Imagine you find yourself wandering The Strip in Las Vegas. You aren't much for casinos; you're there because of a conference. But you walk into one anyway.

For reasons not quite clear, a generous gambler has a proposition: Put a chip anywhere you want on the board and keep any winnings. No strings attached.

Do you take the offer?

A roulette table

Image source: Getty Images.

My answer would be clear -- an enthusiastic yes! I hope yours would be, too.

The idea: A free lottery ticket

Why is this such a good deal? Examine the dynamics.

  1. Downside: You lose nothing. The worst that can happen is that you continue on your way after losing on the roll.
  2. Upside: Even though the odds of you winning aren't great, they exist. And if you do win, you could win huge.

Imagine if you take this a step further. Let's say you resolve to go after any opportunity with those dynamics in your life. Do it enough times and eventually, you'll realize the huge upside benefits -- all without exposing yourself to downside risks.

Technically, I refer to this as a "free lottery ticket." I use the roulette example instead of a lottery ticket because I think the odds of "winning" using this strategy in life are far greater than the odds of winning the lottery.

But the same dynamics are at play: If you're offered a free lottery ticket with no strings attached, take it. Every time. Without exception.

Applied to investing

Recently, I was reviewing my portfolio and was surprised by something: Through April 14th, my portfolio was up 7% on the year despite the COVID-19 -induced fall. Taking it a step further, the average investment I've made over the past ten years is now nearly quadrupling the market.

At the core of those results is a very simple idea -- look for free lottery tickets. How can we find such things in the investing world? Consider:

  • Optionality: Look for companies with optionality -- or a demonstrated ability to explore new ways of fulfilling their missions.
  • Cash: Believe it or not, a little cash on hand is no different than a free lottery ticket.
  • Investing for the long haul: Over the long run, the most you can lose is 100% of your money (technically, that's not "free"), but the most you can gain is uncapped.

We can investigate each with simple examples.

Optionality

Below is a list of my five largest holdings. You'll notice that each has a broad mission and has demonstrated, over time, that it can vastly expand its offerings to fulfill that mission.

Company Mission Statement Original Business Evidence of Optionality
Amazon (NASDAQ:AMZN) To be earth's most customer-centric company Books The "Everything Store" and AWS
Shopify (NYSE:SHOP) To make commerce better for everyone Platform for setting up e-commerce operations Merchant Solutions and fulfillment network
Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) To organize the world's information and make it universally accessible and useful Search advertising Nine products with over one billion users and the company's "Moonshot" bets.
Axon Enterprises (NASDAQ:AAXN) To protect life. Taser stun-guns Body cameras, Evidence.com database, Records Management
MercadoLibre (NASDAQ:MELI) To democratize commerce and financial access E-commerce platform Mercado Pago payment solution

If you bought shares in these five companies five years ago, you'd be sitting on gains of 582%! 

Technically, none of these were "free" lottery tickets. There's always danger in companies losing business and their stocks subsequently falling. That's why it's so important to investigate moats -- or sustainable competitive advantages. But -- while we can't cover each one in this article -- each has very wide moats that add an enormous level of downside protection.

Keep (some) cash on hand

Former Motley Fool contributor Morgan Housel once penned a very thought-provoking article on how he thinks about cash he can invest.

Here's the key quote:

Cash gives you options other assets don't. It lets you take advantage of some situations and protects you from others. And you don't have to forecast what those situations might be. It's the closest thing to finance's get-out-of-jail-free card.

I can hear the objections now. Yes, inflation can eat away at cash sitting in the bank. But market crashes are far more frequent than you think. They're regular enough that -- if you have the fortitude to invest that cash when everyone is losing their nerve -- inflation shouldn't be a major concern.

While I still invest 85% of what I can put away each month in the stock market, I like to try and save 15% of what I can in cash.

Invest for the long haul

But perhaps this is the most important. If you invest for the long haul, returns are asymmetrically in your favor. As long as you don't use margin, the most you can lose in the stock market is 100% of what you put in.

That might not sound free -- because it isn't. But compared with the uncapped gains you can achieve over time, it's as close to a free lottery ticket as you can find. 

Morgan Housel again provides the research proving this out:

  • One year: Between 1871 and 2012, the most you could lose if you invested over just one year was 38%. That's painful.
  • Five years: Over the same time frame, the maximum lost in the market over five years was 13.5% per year.
  • 20 years: If you stay invested for twenty years, the worst you could have down was a gain of 0.7%. Compounded over twenty years, that's still a gain of 15%.

Over time, a diversified portfolio that you let sit has been -- in fact -- a free lottery ticket.

Remember, protect that downside

All of this depends, however, on your ability to let your investments sit in the market. By living below your means, having responsbile levels of insurance, building up an emergency fund, and keeping a little dry powder (cash) in your portfolios, you don't run the risk of having to draw your investments out at the wrong time.

Take this approach now -- while the soil is fertile with solid opportunities -- and you could very well cash in these free lottery tickets twenty years from now.