Behavioral FinanceMost Recent Stories

Playing the Optimal Game Requires an Optimal Understanding

I used to gamble quite a bit.  Not because I enjoyed losing money, but mainly because I was convinced that I understood the games better than most.  I don’t know if that was true (probably not), but my urge to play was not really the result of an addiction or the fact that you get free drinks at most tables.  No, I simply thought I was good at it.  And the main reason I thought I was good at certain games was because I had done an excruciating amount of homework on those games.

It’s amazing how many people will sit down at a blackjack table or a poker game in a drunken stupor or without knowing anything and assume that they might win.  While gambling involves games of chance, there are also optimal (negative sum) outcomes given that you actually understand how to achieve those optimal outcomes.  The thing is, the house already has the edge before you even sit down and your lack of understanding only increases that edge that much more.  The only thing that can get you even remotely close to having an edge is a perfect understanding of the probabilities in certain situations.  And the only way to know that is to know the game perfectly.  What many people don’t seem to understand about gambling is that it’s not about how much you can win, but how much you can avoid losing at the right times.

Regular readers have probably noticed that I have a voracious appetite for understanding things as they are and not as I want them to be.  This is why I shun politics and find behavioral finance to be so important.  But it’s bigger than that.  I know that investing is really a game of probabilities.  In the aggregate we all earn the return of the global financial asset portfolio minus costs and other frictions.  But the person with the best understanding of the financial world will not only reduce those frictions, but will also increase the odds of achieving an optimal asset allocation.  Not to mention, that person will avoid the colossal mistakes that ruin so many portfolios.  In the investment world doing well isn’t so much about what you know, but what you know you don’t know.

Gambling and investing aren’t perfect corollaries.  But they’re similar in more ways than we often think.  And while it’s certainly true that no one can predict what cards will fall next or what the markets might do on any given month I am a firm believer that a superior understanding leads to superior long-term results.