If you play long enough in Las Vegas you will eventually lose. The odds are stacked against you. In the stock market the opposite is true. Stock prices are based on corporate earnings and over time corporate earnings go up. Historically they have increased approximately 7% per year over ten-year or more periods. The amount that investors are willing to pay for these earnings (the price-to-earnings ratio) can soar to well over 25 in times of excitement and plummet to under 10 in periods of despair. But if you assume an average P/E of 15 and assume that earnings go up 7% per year, then the long term investor will make money. But there is a big IF here, investors have to stay the course to get this return. This is not as easy as it seems.
This page is based on some observations about gambling from The Economist and from Marc Faber’s excellent monthly newsletter, The Gloom, Doom and Boom Report (June 2018). The Economist article notes that although gambling is a losers bet, experts can make a difference. For instance there is a lot of math involved in gambling which experts use to their advantage. If you roll two dice, there are 36 possible pairs of numbers. There are six ways to get a 7 but only one way to throw either a 2 or a 12. The experts understand this and bet accordingly. But the uneducated can also play smart. They can settle on a basic strategy and then just stick with it. For instance in poker it means choosing in advance which hands you will play and how you will bet them.
As mentioned earlier, investors can take lessons from successful gamblers. All we have to do is adopt a sound basic strategy and then…stick with it. For instance if you decide that a 60% stock and 40% bond allocation is right for you then just do it, rebalance annually, and stop fretting.
But this takes discipline. In times of rising prices it is easy to get giddy with excitement and boost your stock allocation and vice versa when prices are plummeting it is easy to sell everything to escape the pain.
Marc Faber tells the story of two very successful punters at Hong Kong’s Happy Valley Horse Track. Hong Kong is crazy about gambling and in the 1980’s and 1990’s the bets at the two Hong Kong tracks exceeded all bets placed at all U.S. tracks. Bill Benter and Alan Woods came up with a sophisticated algorithm to determine winners. They were disciplined and stuck to their numbers.
For Faber there are two lessons here. First if you are smart enough (or lucky enough) to come up with a better betting formula your greatest success will be early on. Once others develop their own algorithms the returns get diluted. Second, you must be disciplined and stick to your strategy.
The chart below shows what happens when investors don’t stay disciplined. The chart compares the return of mutual funds with the returns that investors in those funds actually earn. Most investors lose between 1½% and 2% per year. Why? Because they fail to stay invested in the fund. They get excited and buy at highs and then turn around and sell at the lows. The moral of this story is to figure out the strategy most appropriate to your needs and then…learn to go sit quietly in your room.