Want To Bet? (Have Fun, But Don’t Kid Yourself)

Want To Bet?  (Have Fun, But Don’t Kid Yourself)

Investing is often mistaken for speculating and speculating is often sold as a type of prudent investing, which it is definitely not.  Speculating (gambling) is a winner takes all proposition.  We call these games -where either I win and you lose, or you win and I lose- zero sum games.   Flipping a coin is the simplest and fairest (both sides have an even chance of winning) example of a zero sum game.  As games they can be entertaining, but very few of us think a “zero sum” outcome is an acceptable bet to make with our financial future.

Speculating Is Not Investing

Would you flip a coin once to bet your whole nest egg?  Of course not.  What about breaking that  big bet up into many smaller ones?  Well, in the long run in a fair game, both players should end up even, so aside from entertaining yourself, why bother?

Now imagine a game where both players pay a flipper a penny each time to flip the coin for them.  If they play the game long enough, the flipper will own most or all of both of their nest eggs.  In casino gambling, we call the flipper the house and in the long run, the house always wins.  In financial services, we call the flipper the broker (prophetic isn’t it) and if you speculate, they always win, too.

While many investors would not think twice about turning down a chance to have the house flip coins in a fair game.  They actually play a game called “market timing” that may be even more foolish.  Every time they become fearful and pull funds out of the market, they are making a bet (against the whole world of investors and speculators) that the market will go down and that they will know when to get back in.  A willingness to pull out of the market for such a short-term bet also implies that when they eventually buy back in, they will be betting that the market will go up in just the short term.  If they lose that short term bet, they will place yet another by pulling out again.  Since the house wins every time, for the majority (even in casinos and lotteries there are a few winners) of players it is a vicious cycle on a downward spiral.   Are we having fun yet?

But wait, it gets even worse! Because the small investor’s market timing bet is not even a fair one where both players have an even chance.  There is plenty of excellent academic research, like Burton Malkiel’s A Random Walk Down Wall Street, to indicate that the short term movements of the markets are unpredictable for even the “best” active (vs. passive) mutual fund managers.  I suspect the average investor has even less of a chance betting against, high frequency trades placed on public and private exchanges by super computers running proprietary quantitative models.  And, I know, that the individual investor pays the broker more for each trade than the pro’s do.  The inevitable downward spiral of the fair game can become a fast flush when the gaming tables are tilted against you.   For  more proof, Google Dalbar’s excellent research to see how much profit the average investor has flushed away by attempting market timing.

COMING NEXT Week: Investing Is Not Speculating