Although the word "gambler" is often accompanied by other, more disparaging words, such as "irresponsible," I believe that Las Vegas teaches valuable money management lessons. While watching a televised World Series of Poker event run by Harrah's (NYSE:HET), I spotted value-investing wunderkind David Einhorn of Greenlight Capital, a hedge fund manager who allegedly returned 26% annually over the past five years. Einhorn made it all the way to the final table and ended up donating his entire $659,730 in winnings to charity.
I don't think it's a secret that gambling and investing are kissing cousins -- both involve calculating risk/reward equations. Warren Buffett and fellow billionaire Bill Gates are obsessive bridge players, and one of Warren's boyhood business ventures was selling horse-race tip sheets. Also, Pimco's Bill Gross, widely acknowledged as the world's greatest bond mutual fund manager, started his career as a professional blackjack card counter in Las Vegas -- an experience he believes contributed greatly to his success.
Julius Caesar once said that experience is the teacher of all things. Watching a casino dealer take away your remaining chips is a gut-wrenching, visceral experience that teaches swift and tangible lessons.
Every time I walk though a casino, I see gamblers make simple mistakes that violate fundamental probability and money management principles. I believe the two of the biggest mistakes in money management are overly diversifying and over-betting.
The overly diversified gambler
Have you ever walked by a roulette table and seen a gambler spreading his chips over virtually the entire table? Although this gambler has a high frequency of winning, he also has a low payoff because his losses offset his winnings.
This gambler's problem is his need to win frequently. He loves the fact that he regularly experiences wins, but he ignores the probabilities and payoffs. Have you ever had a conversation with an investor who bragged about how one of his stocks shot through the roof, only to later learn that stock was less than 1% of his portfolio?
Spreading your bets only makes sense if each bet has favorable odds. On the other hand, if you're betting at unfavorable odds, spreading your bets guarantees your loss. Because a roulette table's payoff is less than the probability of winning, every time you put a chip on a roulette table, you are paying a "transaction cost" by giving the casino a slightly favorable edge. Suppose I offer you even money on a coin flip, but I charge you a 1% commission. If you bet on both heads and tails, you'll win one bet and lose the other, which returns your money minus the 1% commission. Thus, diversification in unfavorable situations slowly destroys your capital through transaction costs. An investor who owns too many stocks and trades too much virtually guarantees underperformance by paying too much in short-term capital gains taxes and brokerage commissions, and often puts too many bets down when the odds are not in his favor. If you want diversification, you can buy Spiders (AMEX:SPY), Cubes (NASDAQ:QQQQ), or Diamonds (AMEX:DIA), which track the S&P 500, the Nasdaq index, and the Dow Jones index without paying the high brokerage commissions.
The double-downer, aka the over-bettor
Sometimes I'm sitting at the blackjack table and I notice that a gambler is following a double-down betting scheme, where they start with a small bet and double down after every loss in order to recoup their initial investment. The scheme goes something like this. First, bet a small amount, let's say $10. If you lose, double down and bet $20. If you win, then you recoup your initial $10 loss and have a $10 profit on top of that. If you lose again, double down again and bet $40. If you win, then you recoup your $30 loss ($10 on the first hand, $20 on the second), and end up with a $10 profit, or your original bet. In other words, after every loss, double down, and after every win, pocket your profit and start the whole process over again with a $10 bet.
Theoretically, you can't lose under this betting scheme as long as you have the capital to double down. In the real world, you're guaranteed to lose in the long run, because the casino has more money than you. The problem is that the double-down scheme eventually makes you take huge bets that could wipe you out. The history books are riddled with brilliant traders and investors who went bust because they bet too big - some examples are Long-Term Capital Management, Victor Niederhoffer, and recently, Amaranth Advisors.
The key question is: What is the longest string of losses one can expect to encounter at a blackjack table? Let's assume that the odds of winning a blackjack game are 50%. Thus, the probability of 10 losses in a row is 0.5 raised to the tenth power, or 1/1,024. Theoretically, if you play a thousand hands (or 1,024, to be exact) -- which is possible over the course of a weekend in Vegas -- it's likely that at one point you will lose 10 hands in a row.
So let's say you employ a double-down scheme and start with a $10 bet. If you play 1,000 hands, it's likely that at one point you will lose 10 times in a row, and if you double down 10 times in a row, starting with $10, and lose each time, you just lost $10,230. However, because casinos have a table limit, you wouldn't be able to double down after the eighth or ninth hand, meaning your betting scheme failed you. Also, what would more likely happen is that after a string of six or seven losses, which would mean losing $630 or $1,270, you probably would've gotten cold feet and stopped gambling, preferring to eat a huge loss rather than put any more bets down.
The winning gambler
Lastly, there are the people who always seem to leave the casino with pockets bulging full of chips. Winning gamblers, like overly diversified gamblers, spread out their bets to negate the risk of permanent loss of capital, and like over-bettors, they bet big when the odds are in their favor. Unlike overly diversified gamblers, winning gamblers bet selectively and infrequently, and unlike over-bettors, they never risk it all.
In my studies, whenever I hear successful investors talk about money management -- whether it's the great short-term traders profiled in Jack Schwager's Market Wizards, George Soros, Warren Buffett, or poker champion Phil Hellmuth -- the message is always the same: Wait until the odds are in your favor and then go for the jugular, but never risk it all. I think this is a lesson that can be applied to almost any wager, whether its waiting patiently for a stock to drop to an extremely favorable price, or waiting for those pocket aces the next time you're sitting at a poker table at MGM Grand (NYSE:MGM).
To take this a step further, the correct amount to bet would be determined using a formula known as the Kelly method of betting. I plan on following up with an article detailing the simple but powerful Kelly formula (edge divided by odds), and highly advise readers who haven't done so already to read William Poundstone's Fortune's Formula, which explains the evolution of the Kelly formula. Good luck!
For related Foolishness:
You don't have to go all the way to Vegas for excitement -- tomorrow's most surprising blockbuster stocks are available for your perusal today with a 30-day free trial of Motley Fool Rule Breakers. (We cannot guarantee that what happens in Rule Breakers stays in Rule Breakers, but we can guarantee there's no obligation to subscribe.)
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
