net of sorts:

4. Plan B is You. The only assets you can count on after a loss are the ones inside You: your character, your talents, and your will. You don’t have to relish the idea of being friendless and broke in a strange place, but the thought of it cannot fill you with despair. It’s not quite this bleak: There are some social structures and economic institutions that can often soften your landing a little. You can form networks among like-minded adventurers or join an organization that truly supports risk taking. But the networks are not always reliable, and the organizations are rare and selective. However big the loss, the true gambler will survive. As the saying goes, no one commits suicide at the racetrack. They might miss the next race.

Let me emphasize that these four rules are not a recipe for success. I don’t have one of those. At best, if you master all four of these points, you are not certain to fail. If your goals are modest and you have adequate resources, you are likely to succeed. I can’t quantify that, of course, because we’re talking about incalculable risks, by definition. If your goals are wildly ambitious relative to your resources, you’re likely to fail. But you might succeed. If having a real chance of succeeding—and a real chance of failing—is more attractive to you than what life offers in low-risk and calculable options, this book can guide you along the treacherous path you’ve chosen.

FINANCE AND GAMBLING

Finance can only be understood as a gambling game, and gambling games can only be understood as a form of finance. Many people have no trouble accepting the first part: They believe Wall Street is a big casino. When New York introduced offtrack betting (OTB) in 1971, it chose the slogan “If you’re in the stock market, you might find this a better bet.” Bernard Lasker, the chairman of the New York Stock Exchange at that time, sent a telegram protesting the comparison of horse race betting to stocks. New York City OTB president Howard Samuels replied, “I am sure that some of the 48,972 horses that raced in this country in 1970 feel they are a better investment than some of the dogs on the New York Stock Exchange.” He may have been right: That month, April 1971, the Dow Jones Industrial Average closed at 941.75. That was the peak value in inflation-adjusted terms for the next 21 years. But even people who side with Lasker admit that many market participants are gambling.

However, I mean something different from the superficial comparison that you can make or lose money in Las Vegas or on the New York Stock Exchange. I mean that financial products have additional risk embedded in them, the same negative-sum, pure-random risk that underlies roulette and craps. It’s true that a long-term buy-and-hold investor of a diversified portfolio of stocks is taking real economic risk, but that’s a tiny fraction of what goes on in the stock market. No one gets paid a lot of money to sit around worrying about what the average return on equity will be over the next 20 years; no one screams and shouts about it. People do get paid a lot of money, and scream and shout, to trade one stock versus another or buy a stock and sell it five seconds later. The average investor in the stock market gets the average return; everything else is just gambling. Anything you win comes from someone else who loses, all relative to the average return. The bets are negative sum because there are taxes and transaction costs from the exchanges, just like the house edge in a casino. And at least in the stock market there is some underlying economic risk; it’s not all one person winning from another. All other markets except commodity markets are zero sum. Every loan or bond has a borrower and a lender; every foreign currency transaction has a buyer and a seller; every derivative contract has one party paying another. For anyone actually working in the markets, all the excitement and opportunity come from these kinds of bets.

Economists sometimes argue that these transactions contribute to capital allocation and provide important price discovery. But most capital allocation takes place outside the trading markets and, anyway, is far too indirect to justify the amount of trading that takes place. While there’s no doubt that the price discovery function is useful, no corporate manager needs to know a different stock price every second or the prices of dozens of different securities that all add up to one economically unitary firm. There are far more important social questions whose answers can be provided with amazing accuracy by auction markets, yet these remain a hobby of academics rather than a major economic institution.

I think that risk is added to financial products for four reasons, in increasing order of importance:

1. Risk makes products more attractive to investors. People like to gamble, so financial institutions add risk the way a fast-food company sneaks extra fat, sugar, and salt into its offerings. This is the first reason that occurs to most people, and it’s true, but it’s the least of the reasons.

2. Risk is essential for capital formation. People have to be persuaded to take assets that could be used for consumption and think of them as sources of future income. You need risk for this the way you need heat for cooking.

3. Risk creates winners and losers, and a dynamic economy needs both. Everyone is born with a lot of options in life, and volatility increases the value of options. The concentrated capital of winners is a force for change, and losses have freed many a loser to exploit the value of options a comfortable person would ignore.

4. Risk attracts traders. Traders are not passive order takers, but a hugely important dynamic force in the economy. There is a reason the successful ones make so much money. Without enough risk, the right kind of people don’t show up.

The reason I think these things are true is that they explain lots of details about how financial markets are organized that conventional accounts do not. They explain what things are traded and how markets are organized. They explain the level of volatility, the margin requirements, and the profit distribution among traders.

I hope I don’t come across as a crank with a theory of economics that no one has thought of before. There are many different ways to view financial markets, and each of them can have some truth. I don’t claim that every other explanation of financial institutions is wrong; I claim only that it can be enlightening to traders and gamblers to consider their institutions from the other’s perspective. Even if the analogy is not exact, it is illuminating and can serve as an antidote to the narrow thinking and blindness that can lead to disaster.

Modern finance is not an ancient or natural economic system, nor is it only what can be bottled in the form of financial models and analysis. It was developed in the area drained by the Mississippi River between the time steamships opened the vast natural resources for exploitation in the early 1800s and the completion of railroad networks in the last decades of that century. It combined the economic insights of John Law, a Scottish gambler turned French banker, with an extraordinary economic system based on dynamic self-organizing networks used by the Native Americans in the region, catalyzed by some innovations imported with natives of the Congo River and Niger River economies. The first person to publish an explanation in mathematical terms was the finance professor and banker Fischer Black.

A river network with dispersed population and difficult overland transportation induces a far more flexible and dynami...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Foreword
• Preface
• Chapter 1: The Art of Uncalculated Risk
• Chapter 2: Poker Basics
• Chapter 3: Finance Basics
• Chapter 4: A Brief History of Risk Denial
• Chapter 5: Pokernomics
• Chapter 6: Son of a Soft Money Bank
• Chapter 7: The Once-Bold Mates of Morgan
• Chapter 8: The Games People Play
• Chapter 9: Who Got Game
• Chapter 10: Utility Belt
• Annotated Bibliography
• Index