The investment process
Probability on your side
Some people think they are investing when they really are not. I’m thinking here about gambling, trading and risk intolerance.
Let’s define terms. John L. Kelly Jr., who is famous for developing the now well-known betting system called the Kelly Criterion, said that gambling and investing differ only by the minus sign. What he meant is that an investment is a favourable bet. Gambling is an unfavourable bet. (Poundstone, W. 2005 Fortune’s Formula) p.75
When you are placing bets at a casino, the house has an edge. In probability terms, the bettor’s wager has a negative expectation. As Poundstone points out, almost everyone who gambles goes broke over the long run. It’s called Gambler’s Ruin. Professional gamblers will only gamble if they have an edge. They are, technically speaking, investing not gambling. Their secret sauce is money management. They may use a system similar to the Kelly Criterion. But, they need to have an edge to win.
Readers who want to look further into the use of the Kelly Criterion in investing should take a look at my post Lessons from the world of gambling
So, investing is a favourable bet. Here’s how Warren Buffett explained it at the Berkshire Hathaway Annual Meeting in 1989: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”
With equities, investing is only about buying a stock based on the fundamental merits of the company (i.e. probabilities on your side) for an indefinite holding likely for the long term, with the intent of obtaining dividend income along the way and also capital gains. Collateral decisions involve things like asset allocation, diversification and balance.
Because the world is fundamentally uncertain there is no way to calculate these probabilities. The calculation must be done intuitively. This is where investing experience comes in.
Taking a flyer
Some investors think they are investing when they are really gambling. A classic case would be an investor taking a flyer on a story stock. We have all seen them. The company has a concept that could win it a share of a huge addressable market. All it has to do is capture a 5% share and investors will make a fortune. The reality is that only a vanishingly small number of these kinds of companies succeed. The lure is the big payoff. The psychology is the same as buying a lottery ticket. It’s gambling. It’s an unfavourable bet.
Some people think they are investing when they are really trading. Trading is buying and selling stocks with a fairly short holding period. The holding period might be a matter of weeks or months or even a matter of seconds. This is an entirely different animal than investing.
Some professional traders are able to make a go of it. I have no idea how the successful ones do it. Individuals may do it for the thrills. I think of day traders and the like. I suspect almost all of them go bust.
I recently read some advice from a commentator. The idea was to help people get the urge to trade out of their system. The suggestion was to “Have a small side account.” The rationale was: “This allows them to get their need to trade and make changes to their portfolio out of their system, while also minimizing the impact of that trading on the overall portfolio.”
The only good thing about such an idea would be the lesson learned from losing the money. The amount committed to the trading account would be the tuition fee for the lesson. It should be high enough that the loss inflicts real pain, but not so high as to cause real financial damage. For sure, no extra money should be put in the account when the initial stake is lost.
Many years ago I did this with an account designed pursue a spread and straddle strategy recommended by a broker. You don’t need to know what that was, other than that is was high risk and proved to be low reward. I lost most of the money in the account and got the urge out of my system.
The flip side from the folks who think they are investing but are really gambling or trading is the investor who is so risk averse that their ‘investing’ is not really investing at all.
I had a conversation with a legal friend many years ago. He was about 15 years older than I. He was thinking about retirement in about 5 years. We talked about investing. He told me that the biggest mistake he had made was to be too conservative in his investing. He had almost all of his savings in bonds, certificates of deposit and other fixed income. By being risk intolerant he had undermined his retirement.
Giving absolute priority to capital preservation risks capital erosion through inflation. If you put your money in your mattress you are guaranteed to lose to inflation. If you put your money in a bond the face value of the bond will always lose to inflation. There is a place for bonds and cash at certain times as I discuss in ten posts on different aspects of asset allocation.
In particular you might look at My thoughts on asset allocation
Another couple of ‘investment’ vehicles I have trouble with are gold and crypto. I don’t think either of them can truly be called investments. See my post Gold is not an investment
Investing properly done gets the probabilities on your side. It doesn’t have to be high risk. A few ups and downs in the stock market come with the turf. Some investors foolishly take gambles or trade even when the risks outweigh the likely rewards. Some other investors think they are taking no risks with fixed income. In fact their risk is that they won’t reach their goals.
To dig a bit deeper into the whole notion of investment risk-taking, take a look at:
For readers wishing to dig further into the idea of a sound investment process check out The Motherlode Part 4: Principles of Operation
This Part contains four chapters:
You can reach me by email at firstname.lastname@example.org
I’m also on Twitter @rodneylksmith
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