The decision making process – calculating risk

I’m often minded to think back to the “financial crisis” and the causes and fall out therein. As an exercise in uncertainty, you don’t have to go much further than the life of Sir Fred Goodwin. Once revered as the banker who led Royal Bank of Scotland from relatively small provincial institution to the fifth largest bank on the face of the planet. Now reviled as the man who bankrupted it in the process of doing so.

Getting to grips with the fundamental aspects of risk what we now have to understand is that that even if Fred Goodwin were the most competent and brilliant banker on the planet… the law of uncertainty says that there is still a probability that what happened would have happened. It has before and it will again. That’s not to say that Goodwin did all he could to prevent it. But it is to say that no-one could have done everything. For in any system there will always be things we cannot control: “A man does all he can and his destiny will reveal itself.”

The most important question as viewed through this lens is, therefore, did they do all they could? Were the models used by financial institutions accurate? Benoit Mandelbroit has been warning for a long time that they aren’t. According to conventional wisdom taught around the world, he says the chances of the fall in stocks on August 31st 1998 at 1 in 20 million; the odds of the Dow’s fall by 7.7% the previous day 1 in 50 billion and the odds of black Monday 1997 1 in 10 to the power 50, “odds so small” he says “they have no meaning”.

Nothing is certain. Everything has just a probability. The important thing, where the world’s finances are concerned, is to estimate the probabilities effectively. If bankers think the chances of meltdown are less likely than they actually are then obviously they’re going to take more risks than if they estimate them accurately. Likewise in life, if we don’t know the probabilities of outcomes associated with what we do then we’re going to make similar uneducated, potentially poor, decisions.

Ultimately, whenever we do anything our minds consider future possibilities much like an actuary calculating the value of an insurance policy. At a subconscious level we understand and accept uncertainty and do a multitude of tiny little calculations that will ultimately decide what we do. Specifically, we are always multiplying probability by outcome or impact of an possible event: we know the probability of our plane crashing is very low, but we feel that the actual impact of such an event would be huge combining as it does not only the chance of dying in a fireball but also falling 30,000 ft beforehand! Probability times potential outcome here (to give a result that will of course differ for each of us) usually creates a number high enough to cause concern but not enough to stop us making the decision to “take the risk.”

Asking someone on a date is a very different kind of risk. On this occasion, the overall potential impact of the downside is indignity or shame of possible rejection. Not as great, perhaps, as dying in a fireball. But the probability of experiencing it is higher, hence the fear that many of us have of it and why many are less inclined to do it than get into an airplane – or even jump out of one.

The exact probability we’d put on being rejected is going to differ from person to person and situation to situation. In order to make this decision, then, we need not only to make some kind of assessment of the chances of a negative response but also how significant the pain of this possible rejection might be – something that will depend on a large number of private, personal, considerations, not least whether we’ve experienced it before.

But there’s another consideration we take into account in order to make this and every other decision that we ever make: for pain and hurt are not the only possible outcomes of this action. There’s also the potential reward of success – and of course the probability of experiencing it.

And by putting these two probabilities and outcomes together – success and failure – we come up with an expectation which ultimately will define what we decide to do. Whether or not our decision turns out for the best or course is a very different matter!

Catching Butterflies

What does it mean to find the cause of an event? In the aftermath of the actions of Kweku Adoboli there will be a trial and doubtless more than one investigation by UBS and the FSA each concerned with apportioning reasonable blame and establishing the facts with a view to preventing such events from ever happening again. But how effective will such endeavours prove to be? And what on earth do the opinions of a poker player count for in such a debate?

I played poker professionally for much of the three years between 1999 and 2002 before eventually tiring of it and setting up a video production company which I ultimately sold five years later. A lot of people ask me why I started playing in the first place but more ask me why I stopped. My first answer to such a question is that it’s hard to compress the emotions of nearly a decade ago into a satisfying soundbite but that eventually it was the chaos that did it for me in the end. Over any given long term period it was clear that I was earning a living but the results of each night were clearly much more dependent on factors outside of my control than those within.

Specifically, in poker, you can’t control the cards. Naturally, everyone rationally understands that but as someone who now uses poker as a metaphor to teach the subject of risk to corporate clients I’ve lost count of the number of times I have seen a table applaud someone who just got dealt four of a kind. It’s a perfectly ordinary emotional reaction – to congratulate the player who just won the hand – but actually it’s crazy.

There is no skill in getting good cards dealt to you. And conversely getting bad cards is no evidence of ineptitude. But try rationally processing that in the middle of a bad night when card after card comes down, killing your bankroll one hand at a time. Interestingly it’s not the bad hands that you have to worry about. It’s second best hands that destroy you. Hands that start off great but suffer from freak outdraws in the later stages which ship the pot to your oblivious opponent.

The simple fact is that the turn of about 5 river cards are largely going to dictate your results for that night. 30 cards will define your week. 100 for the month. Results don’t start to become statistically significant until at least a school term of daily play. Until then the length of the dealer’s nails as they riffle the cards together between every hand will have a greater impact on your finances than all the great reads and raises that you make!

In order to stay sane and play great poker one needs to rationally understand that the way something actually happened is no indicator of the way that something was necessarily likely to happen or somehow “meant” to happen. In and of itself it doesn’t necessarily mean anything. It’s just what happened to happen on that occasion and there isn’t always anything that anyone can learn from it or change in order to prevent it happening again.

The butterfly effect is 50 years old this year. Officially discovered and named by meteorologist Edward Lorenz it derives its title from an image created by plotting the Lorenz attractor for specific values which happens to resemble the wings of a butterfly. Partly as a result of this, it is often understood to refer to the mindboggling mechanism by which a single butterfly flapping its wings in somewhere like Brazil can somehow cause a rainstorm in Reading.

This is not technically misleading although it does obscure the real lesson of the butterfly effect which, more generally, is that it is confluence of a myriad unknowable events which feedback into each other to cause the sum total of events which impact all our lives. More profoundly, I think, is the inverse implication that the incidents and episodes which affect us all profoundly find their origins in events too insignificant to calculate.

If Mohammed Bouazizi hadn’t had his face slapped in a Tunisian market in December of last year, he probably wouldn’t have set fire to himself when he did and inspired a people to rise up against their unelected dictators at that precise moment at the start of this year. Would they have done so anyway? Maybe. But not in the way that they did, and not with the exact consequences and impact on all our lives that this particular revolution will turn out to have as enacted in this way.

Another thought: If Warren Buffet had been able to retrieve messages from his mobile phone he would apparently have received a message from Bob Diamond proposing terms for a deal to buy out Lehman Brothers a day before it finally went under. Asked later if he would have gone for the deal he suggested that it was “entirely possible”. Would the systemic crisis have occurred if one man had been slightly more tech-savvy? Perhaps. But not in precisely the way that it did. The same people probably wouldn’t have lost their jobs. They wouldn’t have impacted those around them in the way that they went on to do. Your world might now look very different. We’ll never know for sure.

Try this one: if the five of diamonds had fallen on the river of a particular game of Texas Holdem in Las Vegas I would have won the jackpot of $150,000. I know for sure that I would not have met my girlfriend later on that day; wouldn’t have stayed in Vegas for the length of time I did; wouldn’t have met my business partner and set up the production company at that point in time; would not have been commissioned by the University of Nottingham to produce a promo and would not have been assigned a representative of the student union to work with – one Kweku Adoboli.

Kweku and I spent a couple of weeks working on that project. I was a thorn in his side for far too long: getting him to show me all the most picturesque locations of the campus; pestering him to get me students for the crowd scenes when he definitely had much better things to do. Who knows what effect I had on his life: the lectures he missed, the people he met and phonecalls he made that he otherwise wouldn’t. Would he have gone to work for UBS had he not met me? Quite possibly. But probably not in quite the way he actually did.

He might have said different things in interview. Met someone else on his first day. Ended up living somewhere else; going out for different drinks with different people; learning different things and perhaps – most importantly – not hitting “buy” when he meant “sell” at the precise point when he is alleged to have done so at the beginning of this whole sorry business. Whatever he went on to do, or not (and it’s important not to prejudge the results of the ensuing criminal trial) he almost certainly would not have gone on to do in exactly the same way. Kweku was by all accounts (and for what it’s worth my own personal experience confirms) a thoroughly decent man who may have ended up doing some bad things.

But as Nick Leeson is at pains to point out: you don’t set out to commit such fraud. You make one wrong decision and find yourself a victim of events to which you react in a totally unacceptable way. Like any hand of poker, it might all have been so different, if a card had flipped over in the shuffle in a slightly different way; if a butterfly had flapped its wings at a different time. The way that Kweku’s life went on to happen is no indicator of the way that it was necessarily likely to happen or meant to happen. In and of itself it doesn’t necessarily mean anything. It’s just what happened to happen on that occasion and the challenging truth is that there might not be anything that anyone can learn from it or change in order to prevent it happening again. But that probably won’t stop us from trying.

A lot has already been written about Kweku’s actions and much more will be said before it is forgotten: about UBS and The City generally and the morality of the people who work within it. Hopefully the investigations that take place will be fair and thorough and make reasonable and constructive recommendations because I’m not saying that there necessarily can’t be anything to learn as a result. That would be bombastic, dogmatic and, frankly, well beyond the remit of a humble poker player.

I’m just saying that of all the factors that people identify as having caused these sad events, no one will blame that five of diamonds for not coming off the deck. And why would they? It is just one of a myriad butterflies; an incalculable number of unknowable events which feedback into each other to cause the sum total of events which impact all our lives. But if it’s that impossible to truly understand the exact causes of an event, how possible is it to truly prevent a similar – or analogous – event from ever happening again?

We do our best. As we should. But we may as well try catching butterflies.

Posted 04:20pm by Caspar and filed in Risk, Uncertainty

Life’s not fair

“That’s not fair” I cried as my friend completed his set of Vine St, Marlborough St and Bow St that would eventually lead to victory that evening.

I wouldn’t have minded of course had he completed the transaction fairly and squarely but the deal was sealed with the offer of both four hundred pounds of monopoly currency and twenty pounds of actual sterling! “That’s cheating,” I shouted again. And thus began an argument which still rages to this day, twenty years on. To me, there is no debate; what he did was outside of the rules of the game. It was cheating.

I was reminded of this experience recently when, in April of this year, the FBI seized the URL addresses of the two biggest online poker sites, Poker Stars and Full Tilt. The action finally brought an end to their US operations five years after the uncertainty initially created by the Unlawful Internet Gambling Enforcement Act of 2006.

Some have viewed this definitive action to be a good thing, but the unacceptable sting for many players active on the sites at the time is that whilst Full Tilt had a reported $400m in players’ funds it only had $60m in the bank – apparently placing its faith in a kind of fractional reserve system of deposits that is likely to leave thousands of players nearly bankrupt.

“That’s not fair” they have understandably cried as two of the site’s founders are alleged  to have taken dividends of tens of millions from the site leaving the vast majority with almost nothing to show for years of play/work!

Interestingly, while what has happened is almost certainly illegal, and therefore obviously much more serious and profound than a bit of cheating at monopoly, the central problem is very similar: what happened took place outside the basic rules of the game. It still happened, however, and no amount of shouting or complaining is likely to change that fact.

The common perception of poker is that it is broadly a game of epistemic risk. Complete novices sometimes think that it is a game of deductive logic, like blackjack, that starts and ends with the likelihood of a particular card coming down. After playing the game for even just a few hours, however, it is clear that this is only a very small part of the story and that in practice playing the game involves making a series of inductive assessments about our opponents – assessments which get better with experience that leads to greater accomplishment and expertise.  In this respect, the decision-making process of poker is very like that of any other realm of life.

Where poker is unlike life is that often you are forced to make such a decision every 90 seconds or so. Given that you cannot abdicate, delegate or procrastinate during the process of making them, they are even less like a lot of the decisions we make in life which are often left unaddressed for as long as possible! Similarly, the decisions we make in poker are often very one dimensional, focusing merely on the allocation of money, in the form of poker chips, for the purposes of accumulating more in the long term. There is rarely any consideration of society or the greater good of those around you which ultimately is why I stopped playing professionally.

But where poker is exactly the same as life is that – despite a recognized set of rules by which the game can be played reasonably and fairly on a daily basis – from time to time those rules will be breached. Often, such a contravention will be unfair to one or more parties: people may lose money, in the real world they may lose things much more valuable and precious.

In The Black Swan, Taleb defines the “Ludic Fallacy” as the misuse of games to model real-life situations, but in actual fact both are a perfect metaphor for the other and Taleb goes on to say as much. Each has a set of rules which – if and when adhered to – make their play relatively straightforward and enjoyable. In games, however, people cheat and poker sites go under and in real life governments default and whole currencies collapse.

He creates the hypothetical situation of a “fair” coin being flipped ninety nine times and coming up heads every time. Two fictitious creations of the author – Fat Tony and Dr John – are asked for the chances that the next flip will also bring up heads. Dr John’s answer: “obviously fifty-fifty, independent events have no bearing on each other”. Fat Tony: “near enough one hundred percent heads” on the grounds that any coin that flips heads ninety nine times straight is obviously biased.  In other words, just because a game appears to have rules, doesn’t mean that they are – or always will be – adhered to.

(And even if they are, the probability is never an objective 50% Actually the uncertainty principle reigns even here as Dr Jeffrey Hamilton demonstrated accidentally in October 1972 when in a lecture on probability in the University of Warwick he tossed a 2p coin and was astonished as everyone else to witness it land on its edge!)

The effect of such a consideration in the game of poker has the interesting effect of making it much more a game of aleatory or unpredictable – some might say unquantifiable – risk. The probability that the next card is an ace is arguably far less significant in our overall calculations than the chances that the game we’re playing is somehow rigged, or the likelihood of being robbed on our way to the carpark or the probability that the website on which we’re playing doesn’t actually have our money in it, or… who knows what?

When such breaches occur, we may feel aggrieved; we may be moved to protest; we may seek revenge and we may be justified in any and all such responses. But, hopefully, there is one thing we know for sure above all else… from time to time such things will happen. They will. Life… is unfair. And any long-term strategy that does not account for such possibility must surely be inherently flawed in some respect. If we play the game assuming that nothing unfair and outside the rules of the game will ever happen then we’re not playing the game particularly well.

The only question is what will we do in response? Will we have factored such events into our analysis and strategy? Or will the memory of such events still hurt twenty years on?

Posted 01:01pm by Caspar and filed in Decision Making, Uncertainty

Being in Control

In Struck by Lightening Jeffrey S Rosenthal recalls that in 2002 a group of professional statisticians tasked with planning the annual scientific meeting of the Institute of Mathematical Statistics for July 2004 were initially considering Israel but responded to the increase in terrorism of the period and moved it instead to Spain. Upon looking at the figures, however, Rosenthal shows that between October 2000 and April 2002 319 people were killed by suicide bombing. 750 Israelis died in road accidents during the same period. In other words, delegates were twice as likely to be die in a car crash than in a terrorist attack. Ultimately, of course, the statisticians are right. Statistically, they were safer going to Spain than Israel. But not by much. The point is that they felt much safer. Why?

Control is a key word here. Given a choice people prefer to do things which they think they can control. The more they think they have, the safer they feel, even – as in the case of driving in their car instead of sitting on a plane – that isn’t actually the case.

In general, focussing on the things we feel we can control is no bad thing. In his seminal work The Seven Habits of Highly Effective People Steven Covey divides the concerns of the world and its inhabitants into two categories. The universally applicable category is our Circle of Concern. This is, fairly obviously everything about which we are concerned, from the price of petrol to what we’re going to eat for dinner tonight. Some of these concerns, says Covey, are out of our control. There’s nothing we can do about the price of petrol, we might say, so that stays in our Circle of Concern.

But a subset of all the things than concern us is the set of things over which we have some influence. We can decide what we buy to eat for dinner that night and so we focus on that, because that is what effective people do.

There are three points to make about this very elegant way of looking at the world that account for the phenomenal success of the book in the last 20 years.

The first is that no matter how obviously outside of our circle of influence something seems to be, there is usually always something we can do to effect some small measure of control over something. We can’t change global warming single handedly, for example, but we can reduce our personal carbon footprint. As Margaret Meade once observed: “Never underestimate the power of a few committed people to change the world. Indeed, it is the only thing that ever has.”

The second point to make is that once they have proactively identified all the different ways in which they can assume some degree of control over that which initially appeared to be beyond, effective people do NOT spend their time worrying about things in their circle of concern anymore.

Traffic jams, bad weather, random acts of God… all these things may well be naturally frustrating but the only response that makes any sense is “what can I do?” As a Buddhist priest once explained the essence of Buddhism to me “If there’s something I can do about something, I do it. And if there isn’t I forget about it.” It’s a powerful philosophy and approach to life, there’s no doubt about it.

Finally, though, the point that’s often lost on people as they become seduced by the power of Covey’s prose is that however effective they become, however much they grow their circle of influence through the direction of their discipline and the power of their proactivity… there will always, always, always be aspects of their lives which they cannot control. These elements won’t make them any less effective or successful. They won’t mean that they cannot be great leaders of men. But they will mean that there will always, always, always be uncertainty in everything they do and every decision that they take. And that will never sit right with us.

Ceteris paribus, humans don’t like uncertainty or the unknown. When Lisa Simpson tries to hang out with a homeless but harmless saxophone-player, Marge objects and bundles Lisa into a car saying to the vagrant “It’s nothing personal – I just fear the unfamiliar.”

In his benchmark Hierarchy of Needs Abraham Maslow tells us that after the satisfaction of our basic needs, essential to survival, such as eating, drinking, breathing, sleeping and sex, the next most important thing to us as humans is certainty.  Personal security; financial security; health and well-being and a safety net against accidents/illness and the adverse impacts they cause.

We’d rather drive than take a plane because we feel that more control makes us more safe. We’d rather hold a conference in Spain than Israel because by doing so we feel we have minimised uncertainty. But we won’t eradicate it. Not if we want to eat, or drink, or have sex, or travel from A to B.

Every decision we ever take, we take in a world of uncertainty so we need to understand how we deal with it every day because if we do this we can understand a little more about why we do what we do.

Posted 08:58pm by Caspar and filed in Motivation Theories, Uncertainty

Taking Risks on Life’s Journey

The first thing to understand about betting on a roulette table is that when you bet red, at the simplest level, the casino is betting black. And neither is more likely than the other. Indeed, according to some people’s definitions of the word, casinos are “gambling” in the same way that their punters are.

They’re not, of course, which is why most people use the word “gambling” incorrectly and why we need to calibrate our terms when we talk about this complicated but fascinating subject. Every time the wheel is spun, however, uncertainty reigns and nobody but nobody can tell you with any certainty what the result is going to be. It is the visibility of uncertainty in a casino – as opposed to its often invisible nature in life – that makes it such a wonderful little laboratory in which to study the way people that people react to it.

As a young man I never took drugs, bungee-jumped or even placed a bet. Activities associated with risk just never appealed to me. Then, aged 26, – quite out of the blue – I quit my job as a reasonably successful writer for film and television to become a professional poker player.

This was long before poker became the multi-billion dollar industry that it is today. In 1999 poker was the preserve of a few eccentrics and iconoclasts who had either never known any other “career” or who had dropped out of one because it wasn’t offering them the thrills they dreamed of as a child. I guess I fell into the latter category.

With hindsight, it was the best career move I ever made. I learnt more from three years in Las Vegas than any other single formative experience. Playing poker for 10 hours a day 6 days a week for three years certainly taught me a thing or two about risk and just how little most people understand it.

Most people assume that – as a professional poker player – I was a gambler but the fact is that “gambling” is the act of placing a bet where you have the worst of it. In the long term, if you “gamble” you will lose money. Playing poker professionally is not about gambling but taking a series of “calculated risks” with the aim of making a healthy long-term profit at the end of the day.

Isn’t that the aim in business too? What poker players call “bets” business people call “investments” but the uncertainty is still there. We live in an increasingly uncertain business world where it is impossible to guarantee the outcome of anything.

In my seminars I demonstrate how to bet on the roll of a die and make money – even though you lose five times out of six – and explain why professional sports bettors aren’t looking for the horse most likely to win. The implications of that often changes the way people view risk forever.

Operating a business in the knowledge that you will be profitable in the long run, even though some of your investments will fail, is something that the best companies in the world have known for many years: companies like 3M, HP, and Google have created cultures that encourage risk taking and accept failure as a necessary part of their calculations. They don’t sweat the short term any more than a casino manager sweats when someone wins a lot on roulette in one evening: they know that the house will bust them in the end, just as the great company knows that great ideas will always be produced by a healthy culture of innovation and adaptation.

After three years in Vegas I came home to England and effectively became an entrepreneur. I know that I could not possibly have done this without the knowledge and skills that poker gave me and it is a pleasure for me to foster discussions around this whole area with people in business today.

Posted 12:27pm by Caspar and filed in Risk, Uncertainty

Utterly Incredible

If the future wasn’t inherently uncertain then every decision that we ever make would be easy. We’d know exactly which employee to hire, which house to buy, which meal to eat, which hand to fold, which pension plan to invest in, which route to take to work, which boy to kiss, which horse to bet on and what’s inside the box. Life would be very different. Fundamentally, unrecognisably so in fact. Tragically, or fortunately, this is not the world we live in. Continue Reading »

Posted 10:50am by Caspar and filed in Uncertainty

Risk Taking in Poker Business and Life

The future is uncertain. For all of us. Hopefully one of the positive things that we all might take from the “current financial crisis” is the numinous truth of that thought. Perhaps understanding that even the money we have sitting on deposit in our current accounts is not 100% safe will serve us all well in the long run.

Continue Reading »

Posted 01:23pm by Caspar and filed in Risk, Uncertainty