Pocket Aces is the best starting hand in Texas Holdem Poker. Against any other starting-hand combination, Pocket Aces will win approximately 80% of the time.
When facing just one other player, that gives Pocket Aces an expected return of 60%. This expected rate of return includes the times when Pocket Aces loses.
In poker, a profitable bet arises in any situation where your expected return is above 0%. Stock-picking is similar to poker. As stock pickers, we make calculated bets based on the expected rate of return. If the expected rate of return meets our target or exceeds other opportunities, then investing in the stock makes good investment sense.
Expected return for stocks
Like poker, when calculating the expected rate of return for stocks, we should consider all the potential paths a stock can take. In poker there are only two possibilities – you either win or lose. But stock picking is a little more complicated than that. There are numerous potential outcomes that we need to consider when estimating a stock’s expected rate of return.
Stock returns can range widely from -100% (a total loss) to +X,000% (thousands of percent) or more. The expected return for stocks should include an aggregation of all these possible outcomes.
Difference between expected and potential return
The expected rate of return should not be confused with the potential rate of return. The potential rate of return is the upside of investing and does not take into account the other possibilities.
For instance, in poker, when playing Pocket Aces, the potential return is 100% over a single hand played. But the expected return over many hands is 60%.
On the flip side, if you are holding a random starting hand against Pocket Aces, your potential return is still 100% as you still have a 20% chance to win the hand. But the expected rate of return is negative 60%.
Investing in stocks is just like poker. Many stocks may have high potential returns if the company’s management executes perfectly but the actual expected returns may be much lower or even negative as the probability that management executes so perfectly is low.
When investing we are looking for stocks that are just like “Pocket Aces”. These are companies that have high expected returns and not just high potential returns.
Variance and diversification
Another element of poker that transfers well to stock picking is the concept of variance.
If we play just one hand of poker, we are expected to lose with Pocket Aces 20% of the time. In the unfortunate case that Pocket Aces loses over a single hand, our actual returns for that game would be substantially lower than our expected rate of return.
Over two hands, we will break even 32% of the time, lose twice 4% of the time and win twice 64% of the time. In this case, we would now be below our expected return 36% of the time. Poker professionals call this phenomenon variance, which is why small-sample results usually mean nothing for poker players.
However, if we make numerous such bets on Pocket Aces, our rate of return will eventually converge toward 60%.
This is the same when investing in stocks. While we may have put our money in a stock that has a high expected return, the actual outcome may deviate substantially from the expected return.
Final Thoughts
I’ve been fascinated by the game of poker for many years. It is a game of calculation, game theory and exploitation of opponents’ mistakes.
Many elements of poker can also be transferred to investing such as position sizing, return calculations and even portfolio management.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.
