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December 08, 2020

Here is a chance to really impress your friends and family with a little-used Latin phrase which roughly means: -Appearances are deceptive. You may wonder how I found this term; I came across it while looking for some stocking stuffers at this very cool website: This site not only helped me with my shopping needs but also got me thinking about their motto, the title of this blog. Theory 11's main products are cards and magic tricks.

These characteristics were central to a court ruling on gambling online. In this case, a judge noted that there are four basic types of games one could play online. I want to take a moment to go through his logic and then connect the ruling to the world of investing.

The first category of games can be described as games of chance, where the participants have no ability to influence the outcome. The appeal of these lottery-style games is odd to me, since you can actually look up the expected outcomes for participating and see that they are universally negative expectations, but people still love to play them nonetheless. This enthusiasm is due to the literally "one in a million" shot of winning the big one. In the case of Illinois' Lotto, the chance of winning the jackpot is actually 1:20,358,520…but after one-in-a-million, who is actually counting?

The judge's second category are games based mostly on luck, but some modicum of skill influences the result. An example of this category is blackjack. In blackjack, we are dealing with a known number of cards and attempting to get closer to 21 than the dealer without going over. The dealer is constrained by a set of rules telling them when they must or must not "hit," or take another card. In addition, the "player" also gets to see one of the dealer's first two cards. The odds for any visible situation in this game can actually be calculated and the "correct" play ("hit" or "stay") can be established. In fact, most casinos allow you to reference a strategy chart like the one below.

Fritz Report

However, even if you followed the chart exactly, you would still have a slightly negative expected outcome. Depending on the exact house rules (e.g., the number of decks) the house "edge" can get as low as 0.5%. Luckily for the casinos, they know that most people tend to play with their hearts and not always their heads (plus, of course, there are occasionally cocktails involved). Most estimates are that over the course of time, against a fairly good player, the casino will still have somewhere between a 2-4% edge over the player. So, you can see that while there is skill involved, at the end of the day - to win - you will also need some luck.

The third category contains the games where there is more skill at play than luck. This was the most important category for the judge's actual, real-world ruling. The case before the court was a "home" game of poker. This game was organized by an enterprising homeowner and included professional dealers, but did not have an official "rake" whereby the players had to pay for every hand. Rather, the players were expected to tip the dealers, the homeowner, and yes, the cocktail waitress. The homeowner, Mr. Dent, was charged with running an unlicensed gambling establishment. His lawyer argued that, in fact, poker is not gambling.

In his ruling on Commonwealth v. Dent, Judge Thomas James observed that:

"There are over 600 books on the subject of poker strategy and they all agree that poker is a game of skill. He quoted Mike Caro's book Secrets of Winning Poker: "money flows from the bad players to the good players." He also cited "a number of mathematical studies that link 'poker and economics.'" One study in particular showed that "Beginning poker players rely on big hands and lucky draws. Expert poker players use their skill to minimize their losses on their bad hands and maximize their profits on their big hands."

My experience agrees with the judge, because I am not a skilled player, and therefore I usually lose! However, in order to make sure that home-based poker games would not be allowed to go untaxed, the state of Pennsylvania overturned the ruling.

We can have this debate sometime in the future, but I think we can all agree that ultimately, really skilled poker players will usually win (especially if they have deep pockets!). This "skill" is where the title to this blog really comes from. The really great players have the ability to make use of deceptive appearances on both good and bad hands. As the judge noted in his ruling:

"Poker is the one and only [card] game where a skilled player may hold bad cards for hours and still win the money."

The fourth and final category were games where skill dominated any luck factor in determining the result. This category included chess and bridge, where highly skilled players should always beat novices. You have probably heard about the amazing ability of chess grandmasters beating a whole room of good to very good players. This young man (Rameshbabu Praggnanandhaa) was able to beat all 20 of his opponents at once!

Side note: Rameshbabu is also the world record holder for becoming the second youngest chess Grandmaster ever, at the ripe old age of 12 years, 10 months and 14 days, barely falling "short" of Sergey Karjakin (12 years, 7 months). For more info - check out this article.

Ok, so that's all interesting info and the judge's ruling is definitely insightful, but what does it have to do with investing? I have used this analogy for years, because it applies almost perfectly, but before I discuss applications, take a look at this graphic and tell me where YOU fall on the continuum between luck and skill as an investor.

Be honest with yourself.

Now for the more important question: Where should you be? Is investing like chess? Is there actually the potential to be a pure "skill" player, or will there always be some element of luck? Are there market participants who are operating on the "pure luck" end of the spectrum, basically just throwing up their hands in frustration and saying, "Sometimes you win, and sometimes you lose?"

Your answer may depend on which markets you participate in. For example, I think there may be a fair number of people who feel that they got lucky buying TSLA, AMZN, APPL, GOOG, etc. When dealing with stocks, there are extreme unknowns: earnings, PE ratio and market momentum, to name just a few. These are not really knowable so assuming these investors rely on a healthy dose of luck is probably fair. But probably not just a lottery play, either. Category Two, perhaps?

But let's think about fixed income for a minute. In fixed income, we have a much more constrained fact set. As I discussed last week, there are still unknowns - for example, the prepayment speeds affecting MBS - but there are many more "knowns." Category Three, at least? There are rational assumptions that can be made to represent different reasonable scenarios and over time which can help us become a much more skilled "player". The great news about fixed income is that you can practice to learn and improve your skills. You may never become as good as Rameshbabu is at playing chess (maybe only because chess is Category Four, right?), but you can certainly avoid playing the "game" as though it were just a lottery.

Over the next couple weeks, I plan on covering some of these "skill" topics in a little more depth. Consider it my Christmas present to you! And yes, it might feel worse than a lump of coal, but in practicality, I hope it is at least like a pair of socks - maybe not so much fun, but of actual value in your life!

Final, final thought: It is hard to beat, or resist, a well-made Christmas cookie. Especially if it's shaped and decorated into something Christmas-y. Curiously, I always reach for the green-sugared "bell."