Is investing in the stock market gambling?
I used to associate the stock market with gambling. I thought the goal was to pick the next big winner, and if you couldn’t do that, you always lived with the risk of losing everything. Hit it big or lose it all; that’s what I thought the stock market was. The movies and media only fueled this perception. You’ll see headlines all over about how to pick tomorrows winners, and you’ll hear the stories of those who lost fortunes in the Great Depression, or more recently, the Great Recession of 2008. Needless to say, I was leery of the stock market. I simply was not educated about how financial markets work, and how proper investing should take place.
Do you need to hit it big in order to make money in the stock market?
We would all love to find the next Google before they were big. At one time, Google had a low price, and if you invested in it then and held it until now, you could have made a lot of money. Simple, right? Here’s the catch, when Google had a low price, no one knew it was going to be the next big thing. That’s why it had a low price! It was just one of thousands of companies trying to make it in the tech industry, and it was impossible to tell which one would rise above. Once it became a strong company with innovative and powerful products, everyone knew about it, its price skyrocketed, and it was no longer a value to buy. You only know which companies will succeed in hindsight.
There are thousands of professional investment analysts across the world, working for the biggest investment firms with endless resources, all digging through company balance sheets and other financial statements, competing to find the best investments. If there was an obvious deal out there, believe me, they would find it before you, and they would bid the price up quicker than you can move your mouse across the screen and click “buy”. The current price of a stock already includes expectations of future growth. So, if a company looks like it even might take off, it’s price will rise, which is why it’s impossible to find the diamond in the rough; outside of blind luck. Do we give up on investing altogether then? Not when we understand some of the basic principles of investing, starting with where returns come from.
Where do returns come from?
When you own a stock, you own a part of that company. Do business owners think of themselves as gambling their money? Of course not. Sure, there are risks with owning a business, but their business is their job. They put in the work, and they make a profit. As a business owner, you own the rights to the company profits, and this is the same with owning a stock. If a company has 100 shares and you own 1 of them, you own the rights to 1% of that company’s profits! That’s a powerful concept.
This is where returns in the stock market come from: the profits of the companies! Companies exist to make a profit for their investors. Companies do only one of two things with their profits. Either, 1. Pay their investors directly (called dividends), or 2. invest them back into the company, which then makes the company better, and results in a price increase in the stock. Either way, the investor wins! The details of how all this works is beyond the scope of this blog, but if we look at historical data over 20-year periods, returns have averaged right around 8-12% per year, depending on the area of the market you’re investing in.
These returns are subject to what we call compound interest and increase the value of an account exponentially. If you invested $46,000 and never put any more into it, it would grow to $1,000,000 if left in the market for 40 years at an 8% rate of return. That’s an increase of over 21 times! And you didn’t have to pick even one big winner. You can see why Einstein once described compound interest as “The eighth wonder of the world”.
The potential is there to make money in the stock market, even if – and I might say especially if – we don’t swing for the fences trying to find the next big thing. We call this a buy-and-hold strategy, and it’s one of the first and most important principles of investing. Buy investments and hold onto them for the long run, and your portfolio will naturally grow over time.
The lottery ticket investing strategy appeals to our desire to get rich quick. We don’t want to put in the discipline that it takes to build wealth over time. Consequently, many investment firms and investment media outlets will play to this and tell you they have the secrets to the next big thing. They don’t. Think about it, if they did, why would they tell you about it? They would invest in it themselves and make all the money. They claim to know the secrets because people will pay for it, because it appeals to our laziness. Don’t fall for it! No one can predict the future, and if they could, they wouldn’t tell you, but a disciplined buy-and-hold strategy has history and academic research backing it up.
This also means that we don’t have to spend hours and hours every day doing research on the stock market. We don’t have to wade through company fundamentals, trying to pick the best ones, and staring at analytics charts trying to get in and out of the market at the perfect times. The proven buy-hold strategy eliminates all this, and it makes investing accessible. You don’t have to be an expert! It takes time though. Wealth isn’t built this way overnight, and that’s the challenge in front of us. We must overcome the temptation to find an easy way out, and instead stick to the tried and true method.
Now, actually implementing a portfolio set-up for success takes more than just buy-and-hold, it takes proper diversification, focusing on the right factors, asset allocation, re-balancing, tax considerations, and more. We’ll cover some of this in the future, but getting the casino mentality out of our mind is a big step.
Also, always remember, nothing takes the place of a good financial coach.
Next time, I’ll discuss the other side of my dilemma: What’s the risk of losing it all?
*Advisory services offered through Paul Winkler, Inc. (‘PWI’), a Registered Investment Advisor. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities.