With the Grand National having taken place last weekend and the stock market being incredibly volatile, it's all too easy to draw parallels between investing and gambling. After all, predicting the winner in a horse race or winning a bet on the roulette wheel, at a slot machine or whatever else, is down to luck. And with the direction of the stock market being nigh on impossible to predict in the short run, it could be argued that trading over a short time period is akin to having a punt.
However, in the long run, investing and gambling are very different beasts. Certainly, they can offer an individual a similar feeling of ecstasy or heartbreak, but the main difference is that in gambling the house always wins, but in investing we investors can stack the odds in our favour. In other words, by using a number of simple principles, investing over a multi-year period can be as similar to gambling as chalk is to cheese.
One key principle of investing is the margin of safety. This essentially means that instead of buying a share when it's priced at fair value, an investor seeks a discount so as to afford himself/herself a margin of error. In the long run this should increase the overall profitability of a portfolio, while also providing less downside risk.
Certainly, it may require patience to wait for a company's share price to fall to a level that provides a sufficiently wide margin of safety, but over history the most successful investors have tended to be the ones who are willing to await the right price before piling in. Clearly, the riskier the company, the wider the margin of safety that should be sought, since more cyclical companies can see their forecasts downgraded a lot faster than their more defensive peers.
In addition, diversifying between different investments also stacks the odds in an investor's favour. That's because any company can endure a challenging period and all companies therefore come with company-specific risk. By holding multiple companies within a portfolio, the risk of poor overall performance resulting from lacklustre returns from a small number of holdings is reduced and this helps to reduce the risk of the entire portfolio.
Furthermore, by keeping dealing costs to a minimum and sheltering investments from tax through an ISA, it's possible to increase total returns in the long run. For example, the use of aggregated orders keeps dealing costs to a minimum, while ISAs aren't subject to capital gains tax. Although both of these areas may only add relatively small amounts to returns each year, the effect of compounding can make their contributions much greater over a long period of time.
So, while trading shares in the short run may be somewhat similar to gambling, in the long run shares have historically provided much higher, more stable and less risky returns. And by seeking out a margin of safety, keeping costs to a minimum, using an ISA and diversifying, it's possible to generate returns that at least match the FTSE 100's annual gains of 9.1% since the start of 1984.
As such, while the house always wins when it comes to gambling, it seems as though investors really do have the odds stacked firmly in their favour.
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