Investing Isn't Gambling (Usually)

When Genius Failed (Photo credit: Wikipedia)

No, Wall Street isn't Las Vegas. Investing is not gambling.

Notice I use the word investing, not speculating.

NOTE: I am not an investment adviser or broker and this blog post is meant only as an overview of basic investment research and theory within the academic discipline of economics. If you want investment advice, talk to a financial professional and your retirement planning specialist. 

In 1973, Burton Malkiel published the seminal work on efficient market theory, A Random Walk down Wall Street. If you had invested $100,000 that year in a broad, large-cap index fund and held it for the next 30 to 40 years, you would have earned better returns than if you had invested with more than 85 percent of active fund managers. Not by just a little bit, either. According to Charles Wheelan's Naked Economics, you could have outpaced the "stock pickers" by $140,000 with a simple S&P 500 index fund.

In a Las Vegas casino, the house returns 98% of bets. The longer you play, the more you lose. Because the 98% payouts are distributed unevenly, there can be very big winners, a few small winners, and many losers. The house always takes in more than it pays out. Gambling is an illogical faith in your ability to beat the odds.

Gemaakt met Wall Street Professional (Photo credit: Wikipedia)

The stock market, however, generally offers positive returns to all long-term investors over a decade or longer. In other words, if you invest broadly in the market, and everyone else does the same, few individuals will exit the market as losers. In theory, everyone can "win" overall, as long as the economy grows.

The trick to investing is to avoid falling victim to promises of unusual gains. Magical charts, impressive models, and equations only a economist can decipher do not produce better results for most investors. Having faith in chart readers or fundamental investment advisors only guarantees that these brokers and their employers will take a portion of your money.

There is a persistent myth that Wall Street investing is somehow different from other financial transactions. The reality is that buying and selling shares in publicly traded companies is not more or less complex than other financial investments. Unfortunately, the financial industry not only has a motivation to suggest investing is beyond the average person, but also many brokers and market economists believe they can beat the odds.

Some leading economists have had spectacular failures trying to beat the financial markets. From Long-Term Capital Management, founded by two Nobel laureates, to Richard Thaler's behavioral investment fund, economists have not matched index fund returns. For short periods of time, less than two years, some funds do outperform the market averages; yet as stated above, over longer periods an overwhelming majority of stock pickers fail to anticipate market trends.

Investing is not about trying to beat market averages and indices. Investing means buying and holding a broad, diversified portfolio of stocks, corporate bonds, and possibly municipal and treasury bonds.

Buying a stock is either directly or indirectly investing in a company in return for a small percentage of ownership in the company. If you buy an initial public offering (IPO) or a secondary offering, you are directly investing in the company. If you buy shares on the open market, you are purchasing somebody else's share in the company.

Investors buy shares in companies they believe will gain value over time. Unless you are buying a direct offering, remember that you are buying shares from someone else who believes the company is either at peak value or might actually decline in value. As the saying goes, "there are two sides to every stock transaction – one certain the stock is on its way up, and one just as certain the stock is on its way down."

Of course there are many reasons to sell shares. Not everyone trying to liquidate stocks believes companies are going to lose value. For example, a retiree might sell shares on a regular basis to supplement his or her retirement savings. People might also sell shares to raise emergency funds.

However, there are no "undervalued" stocks in a transparent market. Even in an emergency, a stockholder is selling shares in a market with millions of other shares of the same company. Sellers want the highest possible returns, even those selling in a rush. As I will discuss in a future blog post, markets do trend towards fair and accurate valuations.

Speculators and daytraders are not investors. These individuals buy and sell shares within hours, minutes, seconds, or even fractions of seconds. High-frequency traders try to profit from the small and rapid changes in stock prices throughout the day. Statistically, they earn returns approximating market trends. Yes, some will outperform the market on a given day or even for a few months. Yet, in a down market the same individuals tend to lose much more money on their trades.

Many financial advisers will disagree, but statistics indicate true investing offers good returns with the least risk. In fact, long-term investing in the stock market can outperform almost any other form of retirement savings including treasury bonds and other guaranteed returns.

As long as the economy is growing, even at a slow rate, stock values will increase. Innovation has not stopped, companies continue to create new products and services. If you invest in an index fund, it should return capital gains.

Sadly, financial news networks in the general media treat the stock market as if it were a sporting event. Hyperbolic headlines and interviews with overconfident advisors lead people to believe that the stock market is too difficult to comprehend. The reality is far removed from those headlines and the harried pace of online trading. Stocks are a simple, straightforward investment in companies.

Unfortunately, even the professionals rush to buy stocks on the way up and sell those same stocks as markets decline. If you buy shares or invest in index funds every month consistently and hold onto those shares for several years, ignoring both panics and euphoric promises of wealth, you should do okay as an investor.