Here's a guest entry from Tynan. This post is about how a professional gambler looks at money.
Small Things Add Up
I was eighteen, and a freshman in college. For the past few years I'd been making a few hundred dollars a month selling Palm Pilots on eBay. It was a lot of money for a teenager with no real expenses, but of course I spent it all. My knowledge of personal finance was fuzzy at best. Naturally I squandered any money I made.
Then, through a strange series of events, I became a professional gambler. It happened fast, and soon my “studies” were being neglected for long nights of blackjack, roulette, and video poker. Eventually I dropped out of school to make serious money, and thus began my real financial education.
There are a lot of analogs between gambling and real life finance, which should come as no surprise since gambling is simply the bizarre intersection of fun and finance. I learned more about personal finance, discipline, and math during my six years as a professional gambler than any other period of my life.
My hope is that through this series you'll receive the same education, without the inconvenience of making piles of money.
When a gambler plays a game, he receives a payout. A 100% payout is what he'd get from a perfectly even game like flipping a coin. No one has an advantage. A 99% payout means that the gambler will lose, on average, 1% of what he bets. A 101% payout means that the gambler will earn 1% on what he bets. This may sound like a slight amount, but when betting tens of millions of dollars a year, that 2% spread between 99% and 101% represents the difference between going broke and living very comfortably.
As a gambler, I would implement changes to my playing habits. Each alteration might only increase my payout by .05%, but each .05% pushed me closer to the promised land of 101%. When I understood this concept, I realized that life is the same way. Either your spending habits are building your wealth or bleeding it — just like gambling.
For example, do you take money out of an ATM every week? If you do, that's costing you an average of $2.91 per week (according to Bankrate). People don't feel good emotionally taking out $160 at once instead of $40 a week, but that emotion has nothing to do with the real financial costs associated with the extra ATM fees. This irrational emotion is exactly what fuels casinos.
The profit in switching to a monthly withdrawal schedule is $104.76 ($2.91 * 3 * 12 ) per year. That negative emotion some people have is costing them $104.76 per year.
What about tipping 25% instead of 15%? If you're an average American, you're spending an additional $440 per year to feel generous. I'm not saying it's not worth it — I'm just saying that it's costing you.
Switching a credit card balance from 25% APR to a newly opened 10% APR card can save $1250 on a $5000 balance.
We ignore these habits and expenses on a daily basis, but as a professional gambler, small improvements in our habits are the difference between making a living and going bust. I learned my lessons fast and was a successful gambler for six years.
In real life, if we pay attention to our small habits and adjust them, they too can make a big difference. I've listed three changes that an average person could make. The benefit over ten years? Almost $18k — that's big.
Know When to Fold ‘Em
Now, 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.