For this blog post, I first want to link to a post I just read at Kitces.com.  Michael Kitces is a Certified Financial Planner and a renowned blogger of financial planning issues.  Here is the link.  You don’t have to read it all but I want to make sure you have access to it:

What Cyborg Chess Can Teach Us About The Future Of Financial Planning

The post is titled “What Cyborg Chess Can Teach Us About the Future of Financial Planning”.  Cyborg Chess is where human chess players work together with programmed robots, with the result being that the combination of the two are superior to either humans or robots alone.  The Kitces blog post itself draws from a book titled “Average Is Over”, published in 2013 by Tyler Cowen.  Cowen actually did the research on cyborg chess.

Part Human, Part Machine

A Cyborg is part human and part machine.  Arnold Schwarzenegger portrayed a Cyborg in “The Terminator”, and subsequently again as Governor of California (well, maybe not as Governor).  A Cyborg financial planner or wealth manager would mean there is a human intermediary between the investment recommendations that a programmed robot spits out and the actual execution of the trade.  Step 1:  Humans program the robot.  Step 2:  Robot churns data and spits out trade or allocation recommendations.  Step 3:  Humans analyze robot’s recommendations and may or may not make tweaks.  Step 4:  Trade is executed.  In a robot-only or algorithmic trading strategy, there is no Step 3 – the robot executes the trade.

Robots In Conflict

Why does it help to have humans involved?  There may be multiple robots involved, and the robots may make recommendations that are opposed to one another.  Many investment managers use more than one algorithm for the same security or the same investment strategy.  I use multiple indicators that tell me when to Buy and when to Sell.  Sometimes these indicators tell me different things – not necessarily that one is telling me to Sell when the other says Buy, but that the strength of the indicators may be different.  If so, I need to make the call and either overrule one of the indicators, or make a trade that is a compromise between the two.  Don’t want to hurt the feelings of either robot.  (I am kind of using Robot, Indicator, and Algorithm interchangeably here, and I mean basically the same thing – a mathematical calculation based on past performance that predicts with greater than 50% likelihood what the market will do).

Skills Required

An additional point of the Kitces blog is that the human skills required to be a great Cyborg chess player are not the same as the human skills required to be a great Human chess player.  Magnus Carlsen, World Champion and the best chess player in the world today, wouldn’t necessarily be also the best Cyborg chess player.  A good Cyborg chess player must gather the recommendation of the robot and quickly determine if the robot is right or not, and then make the next move.  Quickly meaning within seconds.  The skill is to be able to work together as a team.  Carlsen is looking at the board himself and determining what his next moves are, depending on what his opponent does.  Moves as in plural.  But Carlsen is working alone.  Carlsen is not a team player – a Cyborg chess player is a team player.  Likewise, a good Cyborg financial advisor is part of a team together with the robot/indicator/algorithm.

IMO

Robots work best when there is little or no thinking involved.  There is a lot of thinking involved with investment management and financial planning.  A lot of nuance.  Shades of gray.  Robots don’t work as well in shades of gray, or where there is nuance.  I think I look good in gray – at least as good as I can look.  Humans don’t work as well either by themselves, but paired with a robot, humans make better logic or mathematics-based decisions while at the same time recognizing the nuance.  A combination of Captain Kirk and Mr. Spock.  I believe Cyborg advisors and Cyborg hedge funds are the true way of the future.  Although I don’t want to call myself a Cyborg just yet, I do partner with my robot friends.  Contact me if you want to learn more.

We often say that stocks are “liquid”, meaning basically that they can be bought and sold easily through the various stock markets.   This is not a truism.  Stocks (and corporate bonds) are “marketable”, but they do not fit the definition of “liquid”.  I will explain the difference.

Liquid

A security is liquid if it can be converted to cash quickly without any loss of value.  You can go to your ATM and withdraw $300 in crisp $20’s and your bank account will only be debited $300.  (Except for maybe the $3 fee you pay if you use the ATM of a bank different than your own, but that is a different topic.)  A CD at a bank also will not lose value.  US Treasury Bills also are considered liquid – you redeem them for the face amount without loss of value.  Same with money market funds.  A rule of thumb for financial planners is that clients should have the equivalent of 3 to 6 months of salary saved and kept in liquid assets.  That means in bank and money market deposits or in T-Bills.  In the event of an emergency, the client can draw down on this emergency fund of liquid assets without worrying about a loss of value.  The trade-off for liquidity is that the client likely won’t earn much on their liquid assets, but they are not taking risk, either.

Marketable

Stocks and bonds are considered to be marketable, but not liquid.  Marketable means that the security can be easily sold, but that it could suffer a loss of value when you sell it.  Say you own a stock, and you look and see that it last traded for $42 per share.  If you decide you want to sell it at that time, you likely won’t get $42 per share.  Depending on the depth of the market for that stock, you may get $41.99, meaning your loss of value was only a penny, but you still lost that penny of value.  You can easily sell it – just a click! – but because of the “bid/ask spread”, you probably won’t sell it for what the previous person sold it for.  So, just because you have money invested in stocks, don’t make the mistake of thinking that those are liquid assets.  They are not.  What if you need to sell that stock right when everyone else wants to sell that same stock?  The loss of value will probably be greater than that penny.  Keep your emergency funds in liquid assets – in the Bank!

More Marketable vs. Less Marketable

There are, of course, varying degrees of marketability.  One way to measure marketability is the bid/ask spread.  Ever try to haggle with a merchant?  Ever try to buy event tickets from a scalper?  Then you know about the bid/ask spread.  You want to buy what the seller has, but you don’t want to overpay, or you think what the seller is asking is too high.  So you say, “I’ll give you x for that”, x being a lower price.  The x is your Bid, and the seller’s price is the Ask.  Same thing in stock trading.  If the difference between a stock’s bid and ask is very small, say one or two pennies, then you can deduce that the stock is highly marketable.  The greater the spread, the less marketable the stock becomes.  Marketability is also a function of the volume of trades.  More trading = more marketability.  The largest company stocks and the largest ETFs such as the S&P 500 ETF (SPY) are considered to be the most marketable stocks or securities.  But they are still not considered to be liquid.  Real estate as an investment is not nearly as marketable – although real estate’s marketability changes over time.

IMO

If you want to have your cake and eat it too – in other words, if you want to have relative liquidity yet still earn a decent return on your investments, then investing in highly marketable index ETF’s are probably for you.  Examples are the SPY and the NASDAQ 100 Index (QQQ).  However, invest in these only after you have stashed away the 3 to 6 months of emergency funds in the Bank!  Maybe you can trend toward the 3 months of savings rather than 6 months if you have a large stock or ETF portfolio, but you still need the liquid emergency funds.  Understanding the difference between liquidity and marketability may seem like splitting hairs, but it can be a very important distinction when something bad happens and you need that money.

Opening Day

Today is Opening Day at Saratoga Race Track, one of my favorite places to go.

I love Investing.  It is what I do every day, and most of my waking time is devoted to how I can make myself a better investor and a better investment manager.

One of my favorite hobbies is horse racing.  The Sport of Kings.  So called because only a King can afford to own race horses.  I do not own race horses.  My interest is on watching them race and placing my bets to see if I can predict which one will win.  Our daughter rode Equestrian when she was in school, and we owned a horse and then leased a horse for her.  Owning an Equestrian horse is without a doubt a money-losing proposition.

Similarities

Horse racing and Investing are similar but not the same.  They are similar because the racing fan can get the Daily Racing Form (similar to an investor’s Value Line or Morningstar report or even a company’s financial statements) and analyze the data therein.  The better determines which horse they think will win or be in the money (like an Analyst who labels a stock Buy, Hold or Sell after their review), and then watches the race play out (like those of us who watch the stock ticker or look at our monthly brokerage statements).  They are similar because money management is of paramount importance.  One of the best books on money management in any capacity is “My $50,000 Year At the Races” by Andrew Beyer.  In the book, Beyer discusses how he went from his Ivy League education to trying to make enough money to live on by gambling at the horse races.  It was the late 1970’s and $50,000 was enough money then.  He bided his time until he felt the odds were in his favor and then wagered big.  At the end of that year, he calculated he made the bulk of his $50,000 in only about a handful of races.  A great lesson for investment managers as well:  Bide your time and stay in the game until you see a great opportunity, whereupon you Bet The House.   Beyer became a newspaper columnist and also developed a system of normalizing past performances by horses and come up with a Speed Rating number that today is a standard that is provided for every horse for every race in the Daily Racing Form.  That book is called “Beyer On Speed”.  If you haven’t yet figured it out, I love reading the Daily Racing Form.  Past performances, fractions, pithy descriptions of what each horse did in each race, jockey/trainer profitability based on $2 bet each time this jockey rode a horse trained by this trainer – the Daily Racing Form has it all.  I so wish there was something equivalent in the Investing world, where all the information an investor wants is in one newspaper.  

Hedging

Horse Racing and Investing are similar also because, different than other forms of gambling, in horse racing the bettor can hedge and diversify.  Let’s say there are 10 horses in the field, and you think after reading the Daily Racing Form that 3 of the 10 are clearly better than the other 7.  However, you can’t tell which of the 3 will win.  There are some simple ways to address this.  One is to “box” the three horses in an Exacta.  Then, if 2 of your 3 horses run 1st and 2nd, then you win.  It costs more for an Exacta, but then again Investing hedges also cost more than a pure play investment.

Another way to hedge in horse racing is to bet to Place (2nd place in the race) or Show (3rd place in the race).  The payoffs are smaller, but a bettor can still make money through Place and Show bets.  Sometimes, Exacta and Place and Show bets are the difference between winning and losing at the Track.  

What would an Exacta Box in Investing look like?  Let’s take the 3D Printing industry as an example.  You determine that the 3D Printing industry is likely to have exponential growth, but you don’t know what specific companies will come out on top.  You think 3D Systems, Stratasys and Protolabs are most likely to succeed, so you invest in all three equally.  Then see how it plays out.  In doing so, you have invested in the 3D Printing industry, not necessarily just one company, because you think these 3 will clearly be the winners.  This strategy should outperform a 3D Printing ETF, because you have not invested in non-winning companies.  What if a new player enters the 3D Printing market?  You can adjust your bet – there is not an “ending” to the 3D Printing industry.  

This “Exacta” strategy makes a lot of sense in a lot of emerging industries.  In many new industries, 2 or 3 companies usually emerge as the market leaders over time.  Think Coke and Pepsi, McDonald’s and BK, or Boeing and Airbus.  

Winners

Other industries, though, are different, with one giant market leader.  Google has destroyed all rivals in web search.  Microsoft owns the operating systems business.  Apple is top of the heap in smartphones.  Facebook seems to be the Social Media leader.  Amazon wins hands down in retail.  Netflix?  I’m a skeptic.  These are the FANG stocks (FAANGM?).  These were all Win bets.  They are all Secretariat in the 1973 Belmont Stakes (YouTube it if you don’t know it).  Win bets always pay the most.  What do you think is the next Win bet?  

Differences

Investing is different than horse racing because, in horse racing, results and payoffs are binary, and horse racing odds are stacked against the bettor and in favor of the House.  The race is run, and you either win or lose your bet.  The race is over.  In investing, it is never over, and you can always adjust your investment allocations.  

Horse racing odds are not in the bettor’s favor.  The odds on the racing tote board are Odds Against that horse winning the race.  The Odds can easily be converted to a Probability, as follows:  

Second Number listed in the odds divided by Sum of Both Numbers listed in the odds

So, let’s say a horse is listed as 5:1.  That means bettors think there is a ⅙ probability that horse will win (1 divided by 5+1 or 6).  ⅙ means a 16.7% probability (or possibility) of that horse winning.

How are the odds stacked against the bettor?  Take the odds for all the horses in the race, convert them to a percentage possibility using the math above, and then add up all of the percentage possibilities for all of the horses.  They will add up to more than 100% – usually between 120% and 150%.  That means that, collectively, the horses are overvalued, and that their odds against winning are understated.  

IMO

Horse racing is for fun, for my own entertainment.  Investing in the market is serious business, even though it is still fun for me.  I only bet up to $20 in one race, usually much less.  I take much larger positions in the market.  They are not the same thing.  It is interesting to transpose the terminology from one activity to the other.  Think about how you are approaching them each within a theoretical framework.  Smart money management is key to both activities.  So is discipline – don’t bet or invest without first having done your homework, and then don’t do your homework and not wager or invest accordingly.  Have a methodology and stick to it.  

Visiting a See’s Candies store is a real treat!  See’s are located in only select places.  They are not as ubiquitous as Starbucks.  Their selectness is part of their appeal.  See’s is a Destination.  It smells so good inside a See’s!  With their black-and-white motif, and all of the candies neatly arrayed behind a glass case, it has an old-fashioned feel.

Free Samples!

Once inside a See’s, you want immediate satisfaction – you want to eat a See’s right now!  And See’s satisfies that desire (or perhaps it is a need?) by giving everybody a free sample.  Everyone in the store – whether you are buying a box, or just tagging along – gets a piece of candy to eat right there.  Yum!  If you are there to buy a one-pound box, maybe the sample will prompt you to buy a second box.  Maybe the piece you got as a sample is a type that you hadn’t had before, and you like it so much that you buy a box that would have that one in it.  If you haven’t had a Scotchmallow before, and you get a free sample of one, maybe you will buy a bag full of Scotchmallows.  Genius marketing idea!

The Oracle

What does See’s Candies have to do with investing or money management?  Well, a couple of takes.  See’s Candies is 100% owned by Warren Buffet’s Berkshire Hathaway.  See’s was one of Buffet’s earliest investments.  So you can deduce that See’s Candies as a business is a typical Buffett investment – strong cash flow, low capital-intensity, low-tech, safe business.  Warren must have a sweet tooth.  If he didn’t come up with the idea of giving free samples to everyone in the store, then at least he knows about it and approves of it.  He knows it is good business to hand out free samples.

Blog Posts and Dark Bordeaux

Another take is that, if it is good enough for Warren, it is good enough for me!  One of my aims in selecting topics and blogging about them is to provide free samples of the way I think and approach issues.  My desire is that you will read these free sample blog posts and think, “Wow, that makes total sense!  This guy is really smart!  I should contact him – maybe he can help me in my investments!”  These blog posts are my version of handing out succulent Dark Bordeaux (my favorite) in the See’s Candies store.

Contact Me

If you do conclude you want me to help you, please contact me.  Use the Contact Me page in this blog.  Go to hutchisonroad.com to find out more.  Just email me at [email protected].  I will be glad to answer your questions and hopefully engage you in some capacity to help you with investing and financial planning.

By the way:  Here is the link to the See’s Candies website.  I am not being paid to promote their business, but I do really like their products, and I’m sure you will as well:

http://www.sees.com

 

 

In my previous post, I showed that Beta is a measure of volatility.  I also showed that Beta is pertinent to individual stocks because Beta shows the stock’s volatility relative to a benchmark index, and that Beta is not as pertinent to ETFs or mutual funds.  So now you have a number of new (in the last 5-6 years) fund strategies that call themselves “Smart Beta” funds.  If Beta isn’t pertinent to funds, then is “Smart Beta” either just nonsense or a marketing gimmick by the fund managers?  Well, no, there is a valid concept behind Smart Beta funds, and it may be something you should investigate, especially if you are risk-averse.

Low Volatility

The most prominent Smart Beta ETF’s are PowerShares S&P 500 Low Volatility (Ticker:  SPLV) and IShares MSCI Min Vol (USMV).  Combined, these 2 ETF’s had over $20 billion of assets as of 6/30/17 (Source:  Investopedia).  Both of these funds try to minimize volatility while preserving upside and while still calling themselves index funds.  SPLV mirrors the S&P 500 Low Volatility Index, which is an actual Standard & Poor’s Index.  The Low Volatility Index uses the S&P 500 as its universe of possible stocks to invest in, but limits its “holdings” to the 100 lowest-Beta stocks, and re-balances its “holdings” each quarter.

Risk-Aversion

These low-vol Smart Beta funds appeal to investors’ risk-aversion.  The meme or narrative goes something like this:  Index investing is trendy, and investors (and investment managers for that matter) want to follow the trends and keep expenses low by investing in index funds, but at the same time they don’t like the drawdowns they get with the S&P 500 Index (See: 2008), so they can have their cake and eat it too by investing in a low-volatility index.  In his newest book, “The Undoing Project”, Michael Lewis (Author also of “MoneyBall” and “The Blind Side”) shows that the subjects of his book, economics/psychology professors Amos Tversky and Danny Kahneman demonstrated that Fear is a much greater human motivating factor than is Greed.  Investors are happy to earn more on their investments, but once they have their money, they really don’t want to lose it.  Likewise, investors typically overestimate their “loss threshold” – the amount of loss they can sustain in their portfolio and still be okay with it.  “Wow, I thought I would be okay if I lost 20%, but now that my portfolio is down 5%, I am freaking out!!”  Low-volatility Smart Beta seeks to calm investor fears about drawdowns.

Do They Work?

Yes – so far.  SPLV and USMV have been available to shareholders since 2011.  According to its Product Detail website page, during the 10 worst-down calendar months since its inception, SPLV has mitigated 43% of the S&P 500 Index losses during those months.  Since its inception, SPLV is slightly outperformed the S&P 500 Index, but in the past calendar 12 months (ending 6/30/17), the S&P 500 Index has more than doubled the low-vol index.  Why is this?  The FANG stocks.  The past 12 months has been very favorable to high-Beta investing, including the large cap high-techs such as Facebook, Apple, Netflix and Google.  Low-vol ETF’s won’t be holding FANG stocks.  USMV also claims to have outperformed the S&P 500 Index since its inception, but not in the last 12 months.

Criticisms

The two main criticisms of Smart Beta, particularly low-volatility strategies, are 1) by definition they limit their investments in growth companies because growth companies have higher Betas; and 2) low-volatility strategies will become overpriced as more money flows into them.  #1 is true, and therefore investors are largely in boring, low-growth, high cash flow companies.  I know of an investor in Omaha who follows the same script.  As for #2, there is a long way to go before these strategies start tilting the market – they are still a blip relative to the larger indexes.  That said, don’t overpay.

IMO

Investing in a strategy that is a twist on an Index is nothing new.  The “Dogs of the Dow” strategy has been around for many years.  That strategy invests in the 5 highest-yielding Dow 30 stocks and rebalances every year on the first trading day of the year.  We have not had a true Bear Market (down 20% or more) since 2011 so we don’t really know how these strategies will perform in a Bear Market.  On paper, a low-vol strategy should be somewhat safer, but not completely safe.  They are more applicable to an older investor whose goal is capital preservation.

I have focused on low volatility Smart Beta strategies in this post.  There are other Smart Beta strategies to examine in future blog posts.  Stay tuned!

 

There are a lot of new mutual funds and ETF’s available that call themselves “Smart Beta”.  I want to write about Smart Beta funds, but then I thought I need to write about Beta before writing about Smart Beta.

Volatility

Beta is a measure of an individual security’s volatility relative to the market as a whole.  Mathematically, Beta is equal to the Covariance of the return of Asset A with the return of the benchmark, divided by the Variance of the return of the benchmark.  That means, in order to calculate Beta, one needs the past actual returns of the specific stock and the returns of the appropriate benchmark over a relatively long period of time. Beta is usually stated as a number between -1 and +2.  If a stock has a Beta of +1, that means its Volatility is equal to that of the benchmark.  The most-often used benchmark is the S&P 500 Index.  Beta of 0.5 means the stock is 1/2 as volatile as the benchmark; 1.5 means one and one-half times as volatile as the benchmark.  A negative Beta means that the stock is inversely correlated with the benchmark.

Risk

Risk is a cousin of Volatility.  In Finance, Risk is whether actual returns are consistent with projected returns.  There are two types of Risk:  Systematic and Idiosyncratic.  Systematic Risk is Market Risk, and is measured by Beta.  Systematic Risk is the risk that the entire benchmark faces, and is considered to be non-diversifiable.  Idiosyncratic, or company or asset-specific risk, is risk that is unique to a specific company or industry.  A skilled investment manager can diversify Idiosyncratic risk.  Jim Cramer of “Mad Money” on CNBC runs a segment titled “Am I Diversified?”, wherein callers give Cramer their 5 largest individual stock holdings and ask Cramer if they are truly diversified.  If Cramer deems that they are effectively diversified, he means that the portfolio will not significantly suffer if one stock falls while the others continue to meet expectations.  They are diversified with respect to Idiosyncratic Risk only; not Systemic Risk.  If the entire Benchmark Index plunges, the 5-stock portfolio will also likely plunge along with the Benchmark.  The portfolio is not diversified from Systemic or Market risk, which is measured by Beta.  Total Risk, which is Systematic plus Idiosyncratic Risk, is also called Variability, and is measured by Standard Deviation.  The Sharpe Ratio uses Standard Deviation in the denominator of its equation and is therefore called the “Reward To Variability Ratio”.  The Treynor Ratio uses Beta in the denominator (same numerator as Sharpe Ratio) and is called the “Reward To Volatility Ratio”.  They are topics of future blog posts.

High or Low Beta?

In general, stable companies such as consumer products companies or utilities will have a low Beta (but likely will pay a relatively larger dividend), whereas high-tech and/or growth companies, or companies that are largely influenced by the news of the day will usually have a higher Beta, typically greater than +1 (and a smaller or no dividend).  ETF’s or mutual funds usually do not publish a Beta – because they are already “the Market”.  That does not mean ETF’s don’t have risk – it means that their risk is not measured or expressed by a Beta coefficient.

IMO

Beta is an academic, theoretical computation based on past performance.  Past performance and future results may diverge.  Companies change, investors’ perceptions of companies evolve, and so companies’ stock performance changes over time.  The general message of a company’s Beta is useful; i.e., a Beta greater than 1 probably means the company’s stock is going to be volatile.  If you are an investor who is looking for slow, steady returns and maybe a dividend, you should look toward low-Beta stocks.  Or, you could look to a “Smart-Beta” ETF or mutual fund, which are gaining in popularity and which will be the topic of my next blog post.

Chris Sale, LHP, Boston RedSox

There was an interesting article recently in the Wall Street Journal (I read the WSJ every day and I love it!).  Columnist Jason Gay wrote about Chris Sale of the Boston RedSox, one of MLB’s most dominant pitchers.  The premise of the article was that Sale never “shakes” his catcher, meaning, he never disagrees with the type of pitch or the location of the pitch that his catcher signals prior to the pitch.  With most other pitcher/catcher relationships, there is a “conversation” – catcher puts down a sign (one finger for fastball, two for curve, or something like that, and a wiggle for inside or outside), and pitcher nods his head Yes or No.  Sometimes they can’t agree, so catcher pays a trip to the mound and they have a normal, verbal conversation instead of sign language.

With Chris Sale and his catcher, the conversation is one-sided.  Catcher puts down his sign, and Sale always agrees.  Sale throws what catcher wants and tries to throw it where the catcher wants it. Simple.  The result is Sale works more quickly – no debate between pitches – and the fielders stay alert and don’t fall asleep between pitches.  Sale has natural ability and a strange left-handed delivery, but undoubtedly his success (he is one of the best) is helped by his rapid work.

It works for Sale because of Preparation and Trust.  Sale delegates the pitch type and location to his catcher.  He trusts that his catcher has prepared – he knows something about the hitters, and he knows what types of pitches Sale can throw.  Since he has delegated pitch selection, all Sale needs to do is execute his pitches – throw what the catcher called, and throw it at his mitt.  The KISS method of pitching.  Sale becomes a machine – not thinking on his own, just executing, pitch after pitch.

It is also Process-oriented as opposed to Results-oriented.  Most pitchers are Results-oriented – what result do I want with this pitch?  Sale is Process-oriented.  He trusts that if he and his catcher hold true to their process, the results will follow.  Successful coaches are Process-oriented – John Wooden, the “Wizard of Westwood” (UCLA Basketball) and Nick Saban (University of Alabama Football) are famous for their processes.

Pitching vs. Investing

What, you may ask, do Chris Sale and the Boston RedSox have to do with investing?  Successful investing is also Process-oriented.  Buy-and-hold is Process-oriented, even if Buy-and-hold doesn’t always outperform.  Indexing is Process-oriented.  Algorithmic investing is Process-oriented.  Preparation – do research, do back-testing of investing strategies, know what you are investing in, and know what your objectives are.  Trust – work with an advisor or a broker that shares your objectives, and that you are sure is not conflicted and is not out for him or herself.  If you have an algorithmic or rules-based approach, and you hit a rough patch, you stick with it – you trust that you are in an anomaly period and that the market or the situation will mean-revert and the investing decision will work again going forward.

IMO

All of this is true, but it is easier said than done.  Successful investors and investment managers do prepare and trust, but it takes a lot of work, as well as a steady disposition and approach.  Once you make a decision or take an action, stick with it, and you will probably be ok.  The relationship between investor and manager is key – you really have to trust each other, and be satisfied with what the manager is getting paid.  If the manager is good, it is worth it.

 

Gambling vs. Investing

Have you ever heard the phrase, “The Wall Street Casino”?  Or that “you may as well go to Vegas as buy stocks”?  

These phrases imply that buying stocks, investing in stocks, bonds, or other asset classes, is the same as going to the Roulette wheel and putting your money on Red.  That implication is wrong. Buying stocks or bonds is “Investing”, whereas Roulette is “Gambling”.  

How and why are they different?  Mostly because Gambling outcomes and therefore payoffs are binary.  You either win or you lose, and you are paid off accordingly.  The odds in Gambling are always stacked in favor of The House.  In my Roulette example, there is Red and there is Black, but there are also two Green holes (Zero and ZeroZero), meaning your odds of winning by betting Red are less than 50%.

In Investing, however, payoffs are not binary.  You can be kind-of right, and win a little, or really right, and win a lot.  If you are wrong, you may lose some, but you probably won’t lose your entire investment, as you would in Gambling.  Investing has degrees of being right and wrong.  In addition, Investing plays out over time – one event (such as the spin of the Roulette wheel) does not determine your outcome.  If you don’t like your Investing outcome today, wait a while, and it may very well improve.  

Secondly, you can easily hedge your investments, which is not as easy to do in Gambling.  Hedging tactics include Diversification strategies, including buying several unrelated or uncorrelated stocks instead of just one, or buying a Mutual Fund or an Exchange-Traded Fund (ETF), which may be just one security in your portfolio but which in turn owns shares of many companies.  Owning different asset classes such as Stocks, Bonds and Real Estate is another way to hedge.  In Roulette, you can “hedge” by putting your chip on the corner where 4 squares meet, so that you get paid off if the ball goes into any of those holes, but your payoff is reduced proportionately.  Not so with investing – you can hedge and still win on all your investments at the same time.

Lastly, despite what some Prophets of Doom may tell you, the Investing odds are not stacked against you.  In “Flash Boys”, Michael Lewis (same author as “Moneyball” and “The Blind Side”) shows how some traders Front Run and earn very small fractions at the expense of other investors.  This may be true, but keep in mind that these Front Runners are making very tiny fractions of decimal points on trades, and making money at it by committing millions of billions of dollars.  As an Investor, don’t get turned off by this.  If you have to pay an extra hundredth of a tenth of a cent per share because of front running by others, but you are holding for a long term, you basically will not be affected.  Not anywhere near the effect of the House Rules in Las Vegas.

If you are affected by the extra hundredth of a tenth of a cent, then you are not Investing.  Instead, you are playing a different game called Speculation.  Speculation is somewhere between Gambling and Investing.  In Speculation, outcomes and returns are not Binary, but the chances that it will not work out are much higher than normal Investing.  Investing is owning a Mutual Fund or a portfolio of companies.  Speculation is owning part of a pre-IPO high tech company.  Most wealthy people do not Speculate on their own.  Instead, they give their money to Venture Capital or Private Equity firms whose role is to use their collective knowledge and experience in an effort to minimize the risks of the Speculation and maximize the returns.  This is the same role that a Wealth Advisor or Investment Manager plays to an Investor.  

An investment firm called Indus Wealth, which is based in India (who wouldda thunk?) has a .pdf file that I think compares Gambling with Speculation and Investing in a really good way.  Here is a link to that .pdf file:

http://www.induswealth.com/wp-content/uploads/2014/07/Investment-vs-Speculation.pdf

One of the best points of the Indus Wealth .pdf is what the Gambler, Speculator and Investor should hope to accomplish.  The Investor should be looking merely to build wealth; the Speculator, to risk their capital for a big payoff; and the Gambler, to have fun.  The payoffs of these three undertakings are commensurate with their best expectations.

IMO

Wall Street is called a Casino probably by those who have lost money at it, and the media narrative that it is a casino is a false one.  Investing is a good thing.  Our Country and our Civilization were built by Investors.  The S&P 500 Index is a positive number – that means Growth is the natural state of things, and it means that the Most Likely Case is that the Investor will make money, especially over the long term.  If you are Investor, but you are still concerned about jumping into the pool, or maybe you haven’t been in this particular pool before and want some guidance, employing Wealth Advisor or Investment Manager will help ease your concerns.  Want to invest but don’t have enough money?  Then don’t spend as much and save your money.  

In a future blog post (maybe the next one, but I haven’t decided yet), I will compare Investing with one of my favorite hobbies, Horse Racing.  They are more comparable than Investing and Roulette, but still not the same.