What is the difference between stock trading and gambling in a casino?

Answer by Laurent Bernut:

I’ll give You the same answer I gave two CIOs of Fidelity. The common point between professional poker players, star fund managers and street hookers is that they go to work: it is not meant to be fun.

Excellent question. Beyond taxes and manufactured negative gain expectancy, there is much market participants could learn from professional gamblers:

1. Gambler’s serenity prayer: grant me the serenity to accept folding a losing hand, the courage to take calculated risk and the wisdom to know the difference
2. Cut losses and run winners: in poker, money is made by folding a lot and be aggressive a few times. Successful fund managers spend their time cutting losses. The paradox is that the way to win the war is to accept losing small battles
3. Position sizing: Black jack is a game where You play against the house. It is manufactured to have You lose. Yet, Edwin Thorpe, whose track record towers Warren Buffet’s, beat the dealer. His method forced casinos to adapt. His secret sauce was position sizing, a fraction of Kelly criterion
4. Position sizing algorithms: Gambling is a far more mature industry than investing in the sense that a lot of position sizing algorithms used in finance come from game theory. Martingale, reverse-martingale, drawdown/run-up of bankroll, Kelly Criterion
5. Gambling is boring: hookers, poker players and star managers go to work. It is not meant to be fun. They leave their emotions at the door. Treat gambling and markets as a job so that You can fleece the emotional players
6. Gamblers have a system: gamblers are not smarter, they have smarter gambling habits. Adherence to a system takes discipline. Reinforced discipline is called habit
7. Gambling as trading is not a zero sum game: one of the most common myths about the market is the zero sum game. Slippage, commissions erode however slightly the account. Take every trade as if You put a chip on the table
8. Quantified risk: the notion of calculated risk has unfortunately been perverted by those who do not understand it. Risk is not an abstract dissertation at the end of an investment thesis. Risk is a hard cold probabilistic number
9. Odds and win rates: one of the fallacies of market participants is the belief they need above 50% win rate to be successful. 2 things here: 1. trading edge or gain expectancy shows that low win rate can be compensated by big payouts. 2, Distributions of P&L of most traders (excluding mean reversion and market making) show aggregate win rates over the cycle of 30-45%. Winners compensate for losers. The important lesson here is that traders walk into a trade expecting it to win, when they should be mentally prepared  for a loss. Pre-packaging grief (see my post: The view from the short-side: how we process emotions and the market signature of the 5 stages of grief Kubler-Ross by Laurent Bernut on Alpha Secure ) . This means that throughout the cycle, styles come and go. Making money means knowing when your style is out of favour and betting small and then when in fvaour take risks. Back to the serenity prayer

Conclusion

Investors usually look down on gamblers. Yet, there is much to learn from gamblers. How come a few of them become successful despite built-in unfavorable odds ?

Beginners in both markets and gambling believe they are on to something when they double down after each loss. They believe that their luck is about to turn, so they use martingale (it comes from the French for winning streak). They just forget two things: dice have no memory so each run is independent from the previous one. More importantly, the maximum expected value is break-even. This means that any outcome other than the best one carries an interesting probabilistic property called “certainty of ruin”.

In other words, there is a reason why casinos have gold, marble columns, master paintings and rookie gamblers go broke…

What is the difference between stock trading and gambling in a casino?