How Portfolio Management is Like Poker
Annie Duke is an author, a former world poker champion, a business consultant and an expert on the behavioral pathways of decision-making. Her book, Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts is a favorite of mine (and is now in paperback), because it provides a clear line of sight toward ditching our biases and prior beliefs so we may better understand the world. The job of an economist and investment manager is to communicate a clear, coherent view of economic trajectories, and Duke’s approach to decision-making is directly applicable to that pursuit, as well as to portfolio construction itself.
I was thrilled to have the opportunity to speak with her recently. Below is an edited version of our conversation.
GJ: You know a lot of investment managers are fans of your work.
AD: I do, yeah. I seem to have resonated with them and have developed great friendships with a lot of them. When I first sat down to talk to my editor, she said, “What’s your opinion of the way this book propagates?” And I said, “Oh it’s going to get picked up. It’s going to be adopted by the finance community and then propagate out from there.”
What I didn’t foresee was that the book was going to bring both professional and personal success—my life is richer for it.
That’s wonderful, and it’s also a great example of an unknown outcome. It’s part of your thesis of understanding that we don’t have perfect information.
That’s exactly right.
You write something about poker players that I think is true of asset managers: “They embrace that uncertainty and, instead of focusing on being sure, they try to figure out how unsure they are, making their best guess at the chances that different outcomes will occur. The accuracy of those guesses will depend on how much information they have and how experienced they are at making such guesses.” A lot of asset managers don’t want to tell you there’s guessing involved, but I’ve never heard a more succinct description of our profession.
I’ve actually been thinking about that as I’m writing my new book. We know, objectively speaking, that there is an exact probability of a particular outcome, but because we don’t have perfect information, that exact probability is hidden from us. Because we are really dichotomous thinkers at our core, we know that we can’t get the exact number—but we know if we have perfect information there’s a right answer. And then we think that everything else must be wrong—that guesses are inherently wrong because they are the opposite of having perfect information and the right answer.
Or, if we’re guessing, our guess must not be disciplined or have methodology. But of course, there is. Most investment methodologies exist to manage the fact of incomplete information.
Right, exactly. We do have a way to talk about guessing that allows us to get out of that trap of dichotomous thinking, which is making an “educated guess.” And what do we mean by educated guess? We mean that we’re bringing to bear the information that we have, imperfect as it might be, on our explanation of what we think that probability is.
So how do you communicate to people that by “guesses” you mean “statements of probability?”
There’s really nothing that you can guess at that you know nothing about. I could ask you: “What’s the size of the universe?” That’s not known to man, but you’re not going to guess zero.
Right. We know something, and in some cases we know a lot.
There’s going to be some sort of range. If I said to you, “Imagine a cat—how much does the cat weigh?”, I know you’re not going to guess 100 pounds or more. I want to get people to understand that all guesses are educated guesses.
A “guess” is my best assessment of probabilities.
Once you change your mindset about that, you start to focus on the “educated” part. You realize that you have to become more educated—what do you know, and what would you like to know that’s relevant to this guess? You become laser-focused on vacuuming up knowledge and trying to extract what other people know, what the world knows. Becoming better educated is your job, and it focuses you on the right part of the problem.
The investment manager Sharon French has said that “tradition is not a strategy.” And yet, most everyone in my business practices the inherited wisdom. Like, “Oh you know what, just buy the S&P 500. That’s what everyone does.” Okay, but that assumes that markets are efficient and they always work perfectly all the time. And it involves not caring what an individual company actually even does. Right?
Can I give you a little bit of a different perspective on that? People don’t think necessarily deeply enough about competing incentives. We view the world through our own frame. Let me offer how tradition can be a strategy: Say you have a status quo decision or an innovative decision, and there isn’t a consensus around it. Call it a consensus or non-consensus decision, and then we can think about outcome quality, good and bad. If you have a good outcome from a consensus decision, people are like, “Good job!” If you have a bad outcome from a consensus decision, people are like, “What could you do?” If you have a good outcome from a non-consensus decision, it’s genius. And if you have a bad outcome from a non-consensus decision, you’re fired.
You’re a wingnut.
You’re an idiot. You’re whatever. So now think about how we have misaligned incentives, particularly when you start to think about the way that individuals process losses compared to gains. Being the idiot is much more painful than being a genius is a reward. We’re going to avoid that outcome. And if we are going to have a bad outcome, we would like to be protected by luck.
Given what you write about chess, do you ever play? Or is chess just too imperfect as a decision-making model?
It’s very imperfect as a decision-making model for most of the decisions we make, but that doesn’t mean that it’s not complex. A lot of what makes problems enjoyable is their complexity. I don’t enjoy tic-tac-toe, which at its core has a lot of the same characteristics as chess, but chess is incredibly complex. I happen to be quite poor at it. But I can imagine, because it’s so complex, it will reveal itself to you more as you play it. As I become better, there’s objectively less for me to know, but my view of what there is to know changes. Luck or no luck, information or no information, chess has the right amount of complexity to make it an incredibly interesting activity.