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The Secret to Survival

There are lessons in the game of poker that are applicable to other areas of life. The parallels to real life always amaze me when I consider the nuances of the game.

There are times to be bold, aggressively moving your stack into the center when the situation arises. There are many other times when the appropriate move is to fold and wait for the next hand. How often do you hear 'just give up' in life? Almost never, but there are actually many times when it is the prudent thing to do. Cut your losses and move onto the next opportunity.

Sometimes the game comes freely to you, and winning hands couldn't be easier. Other times it is a total grind, with seemingly no end in sight to the losses.

You are also always playing the other person, which is more important than the cards you're dealt. Now, we believe in making deals for the mutual good. We will not make any deal that we don't believe deeply in our hearts is good for everyone involved. But there is still a lesson to be learned in playing cards with your friendly opponent: you need to understand what they are trying to achieve. Without knowing this, you cannot find success in the game, or as an investor.

Ask good, open-ended questions of those around you. Become an intent listener. Truly desire to seek to understand before speaking. There may be no greater secret to success than learning to simply ask good questions, and listening with an open mind.

There is one particular discipline of the game that has served me and stayed with me throughout the years more than any other. So many times we have come back to this foundational principle, and it has remained true. It is the virtue of position sizing, or in poker lingo, sizing bets according to pot odds.

The premise is this, make decisions based on the odds of success, and only invest largely when the outcome is asymmetrically weighted to the upside. Do not overcommit your principle to opportunities without appropriate upside, or with risk too great.

So many people have committed most of their entire worth into paper assets on Wall Street. We are fed a constant stream of propaganda about this being the prudent thing to do, when the reality is the game is designed that those selling Wall Street products make the majority of the bounty. It is true that patient, long term business ownership is a good way to build wealth, but the game is becoming more and more rigged to encourage excessive trading. Virtually no one sustains long term success by trading in and out of positions.

Let's look at two practical examples of how position sizing might benefit you. Remember that it is appropriately sizing your investments to the amount of risk you're taking on. In regards to paper assets, my preferred total net worth risk exposure is one percent. This may be different for you, but this is the rule we use. Here's how that plays out in reality:

Net worth: $250,000

Company: ABC Gumball Corp.

Desired equity stake: $10,000

Net worth invested: four percent

Maximum loss allowed: $2,500

Trailing Stop: 25 percent ($10,000 x 25 percent loss = $2,500 = 1 percent of net worth)

It's important to recognize that the upside on this trade should be at least 3-to-1, and preferably higher. You shouldn't commit money towards an idea unless the upside is asymmetric. Now, risk can never be totally eliminated, only moved around and prepared for. This is where appropriate position sizing serves us well. In investing as in poker, the commitment should always be sized appropriately to allow for a defensive posture. Be thinking of the downside at all times.

This lesson applies to hard asset investments, as well. So often people commit huge portions of their net worth to a primary residence or investment property, completely misunderstanding how much risk that introduces into the equation. We are huge fans of home ownership and real estate investing, but only when done within the confines of prudent position sizing.

There aren't such straightforward rules when it comes to investing in hard assets, but we use 20 percent of net worth as a general guideline for equity percentage of worth. We should note that we're big fans of utilizing leverage for investment properties, as the tax rules and reality of a fiat currency require this tool for long term success. Just remember that debt is a sharp weapon, and should be used precisely. Let's look at an example of what 25 percent equity portion in an investment property looks like:

Net worth: $350,000

Investment: Triplex for rental purposes

Purchase price: $300,000

Down payment required: $60,000, with $240,000 in financing

Net worth committed to equity: 17 percent

There are of course many other factors to consider when investing in real estate, with durability of cash flows the principle concern. However, this shorthand rule will keep you from over-committing your valuable capital to an opportunity.

We have made good investments and bad investments in our career, but we've always taken care to recognize that appropriate position sizing is what would allow us to survive and thrive another day, regardless of the outcome of a particular investment.

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