THE FUNDAMENTAL THEOREM OF INVESTING

Those of you who have been reading my stuff for a long time know that I am a big fan of poker theory. I enjoy reading blog posts into poker theory by the top pros into the game. Their thinking into approaching risk and properly assessing countless situations involving imperfect information is the most valuable contribution an investor or trader can make to their repertoire.

Forget all of the useless blog posts that 99% of the "popular" bloggers or pundits are putting out currently. They are largely built on feeding popular perceptions in order to retain readership: Bill Ackman is bad, I will write a blog post about Bill Ackman being bad; Facebook is a terrible investment, I will write a post about Facebook being terrible; Facebook is a good investment, I will write a blog post about how great Facebook has become; Tesla is a great company, I will write about how great Tesla has become even though I never mentioned it while it was sitting at 30.

Popular perceptions won't give you an edge, they only take you one step closer to being a pasture animal waiting for the abattoir (credit Miles in one of my favorite movies: Sideways).

However, looking into the mind of a professional who is faced with literally hundreds of decisions daily involving: Calculating odds, mathematical expectations, deception, game theory, inducing, analysis of opponents, changing pace and texture of play....that is valuable. That can be a game changer for any trader or investor. Grasping onto these methods naturally, making them into a consistent part of your overall investment game will take any trader or investor from good to great.

The Theory Of Poker by David Sklansky is a great place to start. In the book Sklansky introduces the fundamental theorem of poker. Wikipedia describes it as follows:

The fundamental theorem of poker is a principle first articulated by David Sklansky that he believes expresses the essential nature of poker as a game of decision-making in the face of incomplete information.

Every time you play a hand differently from the way you would have played it if you could see all your opponents' cards, they gain; and every time you play your hand the same way you would have played it if you could see all their cards, they lose. Conversely, every time opponents play their hands differently from the way they would have if they could see all your cards, you gain; and every time they play their hands the same way they would have played if they could see all your cards, you lose.

The fundamental theorem is stated in common language, but its formulation is based on mathematical reasoning. Each decision that is made in poker can be analyzed in terms of the expected value of the payoff of a decision. The correct decision to make in a given situation is the decision that has the largest expected value. If you could see all your opponents' cards, you would always be able to calculate the correct decision with mathematical certainty. (This is certainly true heads-up, but isnot always true in multi-way pots.) The less you deviate from these correct decisions, the better your expected long-term results. This is the mathematical expression of the Fundamental Theorem.

As applied to the financial markets the fundamental theorem of investing is as follows: Every time you allow the market to persuade you into a decision that is in conflict with your strategy, your opponent (the market) gains. Every time you make a decision that is in accordance with your strategy, your opponent (the market) loses. This is irrespective of the short-term RESULT of the decision. Your focus is on THE DECISION, with expectation that your system of investing is robust to the point of being effective over the long-term.

My decision to begin reducing exposure this past week - with the target of moving to a 75% net long exposure from 100% net long - is precisely in line with my strategy at this point in time. If the market turns around on Monday, gaining 400 points on the Dow, it makes absolutely no difference. My decision has a long-term positive EV. The sole focus should always be on the quality of the decision and not the result.

Again, this comes with the qualifier that your system or methodology of investment is robust enough to withstand the test of time. If you are throwing darts, you have no edge. Therefore, EV becomes a coin-flip. The edge needs to be there. And it is up to you, as an investor or trader, to develop that edge through experience.


Author: admin

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