The Hindu Business Line : However big the loss, true gamblers will survive

The Poker Face of Wall Street, by Aaron Brown, is all about how to gamble and win. Risky read, you may feel, says D. MURALI, but the author's emphasis is on managing risk, not minimising it.

This was a week when we saw that any pursuit of order on the bourses has been nothing short of a wild goose chase. Is there any difference between `economic risk-taking' and `gambling'? The first is `invested with respectability,' and the other, `treated as a vice and product of a parasitic activity,' as Nassim Nicholas Taleb writes in the foreword to The Poker Face of Wall Street, by Aaron Brown, from Wiley (www.wiley.com).

"It is not that gambling imitates economic life, but that economic life is largely modelled after gambling," explains Taleb. Apt, because the book is about `how to gamble and win,' as Brown begins line 1 of chapter 1, titled `The art of calculated risk'. Poker is `hugely popular with financial professionals,' one learns, because "poker has valuable lessons for winning in the markets," and vice-versa. It is a combination of opportunity and anarchy that produced both poker and modern finance, says Brown.

Risky read, you may feel, but the author's emphasis is on managing risk, not minimising it. "A trading desk with good risk management can take on risks that would blow up an unmanaged desk," he cautions. Quite reassuringly: "In the last 15 years, the field of risk management in finance has developed sophisticated mathematics to transmute the chaotic profits of traders into valuable revenue streams."

Four rules

Brown lays down four rules for taking incalculable risks, which apply both to poker and trading, and also to getting married! First, do your homework. "You must avoid unnecessary risks and, just as important, avoid taking risks blindly when they can be calculated."

Second rule: Strike for success. Risk-taking requires both prudence and courage — `prudence in contemplation, courage in execution' — as advised by Dickson Watts, whose 19th century classic Speculation as a Fine Art is cited in the book. "If you do decide to act, act quickly and decisively. Go for maximum success, not minimum risk," instructs Brown. He draws inspiration from Macbeth's resolve after the decision to attack Macduff's castle: "From this moment, the very firstlings of my heart shall be the firstlings of my hand."

The third rule is to make the tough fold. Don't fall into the trap of becoming `pot committed', which is when you put a large bet in the pot and refuse to give up, "even when subsequent events make it wiser to fold the hand."

The final rule reads, `Plan B is you.' Meaning that "the only assets you can count on after a loss are the ones inside you — your character, your talents, and your will." Take heart, therefore, because `however big the loss, the true gambler will survive'.

Financial challenges

Have you ever wondered why financial products should have the risk ingredient? Brown gives four reasons for the `why'. One, the product becomes attractive, "the way a fast food company sneaks extra fat, sugar, and salt into its offerings." Two, risk is essential for capital formation, by persuading people to look at assets that could be used for consumption "as sources of future income." Three, risk creates both winners and losers, as needed in a dynamic economy. And four, risk attracts traders; "without enough risk, the right kind of people don't show up."

Two chapters are devoted to the basics, of poker and finance — about hands and betting, limits and strategies. But what's more important is a section titled `financial challenges'. The first of the six challenges is that we fail to provide even minimal financial services for at least half the world. "Better financial services could make huge progress toward alleviating the miseries of poverty and social ostracism, and could make wealth concentrations more productive," opines Brown.

Three `challenges' that may upset many in finance are: "We lack a basic theory of corporate finance. We don't really understand risk. While our financial models have become very good at pricing securities, they require assumptions that clearly conflict with how security prices actually move." A not-to-miss chapter is `a brief history of risk denial' because it is about `risk in finance and the people who pretend not to see it.' Two of the oldest human activities are gambling and trading, says Brown. It seems Stone Age societies threw sticks, stones, or bones `to decide where to hunt or whether to move on'. Casting lots to determine God's will finds mention in the Bible.

Middle-class vs gambling

"For most of history, there wasn't a big middle class," is a statement early on in the book. "There were rich and poor, life was risky for both, and everyone gambled." It was the middle-class' quest for security that brought gambling to a stop, says the author. "In the US, the middle-class grew so large by the 19th century that a sizeable population began to try to escape it." When you see the economy as `a collection of 20-year speculative projects, many of which will fail completely and none of which will turn out as planned,' you'd realise the economic need and the appeal for `a gambling rather than a middle-class lifestyle' notes Brown elsewhere in the book.

You may chuckle when reading that one of the risk denials is that the ups and downs of the stock market just reflect the ups and downs of the economy. "None of the largest stock market crashes on record were associated with any obviously significant economic news, either before or after the fact," writes Brown. Since modern economy is no longer based on agriculture, investor psychology is more important than economic fundamentals, he explains.

Pokernomics, pokerbank

Enter the world of `pokernomics' in chapter 5, which begins with a reference to two books that Brown found useful in economics: John Law's 1705 work, Money and Trade Considered with a Proposal for Supplying the Nation with Money, and Fischer Black's Exploring General Equilibrium, 290 years later.

Both refuted popular notions. Law was the most sought-after economic advisor in Europe; and he was entrusted with running France's economy. "He did this so successfully that the word `millionaire' was invented to describe all the people he had made rich." Black's view of world was `more like the wide open frontier that was organised by commodity futures exchanges than the smooth equations you see in standard economics textbooks'. Brown adds: "The economic challenges of the future will be met, and the fortunes of the future made, by spread bettors acquiring capital and deploying it dynamically."

A section named `pokerbank' looks at the parallels between poker and bank. And there are differences too. For instance, "the bank is more of a cooperative effort in which everyone will succeed or fail together." In poker, however, the game is dynamic. "If the opportunity expands, the game can easily accommodate newcomers; if the opportunity turns out to be less than expected, losers can find themselves frozen out." Circumstances dictate which one is required — banks or gambling halls.

Games people play

Pick up an understanding of game theory in a chapter titled `the games people play' because "it's important to understand game theory to predict the mistakes of other players who rely on it... than it is to use game theory to improve your own play."

Game theory mistake #1 is to focus on cards instead of strategy, instructs Brown. Another mistake is to worry about what you can't change instead of what you can. Yet another is to play against an opponent instead of with the table. Be warned: "Game theory is a simplified world, like physics, without air resistance, or efficient market finance."

The final chapter `utility belt' is about `how gamblers think, and how other people think they think, and why we all think like gamblers'. Rather than being compulsive, gambling can be a rational choice when "other businesses, particularly financial services business," have failed to meet one's needs. The choice may not be wise, but it isn't a form of mental illness, opines Brown. Faced with options, taking risk makes sense, he advises. "If you win, great. If you lose, you pick up the next option. That's gambling, and it's not a problem."

Ideal read to cool off with before the market opens on Monday.

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