CFI Blog

Do You Have to be Lucky to Beat the Market?

“If you can’t spot the sucker in the first half hour at the table, then you ARE the sucker.”
–Matt Damon, Rounders

I used to play online poker. A friend of mine had shown me his screen playing Texas Hold ‘Em in the first year of business school, back in 2001. I had played the family version of penny ante poker as a little kid, so I knew the rules of the market, but I didn’t realize that you could play other people online for money. Wow.

There was one minor problem. As the British would say, we were skint. While my law school summer internship had allowed us to slay the demons of credit card debt, we weren’t exactly rolling in free cash flow. So, I had to play the free games.

The way that these sites got you hooked was to offer free games and these enormous tournaments where the last few players remaining got a little bit of real money in their accounts. It was usually the top 10, and the winner would get something like $10. If you think about all of the time required to play a knockout tournament of 2,000 players just to try to win $10, the ROI of the time was ridiculously low (to see how Monkey Brain overvalues free items, you can subscribe to my 52 Week Game Plan. It’s free…and you won’t overvalue it!). However, since I didn’t feel like I could justify gambling even $10 to my wife, I plugged away until I won.

Eventually, I took that $10 and parlayed it into a pretty healthy bankroll. I paid for quite a few vacations and a couple of entries into the World Series of Poker (and, yes, I claimed my winnings on my taxes).

Was I some phenomenal player who was mopping the floor with the whales? No. What happened is a phenomenon expertly explained by Michael Maubossin in his article “The Paradox of Skill: Why Greater Skill Leads to More Luck.” Top poker players rely on what they call “dead money” for their profits. The house – either the website hosting the poker or the casino – takes its cut off of the top of every pot. It’s called the rake. So, if there’s a pot of $10, the casino will take fifty cents, and leave everyone playing for $9.50. If you take ten people who are equally skillful, then, over time, they’ll all get their run of good and bad cards, and they’ll cancel each other out. Nobody wins except the house.

That’s why good poker players rely on bad poker players for their profits. Think of the rake – the casino’s piece of the action – as a constant leak in a tub of water. In order for you to continue to be able to take water from the tub, you need a faucet supplying new water. That’s what bad (mostly new) players are – they’re the supply of new money which the more skillful poker players are able to extract from them.

As long as Internet poker was booming, then there was going to be a steady stream of the uninitiated, falling victim to the Dunning-Kruger Effect, where you think that you’re better than you are at something. If all you needed was access to your credit card to fund your playing account, a little bit of bravado, and some naiveté, then the skilled at the poker table could continue to fund themselves.

However, once Congress passed the Unlawful Internet Gambling Enforcement Act (UIGEA), the world of online poker changed. No longer could regular players count on the uninitiated to provide an endless stream of new, dead money. The flow of water from the faucet had stopped, and the endless drip from the tub in the form of the rake continued apace.

Compounding the problem was the proliferation of information about how to get better at poker. At one time, Super System from Doyle Brunson was the only real, comprehensive book about strategies of poker. While it was commonly read by the skilled players, its general penetration in the greater poker playing community was fairly limited. New sites such as the Two Plus Two forums and PocketFives popped up, and, soon enough, the barrier to entry for learning enough information to make you a solid poker player had been reduced to nearly nothing. With a few hours of research and a commitment to hours of playing, it wasn’t difficult to become a fairly skilled poker player.

This is where the paradox of skill started to take over. The overall skill level of the entire online poker economy had increased dramatically, and the spread between best player and worst player shrunk in proportion. The flow of new people at the wrong end of the tail – the least skilled – had stopped. The average skill of the bottom 5% who were getting lopped off each year continued to increase, while the ceiling of skill never really changed, as, theoretically, there is an upper limit to the amount of poker playing skill one can actually possess.

As the paper explains, when there is a decrease in the standard deviation of skill in a community, then the impact of luck will become more and more disproportionate. When there is wide variance of skill, then either luck or skill can account for exceptional performance. When there is narrow variance in skill, then skill rarely accounts for exceptional performance, and it falls to luck to change one’s fortune.

How does this relate to investing?

The same idea applies. Think back to, say, the early 1980s. At that point, there were very few firms that had access to high powered computers that could do extraordinary amounts of number crunching to identify opportunities in the market that the average investor couldn’t identify. Furthermore, there were few investors who could perform an accurate analysis of the underlying performance of the companies they were investing in. To get clear insight required some sort of knowledge that most people didn’t have – either a great algorithm matched with a computer hefty enough to crunch the numbers or someone on the ground at a company to understand what was happening along with someone or a team with the analytical capabilities to digest that information and to make the correct call about what to invest in. Therefore, the disparity in skill between great investors and poor investors was pretty wide.

Now, though, think about how one gets an edge in information to have an insight that nobody else will have. Short of insider trading (which gets picked up on fairly quickly), almost anyone has access to the same set of information upon which they can make decisions. Between the Internet, CNBC and Bloomberg, and personal computers that can perform calculations at blistering speeds, the difference in skill between the most adroit of investors and the average investor has shrunk considerably.

Furthermore, there is a rake in the investing game. Commissions, loads, and management fees give money to the casino, reducing the amount of money available from which investors can make a profit. Granted, the barrier to putting new money into the pool is much lower than it was for online poker, but there is still a drip in the tub.

What this means is that as information and insight continue to proliferate and become more and more available to the average investor, the role of skill in investing will diminish, and the role of luck will continue to grow.

This doesn’t mean that Monkey Brain will realize how much of a factor luck plays in investing success or failure. Monkey Brain hates admitting he was lucky, but he loves telling you that he was unlucky. Let’s see how two primary biases will affect the story he tells you if you try to actively manage your money:


  • Selection bias. Whenever something goes wrong with an investment, Monkey Brain will fall victim to selection bias and tell you that this was simply bad luck. He won’t see a trend, but, instead, will pick and choose where something went right to justify the decisions.
  • Recency bias. When something does go right, Monkey Brain is going to zoom in on that instance as the example to use to show that he has it all under control and is going to continue to make gains like that rather than reverting back to the mean of general underperformance against low-cost index funds.

If there is a shrinking of the distance between highly skilled investors and average skills in investing, then, in general, the overall performance of the whole lot is going to decrease, since no set of investors can exploit an enormous informational advantage over everyone else.

For me, luck is not a good investing strategy. So, what can you do in an environment where it’s going to be very difficult to suss out who has luck and who has skill?

  • Low-cost funds. Don’t let cost be the rake to drain what you have to invest with. Avoid loads. Avoid commissions. Look for the lowest-cost funds available.
  • Index funds. The easiest way to minimize the variance brought about by luck (and its counterpart, lack of luck) is to play the market. You’ll always be slightly below the actual market return, as even low-cost index funds have to pay something to buy and hold those stocks for you, but at least you won’t get whipped around by the vagaries of Lady Luck.

I called time on my online poker-playing career a few years ago. I realized that I was not going to be good enough to make enough money within a few years to be able to retire, and, furthermore, that the lower end of the tail was catching up to me with regular consistency. I had a business to run and didn’t have enough time (or risk tolerance) to devote myself full-time to improving so that I could keep my relative position against the overall pool of players.

The same can be said for my decision not to invest in stocks or in actively managed mutual funds. I didn’t have the time, or probably the acuity, to be able to invest enough in myself to develop and maintain an edge against the overall investing populace so that I could consistently make above-average returns. In fact, my track record of picking wasn’t particularly good in the first place. I had more ground to catch up on than the average bear, and the margin for error wasn’t particularly high. It doesn’t take many bad choices to decimate an investing portfolio and leave you starting over.

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John Davis
John Davis is a nationally recognized expert on credit reporting, credit scoring, and identity theft. He has written four books about his expertise in the field and has been featured extensively in numerous media outlets such as The Wall Street Journal, The Washington Post, CNN, CBS News, CNBC, Fox Business, and many more. With over 20 years of experience helping consumers understand their credit and identity protection rights, John is passionate about empowering people to take control of their finances. He works with financial institutions to develop consumer-friendly policies that promote financial literacy and responsible borrowing habits.

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