Monday, April 14, 2014

Finance and poker

I used to play poker. I don't much play anymore, mostly because I don't have any time or money, but also because people playing poker at casinos are no longer unskilled enough to for me to consistently make money.

Poker is a curious game. It is reasonably well-understood that in theory, "optimal" play in poker guarantees that (absent a rake) you will always break even in the long run, regardless of how well or poorly your opponent plays. Thus, to win at poker, you have to figure out how your opponent is playing non-optimally, and play in the corresponding non-optimal way that will give you positive odds. For example, many inexperienced players play too loosely and passively — they play too many hands that have negative odds, and they don't raise enough when they have positive odds. To take advantage of them, an experienced player will play tightly and aggressively, playing only hands with positive odds and almost always then raising.* Note that the "expert" is playing sub-optimally: "optimal" play requires playing marginally positive hands passively, and bluffing some hands with negative odds. But playing that way will simply break even in the long run, even against sub-optimal play. If the other players understand her tight-aggressive strategy, they will simply fold with mediocre hands whenever she raises.

*One fictional trope that I find amusingly unrealistic is the depiction of the "expert" player as one who can bluff his opponents into folding with better hands. In reality, the real expert will make a lot more money by convincing her opponents to call with worse hands; her bluffs are calculated to fail, to convince opponents to call more. Hence, she will usually show her opponents her (infrequent) successful bluffs and hide her winning hands (and hint they were bluffs).

Another thing that happens all too often in reality is experienced players getting upset with new players for playing poorly. Stupid! You want to
encourage poor play and take advantage of it. Poker is not a game of skill in calculating odds; it is a game of psychological observation and manipulation. If you can't manipulate a newbie, you are not even an intermediate player, much less an expert.

There is one situation in poker when playing correctly has positive odds: when you are no-limit heads-up (you can bet any amount you want, up to your total, and you playing against one opponent), and you have at least double the amount of money he has. Then you just go more or less all in on every hand*, counting on the fact that your opponent has to beat you twice, whereas you have to beat him only once. If the blind (forced opening bet) is large, and it is usually very large near the end of a tournament when the last two players are fighting for first place, your opponent can't wait for a good hand to call you.

*IIRC, the exactly correct strategy is to bet so that if you do lose, you equalize your and your opponent's stacks after the next blind.

If you go to a poker tournament, and you play the optimal strategy, you will lose the tournament. On average, you will neither win nor lose, but there will be a player who figures out the sub-optimal play of other players and takes advantage of them (or who plays sub-optimally, with fatter tails*, and gets lucky), and then beats you by brute force at the end.

*i.e. hey have a higher probability of either going broke quickly or getting rich quickly, with a lower probability of breaking even.

Finance is the same way. The "optimal" strategy is to create a portfolio such that no matter what happens in the economy, your investment earns, in the long run, the same rate as general economic growth (1-4% per year). You'll never* lose with this strategy, but neither can you win: you will never* become relatively wealthier than someone who plays a sub-optimal strategy and either outsmarts other investors, or who just gets lucky. And when any other player gets substantially more than you, he can beat you down by brute force simply by being irrational longer than you can stay solvent.

*Well, rarely; even an optimal strategy has a little room on the tails.

One charming bit of naivete I see in economists is the idea that economics is fundamentally about the optimal allocation of resources to maximize social production. In some abstract theoretical universe this might be true, but in reality, economics is about power; it is about winning. Hence, people, especially people with a lot of money, are not trying to not lose, they are trying to win. They are trying to defeat their opponents. Hence, they cannot play conservatively, i.e. not to lose; even if their strategy is just naively sub-optimal, there are enough other people that some of them will get lucky and win big. The "conservative" strategy cannot (rarely) win big; the whole point is to balance big losers against big winners, and small losers against small winners. This asymmetry becomes even more pronounced in finance, because the big winners get to actually change the rules. Most notably, the rich socialize their own losses and privatize their gains. This tendency causes the financial market to crash (since the rich have no downside risk, they can make bets with negative long-term odds but the potential for short-term gains). Everyone, even the "conservative" investor, loses everything (or at least all his gains), and then state makes up the losses of the rich. ("Sure got a nice economy there. Be a shame if it were to burn down.")

The typical capitalist apologetic for this system is that it promotes innovation. The apologetic is half right. Unlike poker, real life has not only risk, but uncertainty. We have to make wildly speculative bets to create fundamentally new things. Everyone laughs at, but whoda thunk that a search engine and a discount bookstore would be the primary drivers of internet technology, productivity, and economic growth? The probability of any individual speculation paying off is so low, according to the apologetics, that the payoff must be correspondingly large, and that we cannot punish failure by economic "death." Otherwise, no one would ever take speculative bets, and we would have no (or very little) innovation.

However, there are two flaws in the capitalist apologia. First, the reward for winning speculative bets is not increased consumption (Bill and Melinda Gates and their family could not and have no intention of actually themselves consuming $50 billion of goods and services), but political power: the power to tell people (i.e. the workers) what to do and not to do.* There is no need to reward successful innovators with political power; there are plenty of alternatives, such as social status.

*It you think that power is actually held by our elected representatives in the official government, you are hopelessly naive.

Either people "naturally" (i.e. without special, artificially constructed incentives) want to be innovative, or they do not. (More generally, they might or might not want the fruits of innovation more than they dislike the process of innovation.) If we do not naturally want to be innovative, why should we as a society encourage such behavior? If we naturally do want to be innovative, then instead of creating powerful positive incentives, it is sufficient to only remove negative incentives: do not punish people for trying to innovate and failing.

(The other apologia for capitalism is that most people are stupid, lazy, and irrational; they must be ruled for their own good. "Democracy" is at worst a sham and at best just a check on the most egregious corruption of the elite. As a democrat, I reject this premise, for what I think are good reasons.)

That's why I am coming to believe that finance should be entirely public, run by the government. The government can afford to play conservatively, i.e. to play to not lose. Most of our economy, the economy of food, clothes, houses, electricity, water, cars, gasoline, etc., is a game we want to play to not lose. For the rest, encourage small-scale innovation by removing the negative incentive of losing a year's pay trying to innovate: give everyone a free year to try something innovative (a person would have to prove only that she is not going to sit around for a year watching TV); if they're successful, give them some publicity and another year or two to continue being innovative. If they're unsuccessful, they've lost nothing. For the "big bets," innovations that are beyond the scope of the individual or small group, we should vote; why should a private person individually decide how to innovate with the labor of thousands or millions?

Such a society might not be as innovative as full-throttle innovate-or-die capitalism, but I think it will still have substantial innovation and would definitely be a happier society for everyone.

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