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The Golden Rules of Money Management
By Robert Wachtel
In the previous money management articles, I introduced the reader to the “Kelly criterion” -- a mathematical rule designed to choose the optimal amount to bet in various gambling situations, including backgammon -- and explained some of the typical psychological obstacles that a gambler will need to overcome when trying to apply this rule . Having laid this abstract foundation, I would like to get a little more practical. Here, then, are a few of the golden rules of money management. The first rule is the big one, the central axiom of the subject. The others are either corollaries or elucidations of number one.
(1) Try to be a Kelly robot. That is, try to be as cold, unemotional, and mechanical as possible in applying the Kelly criterion (betting X% of your bankroll when you have an X% advantage) to all of your gambling opportunities. Bet Kelly whenever psychologically possible.
(2) Having done all you can to transform yourself into a Kelly robot, come to terms with your own psychological limitations. For example, every gambler has a range of stakes that define his comfort zone. If he plays a game of skill (or, like backgammon or poker, mixed skill and luck) for stakes that are too low, he will not be stimulated enough to concentrate. By the same token, if he plays for stakes that are too high, he will tend to “choke” -- to become paralyzed by fear and unable to do the things he knows are right. The moral of this observation is that if Kelly tells you to play for stakes that are outside your comfort zone, you need to disregard Kelly. The consequence of continuing to play when you are bored or frightened, rates to be far more serious than that of not betting the optimum amount on a given proposition.
Interestingly, this phenomenon (of encountering stakes that are outside of your comfort zone) may occur as a simple consequence of following Kelly! As a poker player, for example, you may go on a “rush” where your bankroll doubles or triples in a short time period. Now, all of a sudden, Kelly will be telling you to play for stakes higher than any you have ever experienced. It is OK, at this point, to slowly ease into a new comfort zone. Play ½ or even ¼ Kelly until you are accustomed to your new financial environment. Conversely, if you go on a losing streak, Kelly will begin to tell you to play for stakes that you may find uninteresting or even humiliating. Again, it may take you a while to come to terms with your new circumstances. During that acclimation period, you are better playing double or even quadruple Kelly if it helps you to focus and enjoy the problem solving required of a winning player.
Similarly, if you discover that you have other psychological quirks which you are unable or unwilling to eradicate (like developing “winner’s fatigue” when you get a little bit ahead in a gambling session), it is probably best to acquiesce to these irrational elements in your makeup. True, you will be deviating from Kelly in doing so; but that is better than being bothered or distracted in gambling situations where clear thinking is crucial.
(3) Remember that the Kelly criterion is a guide to maximizing wealth, but not necessarily happiness. Money, after all, has only a limited ability to deliver satisfaction, an insight that the economists designate as its “marginal utility.” What this means for most of us is that we are not infinitely greedy. Once we have acquired enough money to relax in bourgeois comfort, the pleasure we would obtain through a percentage increase in our fortune is not as great as the pain we would experience through a percentage decrease in it. So, for example, if you give the average citizen with moderate appetites $1,000,000, he might well retire and consider himself set for life. Gaining an extra half-million would neither substantially change his lifestyle nor make him much happier; but were he to lose that much, his world would take a drastic jolt. He might begin worrying about his finances again, lose his sense of self-worth or esteem, or perhaps even have to return to “the salt mines“ : a job he hated.