Do you ever feel like investing is a bit of a gamble? The stock market can sometimes feel as unpredictable as the casino. Take Joe, for example. He starts investing with a $25,000 deposit, $10,000 of which he uses to buy a hot stock his brother Frank recommended. If Joe is lucky and the stock goes up, then he’ll be going back to Frank for advice in the future. If Joe is unlucky and the stock goes down, maybe Joe will get his advice elsewhere next time.
Joe’s actions sound a lot more like gambling than investing. He is making short-term bets without keeping his long-term financial future in mind. To illustrate this, we’ll consider a game of chance, like roulette.
You can bet many ways in roulette. We’ll focus on one of the simplest bets: on odds or evens. Of the 36 red and black numbers from 1 to 36, there are 18 odds, and 18 evens. If those were the only numbers to bet on, you would have an 18/36 or 50/50 chance of winning if betting on odds. So the winning bet pays one to one, or $10 for each $10 bet.
But there is a catch. There are two extra numbers: zero and double zero. There are actually 38 numbers that the ball can land on, so the chances of winning are 18/38, or less than 50/50. With a finite amount of money, the gambler’s probability of losing his money over the long run is 100%. The gambler may have many great runs and enjoy many winning streaks as 18/38 is teasingly close to 50/50, but if he returns to the table to play thousands of games, his gambling will result in a loss.
If we were to visualize this on a graph, it may appear reminiscent of the performance of the stock market, at least in the recent past. While buying and selling individual stocks in the short term can afford the potential for high returns, the strategy also carries the risk of a swift loss, similar to gambling.
Joe can mitigate his risk by constructing a well-diversified portfolio of many stocks and holding it for a long period of time, bearing in mind his tolerance for market volatility and the potential for loss. By doing so, he’s not gambling on an individual stock over the next five minutes, but instead investing in the overall economy over the years. Long-term investors are still subject to the chance that broader economies can falter, but the specific risk of individual stocks is eliminated.
The long time horizon is in our favor. We bet on the systematic risk of the economy. It’s argued that, over a long period of time as the economy grows, population increases, new things get invented, and production processes are improved, stock markets can deliver a positive return while they may suffer setbacks in the short run.
Joe should invest instead of gambling by taking the $25,000 in his brokerage account, going through a rigorous analysis of his cash needs and his risk tolerance, and deciding on the appropriate allocation of stocks, bonds, cash, and other assets. He should make periodic adjustments over time and should avoid acting on impulse to prevent behavioral failings and biases that may negatively affect his returns. By doing so, he doesn’t have to rely on someone’s advice. He has mitigated systematic risk and has time on his side — two things the roulette table just can’t offer.
Robert Dubil is an associate professor at the University of Utah David Eccles School of Business. He earned his PhD in finance from the University of Connecticut. Starlee Holman and Alison Andersen, employees of Zions Bank, assisted in the writing of this article.
Investment products and services offered through Zions Direct, member of FINRA/SIPC.
- Leaving rates alone, Fed sees ultra-slow pace...
- 10 years after housing bubble, damage lingers...
- World stocks leap as fears ease over British...
- Nearly 1 in 3 on Medicare got commonly abused...
- Yellen faces GOP criticism over weak economic...
- Financial Tips & Tricks: When is bankruptcy...
- Michelle Singletary: Should you replace your...
- Dave Ramsey says: You might not need life...
- 10 years after housing bubble, damage... 6
- Costco begins new credit card agreement 4
- Yellen faces GOP criticism over weak... 3
- Nearly 1 in 3 on Medicare got commonly... 1
- Michelle Singletary: Should you replace... 1
- Leaving rates alone, Fed sees... 0
- World stocks leap as fears ease over... 0
- Financial Tips & Tricks: When is... 0