Stock Market A to Z: Strategic Investment vs. Gambling
Despite evidence to the contrary, the popular perception persists that investing in stock market is like throwing dice at a casino. But this isn't quite true.
Most experienced investors will tell you that investing in stocks is about as exciting as watching grass grow. That’s because most of the time, investing means doing nothing.
You could, of course, choose to anthropomorphize your investments. Then you could celebrate your heroic gains and decry dramatic losses. But great investors don’t do that. Instead, they evaluate their investment processes and stock strategies, consider various risk factors, and watch the math work.
Do you believe me when I say that investing in stocks is like watching math unfold in real time? Most people don’t. The media doesn’t stick to the “it’s just math” line. Scandals, high-frequency trading, and dramatic market movements make the headlines.
In the media’s hands, Wall Street looks like a refined version of Vegas.
Then there are the day traders who treat investing like a Final Fantasy video game. They’re quick to post their (somewhat incoherent) thoughts on the “Wall Street Bets” forum on Reddit. And you’ve probably got a crazy uncle who lost thousands in the stock market.
The narrative might go something like this: I saved $15,000, and I worked hard for that money. If I lost $10,000 overnight in the stock market, I would feel devastated. When those are your investing stories, you probably don’t want to risk your hard-earned dollars in the “Wall Street Casino.”
Strategic Investment and the Inflation Casino
But should you only focus on the downward risk? Don’t ignore the fact that without strategic investment, you could lose big — thanks to the big bad risk of inflation.
The Federal Reserve Bank influences the supply of money in the United States. Their stated goal is to increase core inflation (measured by a fancy statistic called Core PCE) by two percent a year. This means that the Fed wants your money to lose two percent of its value by next year.
For most people, a guaranteed two percent loss is better than a possible 50 percent loss. But your money loses about two to three percent of its purchasing power every single year.
In 35 years, your $15,000 will be worth about $7,500. Given this scenario, I would say that it’s riskier if you don’t invest. This is why I like to focus on “positive” risks instead of “negative” ones when I think about investing in stocks.
Making a Strategic Investment vs. Gambling
Investing — in the proper sense of the word — is based on mathematical expectancy. If you take the same “bet” enough times, you know that you’ll come out ahead.
Let’s say that you went to Vegas to play roulette. On the roulette wheel, black comes up half the time and red comes up half the time. (Technically, this isn’t exactly true, because the ball could end on zero. But we’ll ignore that for now.)
If you bet a dollar on black and the ball ends on black, you get $2.00. If the ball ends on red, you lose your dollar. Let’s say that you bet one buck 10 times. How much would you expect to “earn” in this situation? Nothing. You might walk away $10 richer, but you might also walk away $10 poorer. Or you might walk away with exactly $10. The odds of making money or losing money are the same.
Now, consider a different payout schedule. Let’s say that betting on black gives you a $2.00, so you get $3.00 total if your ball lands on black. Red remains at the $1.00 payout. Would you bet black or red? A gambler might choose red based on his or her gut, but an investor knows to choose black every time.
The odds of the ball landing on black are the same as before, but the payout is bigger. Thus, the mathematical expectancy of a return is higher. The more bets on black you make, the more likely you’ll win more money.
Similarly, successful investors make money by focusing on the investing process. A process orientation allows investors to “take the same bet” over and over. In time, this yields profit.
Investing isn’t gambling. It’s not hoping for a return. Strategic investment means knowing that you’ll make a return. Gamblers hope, but investors know.
Dollar-Cost Averaging and Other Stock Strategies
One of the simplest processes for investing involves dollar-cost averaging in broad-based market indexes. This means that you invest the same amount of money every paycheck in a low-cost fund that closely tracks the performance of the total stock market. The process I’ve outlined may sound simple, but it’s incredibly effective. In fact, if you had followed this process last year, you would have outperformed two-thirds of actively managed investment funds.
Active management and stock picking might be right for you, but don’t dabble in those areas until you’ve had time to learn about process first. I recommend investigating more complex processes with Investopedia’s free stock market simulator. This will help you learn about strategic investment and understand the math and process without putting your money at risk.
This is the fifth installment of a multi-part series on investing. To start from the beginning, click here.