Streetwise for Sunday, April 23, 2017
“The race is not always to the swift, but that’s the way to bet” Damon Runyon.
Let me state at the onset that I dislike analogies comparing Wall Street to Las Vegas. Investing and gambling are not the same. Yet, I can see where someone might draw the conclusion that Wall Street is one large casino where millions of Americans gather to each day to place their bets with the hope of striking it rich.
To compound the problem, if you look in the dictionary you will find that gambling is defined as “taking a risk to gain wealth.” And that is essentially the essence of investing.
But what sets investors apart from Las Vegas are the odds. The odds of winning on Wall Street result from, or should result from, past corporate data and solid mathematical forecasting. Implement proven investment strategies and over time you will very likely see a double-digit percentage increase in your wealth.
Looking back in time, the year 1962 saw mathematics professor Dr. Edward O. Thorp publish his revolutionary work “Beat the Dealer,” in which he demonstrated that the game of Blackjack can be defeated using mathematically proven card-counting strategies. Thorp wrote that the utilization of his tried and true unemotional strategy will, in the long run, make you money, a lot of money. (Note: Casinos have since changed the rules to try and defeat card counting.)
Dr. Thorp made it abundantly clear that “hunches” did not pay a role in his strategy. There was only one best play based on the history of the cards already played. However, you had to invest a considerable amount time and practice to implement the strategy successfully.
Interestingly, Thorp’s book ends with two pages dedicated to the stock market. Keep in mind that these words were penned over 53 years ago. Here is an excerpt:
ìThe greatest gambling game played on earth is the one played daily through the brokerage houses across the country…. The advantages of this gambling game are two. First, it presumably serves a social purpose by helping to finance companies…. Second, the average value of stocks has tended strongly upward over the last century so the game has an advantage, on average, for the player.î
Several studies have shown that stocks display the same mathematical randomness as characterized by the games of chance in the casinos, over the short term. However, over a period of years’ stocks have achieved a nominal average return of about 11 percent a year or about a 7 percent real return, meaning after inflation. While compelling, remember you cannot turn an average into any sort of a guarantee.
OK, assume you are now convinced that time is on your side but what about the market. There is still the argument that the market appears to be overdue for a rest. How do you solve that dilemma?
It does not matter if the market falls or rises each year, but rather the price of your investments when you cash in your chips. Keep in mind that if the equity market gains 11 percent per year on average and you invest on a regular basis, it is to your advantage if the market drops and stays low for a portion of your investment life-span.
Let’s look at an idealized example. Assume you invest $5000 initially and then $2000 per year for 10 years, totaling $25,000. With an average annual return of 11 percent, your portfolio will be worth about $51,000.
Now suppose the market loses 10 percent each year for the first 3 years. If the market’s average return for the decade remains at 11 percent, your portfolio will be worth about $15,000 more than the first scenario, or about $66,000, given the same $25,000 investment!
How does this work? Remember you are investing $2,000 per year, so you acquired stock at lower prices early on. If the market returns 11 percent on average for the decade, but loses 10 percent in each of the first three years, it will have an average gain of over 21 percent during the subsequent seven years. The money invested early on takes full advantage of those later higher returns in a manner known as dollar cost averaging.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.