Investing Game Theory

Whether you’re playing poker or jockeying for position on the corporate ladder or investing in the stock market, the fact is that winning is all about understanding the odds. Game theory can help you improve your odds of winning.

The poker game analogy will be useful as we work our way through the mechanics of using game theory in investing. We chose this because the game of poker has some important similarities to investing. For example, you are competing against other investors who may be more skilled than you are, may have more money than you have, or may have better information than you do.

The goal of championship poker, as is in investing, is to avoid getting wiped out while you wait for that Monster Hand with that Monster Pot that will propel you to the final table at the World Series of Poker. Some of the topics we will discuss here include:

• Rules of the game
• The players
• Correct strategy
• When to cash out

Rules of the Game

In the end, investing is a Zero Sum Game. For every winner, there must be a loser. That’s because every time you buy a stock, there is someone else on the opposite side of your trade. When you buy a stock, you are making a bet that the price will go up. But the person who is taking the other side of your trade – the seller – is betting that you are wrong. You can’t both be right. One of you is going to win, and one of you is going to lose.

Before you buy a stock, you should ask yourself “why is someone willing to sell this stock at this price?” If the person who is taking the other side of your trade has done their homework more thoroughly than you, they may know something that you don’t. As part of our coaching, we’ll teach you how to make a checklist of the questions you should ask yourself before you pull the trigger on any trade. This is part of the discipline that you will have to have, if you want to compete successfully in the game of investing.

There are no do-overs. When you make a mistake and lose money, you can never get it back. This is because of the existence of the Game Clock. You only have a finite amount of time to accumulate your winnings, and once your time is up (you need to start spending your winnings in retirement), your time is up. For this reason, it’s critical that you learn to minimize your mistakes, and learn from them so you won’t repeat them.

There is no such thing as a stock-picking Guru. Many investors mistakenly believe that there are highly skilled professionals out there who know how to pick winning stocks consistently. They figure it’s just a matter of time before they find their personal Guru. This is not correct. Stock market Gurus are regular people who are usually smart, hard-working, and extremely lucky. They achieved the status of Guru because they had a serial run of luck with their picks, and eventually their luck will run out. This always happens. Always. So you need to ask yourself, when is this particular Guru’s lucky streak going to end? Will I be the last guy to follow his advice just before he crashes and burns? Beware of the investment Guru, because he doesn’t exist. It’s better to learn how to pick your own stocks, so you don’t have to rely on someone else for your success.

Don’t put all your eggs in the same basket. The most common mistake investors make is putting too much of their money into stocks when the market is going up, and then yanking it all out after the market has gone down. Successful investors have learned that they should always have a balance between stocks, bonds, and cash. That way they don’t have to panic and sell their stocks when the market takes a tumble.

The Players

Would you walk into the poker room in a Las Vegas casino and play against professional card sharks? Would you step onto a football field and play against a professional team? The answer is yes, but only if you have the right skills, ability, and training. It’s the same when it comes to investing. You are competing against the best minds and the biggest bankrolls in the world, and unless you know exactly what you’re doing, you will probably get eaten alive.

One way we can divide the players is between the “smart money” and the “dumb money.” This has very little to do with intelligence or education. It has a lot to do with preparation and experience. The smart money is the class of investors who are well informed, usually have lots of capital behind them, and are well connected to the best sources of information. The dumb money are the folks who are flying by the seat of their pants, hoping that the stock tip they got from their broker, the newsletter they subscribe to, or the guy at the water cooler, will pan out. The dumb money is what’s called a “low-information” investor. We’ll teach you how to avoid being the dumb money.

Correct Strategy

There is a right way and a wrong way to invest. The correct strategy starts with a well-written investment plan, and a discipline to carry it out. Every time you buy or sell a stock, it should be done within the context of your plan. For example, you may have decided to put 60% of your money into stocks. Let’s say that one of the stocks you own announces bad news, and you decide to sell it. The correct strategy would be to not only sell your stock, but to immediately replace it with another stock that you’ve been keeping an eye on. That way you will maintain the same 60% allocation to stocks. There are many other examples of correct strategy, and we’ll teach you all of them.

When To Cash Out

Of all the possible mistakes that investors make, I think the most common, and the most costly, is cashing out too soon. Most inexperienced investors hang on to their losing stocks for far too long, and then they sell when they just can’t stand the pain any longer. At that point, the price of the stock is usually near the bottom. Then, to compound the problem, they wait until the stock has rebounded in price, and by the time they get over the pain of their loss, the price of the stock is near the top of the range. This is commonly called the ” buy high, sell low” strategy, and it’s undoubtedly the biggest reason that most investors never achieve their true potential. We’ll teach you how to know when it’s the right time to cash out, and it won’t be based on emotion. We base our buy and sell decisions on predetermined rules, so that these decisions are based on reason rather than fear and panic.

In game theory, you assess the conditions that influence the odds of winning, including how much you can afford to lose in a worst-case scenario, and your own level of risk aversion. Some people are able to take bigger risks, but you have to play it smart.

Viewing it as a game can help make investing less stressful and open up new strategies for you. But always remember that it’s a game with real consequences. You’re not playing with Monopoly money – you’re putting your life savings at risk. Investing is a serious game.

If you want to learn how to play the game at the same level of competitiveness as the professionals, become a Premium member of ZenInvestor and start your training today.