Do you invest like a gambler, or are you the house?

Photo by Kvnga on Unsplash

A quick disclaimer before we get started today – investing carries risk. Nobody can predict the future of markets and investments can lose money. Past investment performance is not an indicator of future results. What I hope to discuss in this article is the past frequency of market gains vs. market losses, and how this has historically played out for the long-term investor. Discuss with your financial advisor how this information pertains to your individual situation.

Are you a gambler, or are you the casino?

People like to make comparisons between the stock market and gambling. “I don’t want to gamble my money on this stock,” or “The market is too risky, like a casino!” I heard this especially often when I worked with individual investors at an online brokerage firm. I grew to hate the comparisons because investing does not have to feel like gambling. Eventually, I developed a way to take the dreaded gambling analogy and revise it in a way that put the focus back on long term investing, and away from short term trading, uphill odds, and nickel slot machines.

What if, instead of being the gambler, you were the house?

Imagine a casino with hundreds of gamblers playing all the different games that exist against the house. Blackjack, craps, slot machines, something called keno. All these games have odds that favor the house. All of them. The casino does not have to pick and choose which tables to open each day. They don’t close down the craps table because someone went on a hot streak last night, and they don’t unplug “Wheel of Fortune” because they’re worried somebody’s aunt is going to win $100,000 today. Instead, the casino knows that by having a variety of games available, all with the odds favoring the house, they will win more often than they lose and over time that will add up. There’s even enough extra money to provide free drinks to the players.

So what does thinking like the casino (and not like the gambler) have to do with investing?

I mentioned that when you go to a casino, the house has better odds that you do for every game. For example:

• Blackjack – the house “edge” is 1 – 2%. Blackjack is generally the least lopsided game for the player.
• Roulette – a house edge of 2.8% - 5.2% depending on the table.
• Slots – as much as a 20% house edge.

Compare those patterns with some of the statistics behind the S&P 500, the index of the 500 largest publicly traded companies by market capitalization (market capitalization = the value of all a company’s stock shares added together).

• From 1928* - 2020 the S&P 500 including dividends has been positive at the end of the year 68 times or 73% and negative just 25 times or 27%.
• The average annual return from 1928 – 2020 is 11.7%
• $10,000 dollars invested into the S&P 500 in 1990 would be worth $106,213 in 2020

Those sure sound like odds that favor the individual investor. History has rewarded investors who have spread their investments over a broadly diverse allocation and who have kept their funds consistently invested over the long term. So why do people continue to feel like investing is a “gamble”?

Sometimes, when markets go down, they go down hard

The statistics above paint a very positive picture for the markets in most years. But we cannot ignore the reality that:

• In 6 of the 25 annual losses from 1928 - 2020, the loss was greater than 20%.
• Pullbacks of 5% usually happen 1 – 2 times per year, and “corrections” of 10% are common every couple of years.

Long term investors must withstand step losses from time to time, just like the casino has to pay out a big winner every now and then. This is why your financial plan should ensure that you have an investment allocation you can stomach and short term reserves when you need cash that are not invested in risky assets.

The psychology of loss aversion looms large

The concept of “loss aversion” leads us to weigh the negative of investment losses more heavily than the positive of market gains. That means even if we experience investment losses less frequently than gains, or when we experience those losses on retirement money we won’t be spending in the near future, they still hang around in the back of our mind. The story of a family member who invested too aggressively or put all their money in one company and lost big can make us feel like investing is a roll of the dice. Your financial advisor can help you avoid these common investing mistakes.

More than likely you are investing like a gambler, not like the house

When people tell me they are gambling in the market it usually means they are speculating, whether they realize it or not. Unless you are a professional and spending your days digging deep into company book values and earnings projections, most speculators I meet trade for short-term gain. The criteria for picking up a few shares of a stock is usually because they like the product, they saw it featured in a positive news story, or simply because someone on a message board “likes the stock”. No wonder it feels like a gamble, because it is! Speculators can win big when they pick the right stock. Unfortunately, they are up against gamblers odds: a study examining returns from 1983 – 2006 found that 64% of stocks had a lower return than an index of similar stocks. Simply put, most stocks underperform the average. Those are odds I'd rather not be up against.

What does it all mean?

Investing and speculating are two different things. When someone says investing their money in one or two stocks feels like a gamble, I often ask if they have considered the perspective of owning the casino instead of being the gambler - owning a little bit of all of the action knowing that historically stocks as a whole have gone up more often than they have gone down, instead of watching individual stocks like slot machines trying to pick the one that is just about ready to payout, even though the odds might be against you.

Is it OK to speculate sometimes? Sure, just like it’s OK to take a roll of the dice at the craps table every now and then, or to take a few dollars and live dangerously like Austin Powers at the blackjack table as long as you know your limits.

But when it comes to your long term nest egg, you don’t have to speculate, and it doesn’t have to feel like gambling.

_{*The S&P 500 was introduced in 1957. Prior to that the “S&P Composite” had fewer than 500 companies.}

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