Stock Market - Are You Playing The Lottery?
Is investing in the stock market like playing the lottery?
At work the other day, I heard a fellow co-worker telling another employee that he doesn’t like to invest in the stock market. “It’s like playing the lottery,” he said. I was immediately drawn to learn more and also question why he felt that way. How could something that has averaged slightly over 9% through the last 30+ years be compared to playing the lottery. After some deep thought, I found the answer. There is a lack of understanding what investing in the stock market means and how it works. So let’s talk more about that and determine if you’re investing in the stock market or gambling with your money.
Are You Gambling?
If you invest wisely in the stock market, you’re not gambling. There is risk but there is nothing that returns any level of significant return on your investment that doesn’t involve risk. I was originally confused by this comment because investing in a business is not gambling in my mind. Gambling assumes you are playing a game, you have only a slight chance of winning, and then only if you ‘win’ will you keep any of your money. But it’s likely you will lose it all. That’s not my experience in investing and I wanted to explore the difference as well as how to know if you are playing the right game.
First off, I’d argue that investing in any business is never gambling. If it’s a super risky business and it doesn’t have a good chance of succeeding, it might have a very high risk of failing but it still isn’t gambling. You aren’t counting on pure luck as to whether that business succeeds or fails. Is it a good business, run by good management? Do they have a competitive advantage over their competition? Is there demand for their product? Those are the factors that will ultimately decide a business’s fate, not luck. Most of investing is understanding these risks and making sure you are investing the right amount of money in risky vs safer investments based on your comfort with risk.
According to Gallup, 52 percent of U.S. adults owned stock in 2016. So if investing in stocks is gambling why would half of America invest in stocks? Furthermore, this post from Financial Samurai states that, “According to the Federal Reserve, of the 10 percent of families with the highest income, 92 percent owned stock as of 2013”. If owning stocks was gambling, then why would 9 out of 10 of people with the top 10% of income own stocks? Think it's fair to say it’s not playing the lottery. It's a method of investing that involves risk and depending on how you play it, it becomes more or less risky. Overall the market will go up and down, but over time there is no investment that has proven to return better results than investing in successful businesses.
How to invest without gambling
Buy Valuable Stocks: Research the value of a stock and invest in companies that have a high intrinsic value. Essentially you are looking for companies with strong growth potential in relation to the current share price. Here is a calculator to help you calculate intrinsic worth of a companies stock.
Invest in Index Funds: Buy a broad spectrum of companies through index funds and/or mutual funds. Take for example the S&P 500. Any index fund or mutual funds that tracks the S&P 500 index will purchase shares of the top 500 companies in America. Meaning, you are effectively buying a little of the biggest 500 companies in America. Sure, the stock market could go down to zero but if you think about it, the likelihood that the value of business in America goes down to zero is probably zero. Unless our entire nation folds. It's not playing the lottery, it's investing in the American economy.
Invest in Real Estate: Real estate is a great alternative to traditional stocks and bonds and is also a great way to diversify your portfolio. REITS or Real Estate Investment Trusts invest directly into real estate projects and usually return a fairly high dividend for your investment. When you purchase shares of a REIT fund you are purchasing shares in a business that invests directly into real estate. Is buying an office building gambling? Would purchasing a storage unit be considered gambling? Well, that’s exactly what these companies invest in and you can too.
Focus On Asset Allocation: Depending on your tolerance for risk and how much you are willing to lose in a given year or decade should drive your desired asset allocation. Without getting into how to do that in this post, you should consider a balance of stocks and other investments such as bonds, real estate, and even gold/commodities. Stocks have proven to have a greater long term return but are more volatile in a given year. So if you want to diversify your investments consider a percentage of bonds in your portfolio to counter act the volatility of stocks. Historically, bond prices will rise when stocks are falling or at a minimum, decrease in value at a much smaller rate.
How to know when you’re gambling
Investing In The Next Big Stock: You are buying a random stock ticker because someone told you it’s the next Amazon or Google. That is gambling because you don’t understand the business, you are just investing on hearsay.
Don’t Understand Risks: If you don’t understand the risk you are taking buy purchasing stocks vs bonds as an example, then it can feel like gambling. Risks in any investment will result in greater potential return but also greater potential loss. Make sure you understand risk before investing in stocks.
Purchasing stocks with zero research: Gambling is when you don't do research or you are investing in a highly speculative company with little to no knowledge of the underlying business. Investing like that is gambling because who knows if the company is likely to be successful. Most importantly as an investor you should know why you are investing in a company and without some research, you won’t know why a business will succeed or fail.
Buying Stocks Only For The Dividend: Purchasing stocks or index funds that return a desirable dividend is great, but make sure to also consider the underlying business or index you are investing in. Some key things to consider are how long have they been paying a dividend. Is the underlying business something you want to invest in outside of the dividend because dividends can get cut and/or change.
Buying Stocks Purely on Growth: Are you buying a stocks, ETF, or index fund because it’s gone up 50% in the last year or two? Be wary with this one because perhaps the company continues to grow at that rate but most likely if it’s grown that much already, the bulk of the growth has already been priced into the market. If you decide to invest in something with this kind of growth I would recommend you have a good understanding of how that company is going to continue to grow at that rate. If not, you should probably pass on it.
Buying Stocks Because They Are at a 52 Week Low: It is tempting to buy stocks at their 52 week low but that shouldn’t be your sole purpose for investing in something. Many stocks that are tanking will be hit a 52 week low and then hit it again the next year. If you are going to invest in a company because it’s at a 52 week low make sure you see a strategy on how that company is going to turn itself around. Why is the business at a one year low? Is the business burdened in debt? If so, can it sell some of its assets or parts of its business to get out of debt? These are the types of answers you’ll want to come up with for yourself so you know why you are investing in a given business.
There are only a few ways to continue to build wealth and own assets that have proven to appreciate for more than 100 years. It’s to own businesses, owning assets such as oil, gas, or gold; and to own real estate. There really aren’t any other proven and consistent methods to gaining wealth. Remember, ‘When you purchase shares of a stock, you are buying a partial share of a company.’ Owning any business can be risky, but the reality is most people confuse that risk with gambling.
Those who are afraid to invest in good businesses and lack the understanding of what they are truly investing in are the people who will struggle to build long term wealth.
There is certainly a risk when you invest in businesses but there is also a very strong chance of an 8-10% return, especially over a 10 to 20 year period with any stock in the fortune 500. Owning your own business is often the most profitable way to gain substantial wealth but that’s not for everyone. If it is, you’ll likely get a great return but it also comes with greater risk of losing your initial investment if it fails.
Personally, I think the biggest risk of all is not investing your money into good businesses. At best, you’re sitting on your cash as it depreciates because of inflation or at worse, people like my colleague, get caught up in trying to find alternative ways to ‘get rich’ and end up actually gambling it away in the lottery or chasing a get rich quick investment like bitcoin.
If you look at stock prices everyday it can feel like gambling, but when looking at the return over a decade or more, it’s not a gamble at all. In fact, it’s one of the most proven ways to grow your wealth and eventually achieve financial independence.
If you’re new to investing in the stock market it feels intimidating you’re not alone! I’d recommend looking into some online resources that can help you get started. For example, try checking out Betterment and/or Wealthfront who provide great services and can help anyone get started investing in an easy and intuitive way.