How Poker Explains the Battle of Passive and Active Investing

Tracy Alloway (0:09)

Hello, and welcome to another edition of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:13)

And I'm Joe Weisenthal.

Tracy Alloway (0:15)

So, Joe, every once in a while, we like to talk about poker on this show, right?

Joe Weisenthal (0:22)

That's true. We've had a few poker and gambling episodes. I think it's one of our popular recurring themes.

Tracy Alloway (0:31)

Yeah, and every time I usually manage to make my complete incomprehension of poker quite obvious. But one thing I do understand, and I think one reason we end up talking about poker so much is because it's a game that's kind of all about a combination of luck and strategy, right?

Joe Weisenthal (0:51)

Yeah, you know what I like? You always point out with these poker episodes that you don't really play poker, that you're not much of a gambler.

Tracy Alloway (0:58)

It's my caveat.

Joe Weisenthal (0:59)

But you do seem to intuitively recognize that through the study of poker, there's a lot of interesting stuff there. So even though it's not your thing, you grasp its power as a metaphor.

Tracy Alloway (1:13)

Well, here's my...

Joe Weisenthal (1:14)

Is that true?

Tracy Alloway (1:15)

I would hope so. I would hope that I'm able to talk about poker in the most basic sense, but please don't ask me about any hands and things like that.

Joe Weisenthal (1:25)

Wait, Tracy, which is better, a full house or a flush?

Tracy Alloway (1:31)

A full house?

Joe Weisenthal (1:33)

Yeah, that's right.

Tracy Alloway (1:35)

Maybe I should play poker. Should we play poker together?

Okay, look, the reason I'm bringing up poker yet again is because there's someone who's actually going to be able to connect poker with one of the biggest trends that's currently happening in financial markets, and that is, of course, the debate between active versus passive investment management.

Joe Weisenthal (1:56)

Right, and I think we've also talked about this topic too, or if we haven't, we really should have this idea that there's this huge wall of money every month, every day, leaving traditional mutual funds, traditional investing strategies, and opting for more passive strategies that are lower fees, not really intended to beat the market, but at low cost, essentially replicate the market's performance.

Tracy Alloway (2:21)

Yeah, that's right. And so the guy who we're going to speak with today has actually written, well, he's written a lot about poker. He's written a lot about luck and investment strategy, but he has also specifically written a really great paper about how passive investing, the rise of passive investing, provides both opportunities and challenges for active managers. And he kind of likens it to the idea of weak poker players either staying at the table or leaving. So it's a really interesting analogy.

Joe Weisenthal (2:54)

So should we get started?

Tracy Alloway (3:05)

Let's introduce him. Okay, so we have Michael Mobison. He is, of course, the head of global financial strategies at Credit Suisse.

Michael, thank you so much for joining us today.

Michael Mauboussin (3:16)

Tracy, Joe, great to be with you guys.

Tracy Alloway (3:19)

I mean, shall we start with that poker analogy? Why did you reach for poker when it came to describing the dynamic between active versus passive management right now?

Michael Mauboussin (3:30)

You know, Tracy, I actually think it's a very, very powerful way to think about this problem. So let's imagine I say, Tracy, Joe, do you want to come to my house Friday night to play poker?

Your first question, I suppose, assuming you like to make money is, who else will be there?

Joe Weisenthal (3:44)

First of all, for what it's worth, I'm just going to say yes, because I'm a junkie. But yes, if I were smarter and more rational, I would ask that. But I would actually say that.

Michael Mauboussin (3:52)

So Joe, you ask, you say, who else will be there? And I say, hey, a couple of really rich players who are very bad at poker, you'd be like, I'll be right over, right? Because you could see where your money is going to come from. But by contrast, if I say, hey, the players I come from are really great players, they're really sharp.

You probably know they're better than you. You probably say, I got better things to do.

Right. So to me, there are a couple of really big lessons from poker and thinking about this active indexing discussion. One is, it's very important for active managers to recognize for every winner, there has to be a loser, right? $1,000 walks into my house to play poker on Friday night. $1,000 walks out, right? So it's going to get shuffled around, but that's the main thing, is there's got to be a loser for every winner. And second is, if you pay to play, the amount of money walking out will be slightly less than the money walking in.