Spotting the Sucker
“Listen, here’s the thing. If you can’t spot the sucker in your first half-hour at the table, then you ARE the sucker.” -Mike McDermott
I’ve heard some people say that investing in the stock market is no different than gambling. It is a zero-sum game. For every winner, there is a loser. This misconception is understandable. If you watch the market day-to-day, stock prices are very random. My friend James Sweeney at Switchpoint Financial does a good job of dispelling this myth. He points out that it is important to understand the difference between zero-sum games and how capital markets work.
“Gambling is clearly a zero-sum game. If five friends get together to play poker and each brings $100, only $500 is leaving the table at the end of the night. Someone will inevitably go home with more $100, but each dollar gained by one player is offset by a dollar lost by another. In zero-sum games, there is no creation of wealth, only transfers of wealth between participants.“
“Unlike gambling, markets actually do create wealth. To see why this is true it’s easier to focus on an individual company, rather than this abstract thing we call “the market”. When a company issues stock, they aren’t handing out lottery tickets, they are offering ownership in their company. The investment is used to purchase new buildings or equipment, hire workers, etc. all with the goal of generating profits. As an owner of the company, you are entitled to a portion of those profits.
Of course, there is risk in investing. Individual companies can go bankrupt. During times of economic uncertainty, the entire stock market can fall dramatically. However, unlike gambling, taking risk by investing in markets has rewarded disciplined, long-term investors throughout history, averaging about 12% per year for small company stocks and 10% per year for large company stocks.
The key is to make sure you invest in a way that keeps the odds in your favor.”
Sitting at the Market Poker Table
Investing in the stock market over the long-term is not a zero-sum game. In aggregate, capital markets do create wealth. There are two sides of this coin, though. While investing over the long-term is clearly not zero-sum, actively trading the stock market IS zero-sum. If you group all the passive investors together and all active investors together, in aggregate, they both hold ‘the market.’” Logically, that means their aggregate returns are what the market gives them. This also means that if we group all the active traders together, as a group, their returns are zero-sum. For every winning active trader, there is a losing active trader. Think of active trading as the world’s largest poker game. You don’t have to earn your seat at the final table, though. There’s only one table to sit at, and there are some very good players sitting across from you.
If you’re going to sit down at the market’s poker table, it’s important to know who your opponents are. If you aren’t familiar with Ray Dalio, he is the CEO and founder of the largest hedge fund in the world, Bridgewater Associates. Some say Dalio is the most successful fund manager in history. He’s a legend in investment circles and a brilliant guy. When asked about how an average investor should treat the stock market, he said the following (emphasis my own) :
“The bets are zero-sum, right? In order for you to beat me in the game, it’s like poker – it’s a zero-sum game.
We have 1500 people who work at Bridgewater. We spend hundreds of millions of dollars on research and so on, we’ve been doing this for 37 years, and we don’t know that we’re going to win. In other words, we work that. We have to have diversified bets. We have a lot of diversified bets, and so on.
So, it’s very important for most people to know when not to make a bet, because if you’re going to come to the poker table, you’re going to have to beat me, and you’re going to have to beat those who take money.
So, the nature of investing is that a very small percentage of the people take money, essentially, in that poker game, away from other people who don’t know when prices go up whether that means it’s a good investment or if it’s a more expensive investment.”
Does that sound like somebody you want to bet against? Probably not. But he’d be just one of your opponents. How about Jim Simons? Have you heard of him? He’s a famous mathematician and hedge fund manager who founded Rennaissance Technologies. What is Rennaissance? From Wikipedia…
“Renaissance is a firm run by and for scientists, employing preferably those with non-financial backgrounds for quantitative finance research like mathematicians, statisticians, pure and experimental physicists, astronomers, and computer scientists. About a third of its about 300 or so employees have PhDs. Renaissance engages roughly 150 researchers and computer programmers, half of whom have PhDs in scientific disciplines. Mathematician Isadore Singer referred to Renaissance’s East Setauket office as the best physics and mathematics department in the world.“
How has Rennaissance Technology done? Pretty well actually. From 1994 to mid-2014 its flagship fund, The Medallion Fund, has averaged a 71.8% annual return (before fees).
Here’s a question for you. What is hanging on the wall of your office? Some pictures of your family? Your diploma? Maybe a whiteboard or two? Do you know what is hanging on Jim Simons’s office wall? According to a 2014 New York Times (Seeker, Doer, Giver, Ponderer) story, hanging on Simons’s office wall are some of the equations he wrote with the geometer Shiing-Shen Chern that define many esoteric aspects of physics. It looks like this:
So again, if you want to sit at this poker table, Jim Simons is one of the guys your playing against. Do you want more bad news? Simons loves poker.
Personally, I love reading about guys like Simons and Dalio. They are super smart and have so many great ideas to learn from. But do you know what one of the most important lessons I’ve learned from those guys is?
I’m not them.
I’m not that smart. I can’t hire PhDs or physicists. I can’t afford to pay analysts to spy on oil fields or sit outside every Apple Store in country to better predict sales. I can’t build my office next to a stock exchange or co-locate my servers so I can execute faster trades. I’m not Ray Dalio. I’m not Jim Simons and I’m not Warren Buffet.
One big difference between actively trading in markets and playing poker in a casino is that in a casino, you can pick your game. If you are actively trading in the market, though, you have to sit at the same table as Simons and Dalio. Warren Buffet gets to check raise you and call your bluff. Long ago I admitted to myself that I don’t have the resources or the brains to sit at their poker table and challenge them at their game.
The good news is, that’s ok. We can all be successful investors, but it requires humility. Know your limitations. Know what game you are playing. You don’t have to sit at the high limit pro tables and play head to head. Being honest with yourself is being smart. You’re not as good as those guys and I guarantee they will take your money.
Does that mean you shouldn’t invest in the markets at all? Absolutely not.
Be the Rake
In poker, “the rake” is a fee taken by the dealer, cardroom or casino out of each pot for providing the services necessary for the game to take place. It is the business of poker, not the active game. Look at the rake as passively following the market. No, it’s not an apples to apples comparison. There is risk in the market and over shorter periods, you might not make money whereas in a casino, the rake always pays. But over the long term, markets do pay people for taking that risk. Your edge is your ability to be patient. You don’t have to go all in and you don’t have to sit no-limit, heads up with Dalio.
So know the market and know yourself. Be patient and avoid the temptation to gamble with the big boys. We all have a spot at the table, just don’t be the sucker.
Sources: Ray Dalio’s Poker  How an Exclusive Hedge Fund Turbocharged Its Retirement Plan