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Q: Is investing really all that different from gambling?
A friend recently insisted that investing in stocks was exactly the same as gambling. After looking up the definition of "gambling" (i.e., betting on an uncertain outcome), I had to admit he had a point. So, is there a difference? -- Signed, Leaning Toward Las Vegas
A: Is there a certain amount of risk involved? There sure is. Does it involve playing the odds? Oh yes it does. And is the outcome somewhat uncertain? Absolutely.
Hmm ... it seems that investing is a lot like gambling after all.
Still, I like the odds in the stock market a whole lot better than the ones in Vegas. Yes, even now.
Fool member ComputerOldFogey explained the difference between gambling and investing in a great discussion board post we highlighted a couple of years ago. He pointed out that actual gambling -- the kind that involves plastic chips, blinking lights, overly air-conditioned rooms, and lots of free beverages -- is a zero-sum game: When someone wins, someone else has to lose. In gambling, the pie is only so big, so when you roll snake eyes and snag a slice, there's less left over for everyone else. And even when you do win, you lose because the house always takes a cut.
The stock market, on the other hand, churns out long-term winners all the time -- and not to the detriment of everyone else in the game. The stock market pie grows when business and economies grow. (And, as we've seen lately, it does the opposite when businesses and economies shrink.) But if you stay invested for the long-term (we're talking 10, 20, and 30 years), the odds of making money on your "bet" heavily tilt in your favor. On average, over time, those who remain invested in the stock market win.
Let's not completely dismiss the role of luck in playing cards and picking stocks. Gamblers use all sorts of voodoo to improve their luck (such as wearing unlaundered items of clothing or carrying taxidermied bunny parts in their pockets).
Investors also have a bag of tricks to reduce the uncertainty surrounding every bet: Information.
Access to information gives investors a real edge over gamblers. Investors are free to look at everyone's hand (checking out inside ownership, top mutual fund holdings, etc.). The dealer's hand -- company 10-K and 10-Q financial reports, conference calls, and operational reports -- is literally an open book. It's like playing poker at a table where everyone's cards are face up. He who does his homework -- researching each investment, playing out different scenarios to stress-test its performance -- creates his own luck.
In other words, if you're not "cheating," you're not investing the right way.
Turn the odds in your favor
Research and making fully informed bets on stocks isn't the only way to ensure a winning streak. Here are a few other ways to reduce uncertainty:
1. Don't gamble with money you need for your cab fare home. You've heard it before, but we'll repeat it anyway: Do not invest money you need in the next five years (at least), or seven to 10 if you're more risk-averse. A friend of a friend is doing the walk of shame because he "lost" the money in the market that he was going to use as a down payment on a home. "Lost" isn't the word I'd use; this guy bet with that money -- and the gamble didn't pay off.
2. Study the table before you place any bets. Peter Lynch famously said, "Never invest in any idea you cannot illustrate with a crayon." In other words, don't put your money down until you know the business well enough to describe it in plain, easy-to-understand terms.
If you don't already have a one-sheeter on every stock in your portfolio, then draw it up now. What you want is a simple rundown of why you invested in the company in the first place, your expectations for the business in the future, critical catalysts that are required to achieve the growth you need, and what role this company plays in your overall portfolio. Each time you get a bad gut feeling, review this original investing thesis. Don't let your emotions drive your decisions.
3. Fold for the right reasons. There are many things that might make us want to sell an investment. The CEO comes under investigation by the SEC. The company's products or services no longer dominate their market. The stock has to grow by 100% per year to justify the price. The company reports negative earnings for four quarters in a row. All are perfectly sound reasons to consider cashing in your chips.
What you don't want to do is fold your cards in an emotional state. On the Stock Advisor discussion board, Jim Mueller (TMF Gebinr) gave some sound selling advice: "Have a sell strategy in place at the time of buying. What this does is to take a lot of the emotion out of the decision. There's a plan in place (which can be changed as the situation warrants) that guides you in making that decision."
Another reason to sell -- one that's very relevant these days -- is that you've found a better place to invest. AIG (NYSE: AIG ) , Rite Aid (NYSE: RAD ) , and Citigroup (NYSE: C ) have dipped into penny-stock territory, making many feel that their money would be better put to work elsewhere.
Yet some really solid businesses are also trading at multi-year lows. Companies like Microsoft (Nasdaq: MSFT ) , Costco (Nasdaq: COST ) , and FedEx (NYSE: FDX ) have been hurt in this downturn but retain many of the competitive advantages that produced stellar returns in past years.
But remember, just because something looks "cheap" or like a "sure" thing doesn't mean it is. So before you place your bets, heed the three simple rules we outlined above. To invest with anything less than your full due diligence really is gambling.
Get real answers: Got a pressing financial question? Simply type your question in the comments field below, or email us at [email protected]. We cannot respond to every question we get, particularly ones about specific investments (our lawyers make us say that). So to increase your chances of getting your question answered on Fool.com, keep it fairly broad and relevant. And sign it with a funny name.