Manage your Finances like a Professional Gambler II: Know When to Fold ‘Em
Monday, 5th February 2007 (by J.D. Roth) Love him or hate him, Tynan is back with a second installment in his series describing how to manage money like a professional gambler. Once again the article features sound advice. But once again Tynan’s personality may rub some people the wrong way!
For six years I was a professional gambler, during which time I learned valuable lessons about personal finance that I still use today.
In my first article I talked about how professional gamblers need to get the payout over 100% in order to profit. One way to get the payout over 100% is to play a progressive video poker machine. Normally Jacks Or Better, the standard variant of video poker, pays out around 99.5%. This is a losing game, with the expectation of losing $5 for every $1000 wagered. To assess the payout value of video poker, multiply the payout of each individual hand by the probability of getting that hand and adding them all up. The payouts for hands vary from $5 for a single pair to a whopping $4000 for the highly unlikely royal flush.
Progressive video poker is different. Its payout varies because the prize for the royal flush varies. It starts off low, sometimes even below the standard $4000, but as more and more people play a machine without hitting the royal flush, the prize increases. Since the overall payout of the machine is based on the payout of all of the hands, as the royal flush becomes more valuable the payout of the machine rises. Somewhere around $4600 it breaks over 100% and becomes worth playing.
Let’s say that we have a gambler named Bob. He sits down at the machine when the progressive royal flush payout is at $4600. Because the payout is so high, he’s making a smart move. He plays and plays and plays, losing $500 in the process. A positive payout is no guarantee of winning in the short term. He takes a quick break to go to the bathroom and when he gets back, someone else has won the jackpot and it has been reset to $4000.
If he’s like most amateur gamblers, he thinks, “I already have so much money in, I may as well keep playing.” This is an incorrect move because the amount of money he has in the machine has no bearing on the payout. When the payout is good, it’s worth playing. When it’s bad, it’s not. The difference between a pro and an amateur is that the pro doesn’t care how much of his money is in the machine — when it’s worth playing he’ll play, and otherwise he won’t.
There are two fantastic examples of how people make this mistake in everyday life.
People love to play the stock market. I’ve played it a bit, but quickly learned that I was an amateur, and that it’s more like gambling than most people give it credit for. Now I let Warren Buffet manage my money for me.
When stocks go up, people are thrilled. When they go down, they make poor choices. Let’s say that Bob decides to invest his money. He invests in a solid company named Acme Widgets, and watches his investment increase. Suddenly there’s a change in management and Acme starts going down the tubes, along with his investment. He invested $1000 in Acme, but now his holdings are only worth $100. He thinks to himself, “I know I should sell, but I’ve got $1000 in, so I may as well see if I make it back.”
What he doesn’t consider is that Acme has no idea how much money he has invested, and that original investment has nothing to do with the prospect of Acme going back up. If he wouldn’t buy Acme with its shares at 10%, then he shouldn’t hold them at 10%. Not selling is the same thing as buying. That isn’t to say that you should sell when stock prices drop, but only that you should sell when it’s no longer a good investment by whatever decision process you use.
The same principle applies to real life purchases, and is commonly exhibited when people buy cars.
Bob makes a stupid move and buys a brand new truck for $25,000 from the dealer. A year later its value has declined to only $15,000 and he’s is in bad need of money. He looks into selling the truck, but people are only willing to pay $15,000 for it now. Disgruntled, he refuses to sell and thinks “I paid a lot more for it. I may as well keep it.” Again, the market doesn’t care what he paid for his truck. Whether he paid $5,000 or $50,000, it’s still only worth $15,000.
If he was to shop for a car today, on his limited budget, he would probably buy a car that cost only $10,000. By that metric, he should sell his depreciated car for the fair market value of $15,000 and buy a cheaper one for $10,000.
In fact, purchases should be sold if you wouldn’t buy them today for their current value. I bought a monitor for $800 a year ago that is now only worth $600. I still like the monitor a lot, but I use my laptop most of the time now so the monitor isn’t as valuable to me. Even though it was a good purchase a year ago, if didn’t have the monitor today I wouldn’t buy it. Thus, it gets sold.
The only other factor is my time expenditure to sell the item. If I have a computer mouse that I don’t use anymore, but it’s only worth $5, it’s probably not worth my time to sell it.
I think this is terrific advice. Too many people “let it ride”, or worse, throw good money after bad. Based on Tynan’s advice, I have several items I should be auctioning on eBay. And you know what? I think I might.
This article is about Choices
I have a friend who purchased a manufactured home new many years ago. They moved out of it when they stilled owed more than the market was willing to pay.
Between the loan and lot rent I expect they spent over $20,000 just to let it sit there. And they still owe more than it’s worth.
I would have instead taken a personal loan out for the $20k and sold it quickly – that loan would be largely paid off by now.
Instead, they are pretty much in the same position that they were in when they moved, and perhaps in two more years they’ll have sunk another $20k into it.
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I was critical of your posting of Tynan’s advice last time. I still think it is risky business glamorizing the avarice of gambling. Even so, we are all? adults here.
I do appreciate Tynan’s words regarding the “gamblers fallacy” – thinking that a machine or game is primed for a big payout because of all of the prior play without one. The fact in, each roll of the dice or push of a button is a “start over”. How many compulsive gamblers have gotten themselves into a heap of trouble following this simple fallacy? Shedding light on this is a good thing. I think.
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Playing Devil’s advocate here:
Tynan wrote:
This makes me think of one real-world company that followed this trajectory: Apple Computer. When Steve Jobs was forced out of the company by John Scully way back when, Apple started going down the tubes. A lot of people predicted the company would go out of business and its stock was pretty much worthless. But if I had owned a big chunk of Apple stock back then and had held it instead of selling, I’d be a very rich man today. There’s no way to predict what the future will hold.
Also, I think the advice that “purchases should be sold if you wouldn’t buy them today for their current value” needs some qualification: doesn’t Tynan mean “purchases that you no longer use or need?” And really, if you no longer use it or need it you might as well sell it anyway. If I bought a monitor and wasn’t using it anymore because I was using my laptop exclusively, I’d sell the monitor regardless of whether it had gone down in value…if I don’t need something anymore I sell or donate it.
Furthermore, if you were to take the “sell if you wouldn’t buy it today for its current value” literally, you’d be constantly buying fast-depreciating items like computers, cars, etc. to replace your old ones, which doesn’t make sense. If your computer or car works fine now and you don’t need to sell it for financial reasons, I’d say hang onto it until you really need a newer one.
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I would like to repeat that taking Tynan’s advice of ‘selling if you wouldn’t buy it today for its current value’ as he wrote it would be a horrible disaster for anyone. This advice (1) undermines the time-tested buy-and-hold strategy and, if really followed literally, (2) puts one on the track of continually losing money.
If someone is thinking of selling a vehicle that depreciated more quickly than what they are confortable with, what would really be wrong with them resigning to hang on to the vehicle for a little while, if it’s not necessary for some reason to purchase a new one? If the person has the ability to continue using the current vehicle, they might as well get the equivalent usage out of the vehicle for its deprication (since new vehicle deprication levels off after the initial drop).
There is certainly something to be said for not hoarding useless things, for being able to recognize when something has finally lost all value and letting go of it (difficult as the Apple example above illustrates), and for the wisdom in cutting your losses when appropriate, but this advice goes too far overboard.
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I think that with the qualification of ‘stuff you don’t need or want’ this is a good way of thinking of things. How much you paid for something is irrelevant to what its worth, both in terms of money and its value to you.
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I’m not sure everyone is understanding the advice to sell something if you wouldn’t buy it today for its current value. Think of it this way: You have an object that provides some utility to you. You can sell the object for X dollars. If you can buy something that can provide the same utility for *less* than X dollars, it is pretty reasonable to sell the object, buy the cheaper thing that provides you with the same utility, and pocket the difference.
So with regards to the truck, the thought is that the truck isn’t worth $15,000 to the guy, and he would get the same utility out of a $10,000 vehicle.
This advice will not lead to constantly buying fast-depreciating items. The point isn’t that the truck depreciated, so he should sell it. The point is that he should sell it *even though* it depreciated. Whether or not it was originally worth $25,000 or even $15,000 to him is irrelevant, because *now* the truck is only worth $10,000 to him.
When you have something worth $X to you (i.e., that you could replace for $X) and that you can sell for $Y, if Y is greater than X, sell it.
It’s simple advice, and I believe the main point is that you should keep it in mind to override any curveballs your psyche throws at you like “Oh, but I spent so much on it, it would be a waste to sell it now!”
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You have an object that provides some utility to you. You can sell the object for X dollars. If you can buy something that can provide the same utility for *less* than X dollars, it is pretty reasonable to sell the object, buy the cheaper thing that provides you with the same utility, and pocket the difference.
This sounds a lot like that “value your possessions by how long you’ve owned them” idea from a week or two ago, except that this time there’s no indication about how to value your possessions. When it comes down to it, most people simply can’t decide that something they own is worth $X to them.
Let’s say you have had a car for a few years. To decide whether to keep that car, you first have to figure out what it is worth to someone else, keeping in mind that someone else has an interest in fooling you into thinking that value is lower than it is. Then you have to decide what it is worth to you — not only do you get to convert its utility to you into a monetary value, but you also get to figure in the costs of the transaction and the opportunity costs of making the sale (which include things like the value of the additional risk of buying a cheaper car which might be reliable but might also be a lemon). Finally you have to decide whether the difference between those two figures is enough to make the transaction worthwhile.
Most people simply cannot do that effectively, and there’s nothing here to suggest how to do it, only that it should be done.
On top of that, you need to figure out for which things you own it’s worth even starting the process. You can’t do that evaluation for everything you own against everything you could possibly own, so you have to know which things are worth the time to concentrate on, and to do that you have to know a lot about the market that you could possibly sell those things on. Again, most people don’t have that ability, and there’s no advice here on how to generate it (for reasons I find obvious — it’s hard.)
Tylan probably spends a lot of time thinking about finance. That has the potential to generate a lot of financial strategies that have gambling analogies, but that’s only the minimum requirement. With clearly no experience actually dealing with other people’s financial situations, his advice doesn’t help anyone to improve their situation at all, only to wonder why it all sounds so easy on paper.
“Oh, but I spent so much on it, it would be a waste to sell it now!”
This is just sunk costs again. But Tylan isn’t saying “account for sunk costs”, he’s proposing an impossible process of assigning cash value to utility, just like the earlier guest post about calculating value based on time owned did. Yes, when you throw out all of the recommended methods you can end up with “account for sunk costs”, but the extra baggage doesn’t make the point any clearer or readers any richer.
JD, I know this guest post had been lined up for a while, but any proposal that involves calculating the cash value of something one already owns really needs to send up a red flag and invite the questions, “Is that calculation even possible, and is its result meaningful?”
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Argh, sorry! I managed to write that whole comment with “Tyler” and then went back to correct myself, but got that wrong too! Apologies, Tynan.
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There are two places this has real value: When you want to sell an object that has carrying costs, and when you want to sell an object that will depreciate over time.
Real estate is an excellent example of the first, as the first comment pointed out. Just to use some numbers, let’s say you have a house that you have a mortgage of $300,000 on. The carrying cost of that mortgage is roughly $2000 per month, more or less, let’s say.
You get a job offer out of town, need to sell, and looking at comps you price your house at $350,000. A month later you get your sole offer to date, for $330,000. The market is softening, there’s lots of competition–not a good time to be selling.
You could decide to stick it out, and hope for a better offer…but for each month that passes without a sale you’re lowering your take from the sale by $2000–plus the opportunity cost of that money and the inconvenience of keeping your plans on hold, perhaps paying two mortgages at once, etc.
If you get a full price offer a month later, you look like a genius. But if you still have the house a few months later, you’re now a stale listing AND you’re no better off than if you had accepted the original offer. Indeed, you might have been able to counter and get a bit more.
The other time to do this sort of analysis is when you might part with something that has a rapid depreciation curve–computer hardware or software, electronics, or the like. If you have a flat-panel monitor you’re not using that’s still in the “acceptable” size range, sell now, rather than wait for the day that people simply laugh and wonder how you ever worked on something as dinky. Or if you’re done with a new game, sell while it’s still a current title and not when it’s been superseded by the latest version.
Cars are the same way. Yeah, you made the stupid decision to buy new. Yeah, you need to sell because finances are tight. Yeah, you lost a bunch of money. However, don’t forget to factor in the carrying costs when deciding to tough it out: is there a payment that will go away or be greatly reduced if you sell? Does your potential new car require less gas, cheaper (liability only?) insurance, and perhaps can be parked on the street instead of in a rented spot? make sure you look at the entire picture rather than just how much money you’ve lost.
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wha says:
I would like to repeat that taking Tynan’s advice of “selling if you wouldn’t buy it today for its current value” as he wrote it would be a horrible disaster for anyone. This advice (1) undermines the time-tested buy-and-hold strategy and, if really followed literally, (2) puts one on the track of continually losing money.
I disagree. In fact, I’m pretty sure Tynan’s advice is cribbed from Warren Buffett (although I can’t seem to track down the source).
If you’re holding Stock A, and are thinking about buying Stock B, you need to look at which one is currently selling at a greater discount to intrinsic value. If it’s A, you should just buy more of Stock A. If it’s B, you should sell A and use the proceeds to buy B. (Thus the rule: if you wouldn’t buy A today, you should sell it.)
Logically, this makes sense, in that you should only hold those stocks that are going to give you the greatest return from their present levels (not the price at which you bought it; a stock doesn’t care how much you paid for it).
Of course, the rule relies on a number of major assumptions, mostly related to one’s tolerance for risk and level of ability in security analysis, but the reasoning is sound.
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“Not selling is the same as buying.”
This is just not true, because it ignores transaction costs (commission, sales tax, etc.).
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majeest: Tynan credits Warren Buffet in this post, silly. But he then goes on to say that it applies to everyday purchases that aren’t investments, and that’s where things break.
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