Investing or rolling the dice?
- Friday, July 16, 1999
You want to make some money with your money, so where do you go? To Las Vegas? The corner convenience store for a lottery ticket? What about Wall Street, a broker, or an online investment service?
Some people say the two approaches are similar. But they're not, and the difference is clearly revealed in the mathematical odds of making gains on your money.
Gambling is a big business in America, but most of the money is being made by those who own the gambling establishments, not the gamblers. In fact, the main reason gambling is so profitable (at least for the owners) is because YOUR odds of winning are slightly less than 50%. More than half the time, you walk away with less money than you had to begin with.
Historically, the odds are much, much better for investments. Of course, there is always a risk when you invest. But the bottom line is that intelligent investing is much better than rolling the dice.
Gambling with the market
Some people gamble in a casino. Others choose to gamble on the stock market. Instead of making intelligent investments, they rely on rumors, unsubstantiated tips, or hunches. Such people might as well throw a dart at the financial tables in the Wall Street Journal. They're still gambling, but they're just using stocks instead of dice.
However, if you want to invest wisely, you will need solid information and portfolio diversification.
Knowledge and Diversity
Leverage your time by utilizing other peoples research. Crosswalk.com's Money Channel contains a lot of information and reasearch on investing. The information used by portfolio managers to make their stock selections is public knowledge and therefore available to everyone. Crosswalk.coms Virtual Stock Exchange is another great place to gain market knowledge by practicing making investment decisions without risking any "real" money.
Diversification simply means spreading out your portfolio over many investments so that you avoid excessive exposure to any single source of risk.
In short, the difference between gambling and investing lies in the approach you take in allocating your money.
Some people do well with investments. Others flounder. I have found that what separates those who succeed from the others is that the wise investors have:a long term, diversified strategy for accumulating wealth while protecting against unrecoverable losses.
- A long term
- strategy for accumulating wealth
- while protecting against unrecoverable losses.
The gambler may indeed make a lot of money in the stock market, but he has risked losing all his savings, foregone sleep on many nights, and should probably think of buying stock in an antacid company.
The investors among us will get to their goal by methodically implementing and following a solid plan:
Portfolio managers love to use a term called "risk-return trade-off," which means if you are willing to take on the risk, there is a reward of higher expected returns.
Let's explain this principle by examining the two hypothetical investors.
Both John and Mary have opened accounts for buying and selling stock in the market.
John decides that he is going to make a fortune in a pharmaceutical company which he heard on a tip was going to have a new miracle drug.
Mary decides that she can't afford to lose a significant portion of her money. She has 30 years until retirement and wants to participate in the stock market in a slow and gradual manner.
John buys ABC Labs with all the money in his account. Mary buys various stocks, across industries and sectors so that her portfolio carries approximately the same risk as the S&P 500 market index. Now let's look at some probability numbers surrounding these two different investments.
John's investment hinges on a new drug, which can have many hurdles to cross before being approved, if it's approved at all. Mary also carries the risk of her stocks not producing up to expectations, but her diversification across industries will lower her exposure to this risk. Market indexes, such as the S&P 500, are benchmarks for measuring performance, so we can assume that within the index there are industries which are performing better and those that are performing worse than the overall index.
Looking at the numbers
John's portfolio carries a higher "expected return" (say 50% annually) than Mary's portfolio (which has historically shown about 12% growth annually), but John's standard deviation (a measure of volatility or risk in a portfolio) is 70% while Mary's is 15%.
A statistics professor will tell you that 95% of the time, a return will be within a range of two standard deviations above or below the expected return. For John this means he could make 190% or lose 90% on his money. Mary can expect a return between a gain of 42% or a loss of 18% about 95% of the time.
Obviously, John is risking too much money to be called an "investor." He has a very real chance to be left with 10% of his money (or less) in a short period of time. Mary has reduced her exposure to risk and set up a good long-term portfolio to meet her goals. Mary can be called an investor and not a gambler.
Looking at the Long-Term
A $50,000 portfolio invested wisely, which gains 12% annually, will grow to $1,618,000 in thirty years. In fact, if the $50,000 is invested initially and $500 is added monthly over the next thirty years, it will grow to $3,544,000.
This approach, as we said before, is a long term diversified strategy for accumulating wealth while protecting against unrecoverable losses.
The same amount of money invested without this kind of prudent deliberation could, at least theoretically, turn into millions of dollars overnight. At the same time, it could disappear overnight, too.
Have the patience and the discipline to develop reasonable goals and create a plan for reaching those goals. It pays to be an investor rather than a gambler.
For more information on Craig Van Hulzen's portfolio management, click here to read Craig's bio.
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