“It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.” — John Maynard Keynes
While he’s remembered for the idea that governments should spend in tough times to offset recessions (called “Keynesianism”), British economist John Maynard Keynes nevertheless had an enviable track record as an investor.
From 1933 to 1946 — once he began to study investments rather than try to guess market directions based on economics — he beat the market by 8 percentage points a year, on average.
The “casino” quote comes from a book, “The General Theory of Employment, Interest and Money”, which was published in early 1936. Presumably, by then Keynes had begun to realize that investing is far different from simply throwing chips on a craps table. Otherwise, he might have quit altogether.
But how is investing different from gambling? For the first of a series of articles in the style of TV’s “Mythbusters” program, let’s take this particular myth apart step-by-step and see if we can’t bust it for good.
So, first a definition. What is gambling, exactly? Gaming comes in dozens of forms: card games, dice, sports books, slots, and the more broadly accepted ideas of playing the lottery or taking part in, say, a church raffle.
In the simplest form, then, gambling is taking a risk with money in hopes of a reward, that is, more money. You lose, you pay.
Typically, there are odds you can learn in advance. In a lottery it’s published by law. For horse racing and sports betting, you can see the odds shifting as bets come in. Casino game odds are not hard to come by.
Investing, however, has a very different definition, which is the spending of money with the expectation of profit. If you put money into a small business, it might go under, and it might break even. But the reason you took the risk was because, one presumes, you have a pretty clear idea of how your money will be returned, plus some.
Ah, you say, but people lose money in the market all the time! Sometimes all of their savings! Yes, they do, and that’s because too many people persist in treating investing as if it were casino game, hoping for a big kill that will allow them cash out and quit the game completely.
Let’s Get Busting
Yes, there are plenty of risky ways to put your money into the markets, such as trading on margin (using borrowed money) and buying and selling highly illiquid penny stocks.
But let’s bust a myth here. How can an investor actually invest, that is, put money to work with a reasonable expectation of return? The following is a breakdown of investing styles in order of relative riskiness:
1) Buy a CD. Most people think of certificates of deposit (CDs) as a form of savings account, and they certainly feel like that. However, if you hold a CD to maturity and its interest rate is higher than the inflation rate, you get your money back with a little extra while the issuing bank takes on the risk of properly lending out the principal in the meantime. You’re a conservative investor, but by definition an investor. Most CDs are insured by the FDIC as well.
2) Buy a bond. Famous investors such as Warren Buffett often talk about the “risk-free rate,” that is, the current interest rate on U.S. Treasury bills, after inflation. As the logic goes, any investment that entails higher risk must pay more than a U.S. Treasury bill of a similar holding period, or why bother? If real rates (the rate taking into consideration inflation) are high enough, there’s simply no reason to invest it otherwise. Just buy a bond and go to the beach.
If inflation is a bother, you could always buy TIPs, short for Treasury Inflation-Protected Securities. These pay you a bond return plus the inflation rate, by design. Not exciting, but TIPs buyers aren’t after “exciting,” they’re after “safe.”
3) Buy a stock. There is a gulf of risk between owning a bond and owning a stock. Right off, stocks can lose value. Dividends can be cut. All kinds of bad behavior can be uncovered behind the scenes at whatever company you happen to buy, and of course the economy can slide into the dumper, taking your principal with it as stock prices fall, presuming you sell in the panic.
Nevertheless, stock over sufficiently long periods make money, as Wharton Professor Jeremy Siegel posits in his bestseller “Stocks for the Long Run”. In short, he found, stocks returned 6.8% per year after inflation, compared to bonds at 1.7% percent and gold in negative territory (-0.4%). His numbers go back to 1802, although it’s worth pointing out that, for various reasons, Siegel expects stocks to return around 5 percent (after inflation) for the next few decades.
4) Buy assets that are drastically mispriced. That, in a nutshell, is how Keynes did it. He got down in the dirt and figured out which companies were making money and which weren’t, and he picked industries out of favor at the right moments, sometimes taking huge stakes in them. He was, after all, a pioneer in equity, or stock, investing at a time when his peers stuck to bonds.
As Warren Buffett often states, it’s better to buy stocks on sale, although that implies you know the correct price while others simply don’t or don’t believe it.
Most of the time, Buffett knows the right price. As a result, he buys rarely, and when he does, he spends big. This focus on value and underlying worth is far different from gambling, and that’s true whether you are in for a couple hundred bucks or a number with 10 zeros after it.
5) Buy index funds or ETFs. If you cannot stomach buying a single stock or can’t do the research, buy a fund that holds a selection of stocks. Buy a cheap fund, one that tracks the whole market or large slices of it at minimal cost. As we have explained many times on this blog, expenses and fund fees over time will eat your returns alive. Think of active fund managers as the house in a casino, because that’s what they are in most cases for most investors. Remember: The house never loses.
The best way to invest over the long run and reduce your risk to a minimum is to carefully construct an asset allocation that takes into account your personal goals. Then, have the discipline to sell gainers and buy losers in your selection in order to maintain your allocation model over time.
As researchers have shown, active management has no measurable impact on returns. In fact, it adds only risk. You would do just as well, and almost certainly better considering the fees, by owning passive investments in a thoughtful selection of index funds.
Result: Investment myth busted. Gambling is gambling, while investing is seeking a reasonable, inflation-adjusted return for the use of your money over time, whether in the form of interest payments, dividends, or stock appreciation.