For most investors, the relationship between investing and profits seems simple enough. You buy low, sell high, and your portfolio grows – or so goes the story.
In reality, success ultimately comes down to defeating something called “Gambler’s Ruin.”
We’re going to talk about that today – what it is, what it means for your money and, most importantly, how to beat it.
It’s a column you won’t want to miss because it’ll give you an edge other investors would pay dearly to have. Not one in 250,000 understands it.
The difference between heartache and success comes down to this concept.
Most investors have never heard of “Gambler’s Ruin,” but understanding its implications can make the difference between heartache and success in the stock market, especially now.
Here’s how it works:
Imagine that Player One and Player Two each have a finite number of pennies, which they flip one at a time, calling “heads” or “tails.” The player who calls the flip correctly gets to keep the penny.
Since a penny has only two sides, it would seem on the surface that each player has a 50% probability of winning – and that’s indeed the case for each individual flip.
But, if the process is repeated indefinitely, the probability that one of the two players will eventually lose all his or her pennies is 100%.
In mathematical terms, the chance that Player One and Player Two (P1 and P2, respectively) will be rendered penniless is expressed as:
P1 = n2 / (n1 + n2)
P2 = n1 / (n1 + n2)
In plain English, what this says is that if you are one of the players, your chance of going bankrupt is equal to the ratio of pennies your opponent starts out with to the total number of pennies.
While there are wrinkles in the theory, the basic concept is that the player starting out with the smallest number of pennies has the greatest chance of going bankrupt.
In the stock market the player with the smallest number of pennies is you… and me…and any other individual investor, for that matter, who is up against the big boys pushing highly leveraged portfolios worth billions.
Here’s Why Professional Investors Always Take Money Off the Table
If you’ve ever been to Las Vegas or Monte Carlo, chances are you understand this at some level, if for no other reason than that the longer you stay at the tables, the greater the probability that you will lose. The house simply has more money and better odds.
Investing is much the same.
Since Wall Street casinos (read that as investment houses, hedge funds, mutual funds, and the like) have more pennies than their individual patrons (retail investors), they can play the game longer. Not better, longer.
More often than not, that means they come out ahead because the smaller players get wiped out or, as is the case over the past decade, give up.
That’s why, unless you have some means of protecting your assets- whether you’re at the gaming tables or in the stock market – the principle of Gambler’s Ruin dictates that you will eventually give them up.
Perhaps that’s through losses or the attrition of accumulated commissions and fees, but if you do not change your behavior, it will happen. The only question is when.
If you start with lots of money, it may take several generations, but the fact that it takes extra time doesn’t invalidate the math.
But again, and I can’t stress this enough – that’s if you do nothing but play the odds.
Playing to Win
To win you just need to change your game in such a way that the odds reflect the strengths we bring to the table and to the markets as individual investors.
Let me explain.
When you’re going through periods of high growth, opportunities come at you so fast that it seems almost incomprehensible.
In that kind of environment, an investor can easily conclude he or she is a genius. That’s very dangerous because the principle of Gambler’s Ruin is still at work.
Even during the best of times, the markets move with alarming regularity to the downside. In fact, over time, about one in every three days is a down day. That’s why profits just aren’t simply a matter of finding opportunities and going along for the ride. You’ve got to have risk management top drawer at all times.
Using the Total Wealth framework, ask yourself:
- Does the company you want to buy tap into one of more of our Unstoppable Trends?
- Is it a “must have” with a strong global operation with an even stronger balance sheet, growing earnings, and top line revenue? And, does management have an international vision (I won’t recommend any company that doesn’t.)
- Does it help protect your portfolio with ongoing demand for its products, dividends, or otherwise compelling risk management? Does it pay a dividend, which is not only compensation for the risk you are taking as an investor, but an implied promise from management that it will do what it says?
Each of these points are odds-eveners – for lack of a better term – that help you avoid Gambler’s Ruin by exploiting weaknesses that take away the advantages of size and scale enjoyed by the big boys.
They’re also winning characteristics that shift the house odds in your favor. You won’t be going to the tables with a maximum loss in mind, to use a Vegas analogy, but, instead, with a winner’s mentality.
How to Grow Your Pile of Chips Going Against the Pros
Every chance you get to bend the rules to your advantage equals higher potential returns.
But… but… Wall Street’s big boys have a nearly infinite pile of chips and computers…
Yes, they do.
Even so, you can even the odds.
Institutions are very “name driven,” but they are hampered by their size. Very few individual investors are. Think about it: they just can’t waltz in a pick up a cool million shares of Microsoft, for example.
As a result, institutions are likely to wait until everybody is selling, then begin picking up shares of quality companies on big down days. These big traders are especially active at or near big bottoms or market tops because that’s when they’re likely to get the biggest bang for their buck and the price they want without moving the markets.
On the other hand, most individuals don’t have this problem. Very few are moving a billion at a shot, so unless you’re trading something in the ultra-microcap range, you can be early or even a little late to the party and still do just fine.
Traders are paid to win and hate losing money no matter how much of it they’ve got. If you understand that, you will understand what I am about to say next – pros would rather hit singles and doubles than home runs all day. They know that’s what pays the bills.
That’s not to say they won’t go for the homers. But if a professional manager can lock in profits with one or two big name investments backed by trillions worldwide, he’ll do that instead. For him, it beats trying to make 30-50 companies “work” by trading them into the ground.
This is a distinct advantage for individual investors because big companies matter – not just in terms of potential, but in terms of being defensive, too. That’s why, for example, we’ve talked about the increasing concentration in a select few stocks even as everything else has deteriorated this year.
The big traders tend to stick with their winners. They may trade around them, but most build a core portfolio, then guard it like a hawk, depending on their market expectations.
Individuals, on the other hand, seem obsessed with the thrill of the chase. It’s sexy, it’s fun to talk about at cocktail parties, and it makes for great dinner table conversation. That is until you get into a pissing match with a big trader determined to hammer you into submission. Then it’s downright unpleasant.
Limit Orders Are Your Best Equalizer Against Wall Street
In the old days, institutions owned the markets. These days, thanks to the advent of electronic trading and platforms that are available at nearly every online e-brokerage firm, individual traders can.
It may not seem that way given the computerization and high frequency trading in the headlines of late, but simply using limit orders or selling puts to “buy” a stock, bond, or ETF can put you at the table rather than on the menu.
The big boys count on uninformed individuals making trades at the market. Take away that advantage by being informed, having a strategy like Total Wealth, and proper risk management, and you even the odds considerably.
Small investors can avoid the noise. I know that’s hard to imagine given 7.9% slump the Dow has seen in January so far, but it’s born out by history.
Institutions are under extreme pressure to trade actively. They can’t just step aside. That’s why if they can offload their risk to unsuspecting individuals, they will. But guess what?
This works in reverse. If you refuse to play the game and confine your investment decision-making to the criteria such as I just outlined using Total Wealth Tactics like Lowball Orders, Limits and Free Trades, you’re automatically on your terms rather than theirs – no matter what kind of day the markets are having.
Learn these things – and practice them every chance you get – and “Gambler’s Ruin” won’t rob you of your retirement.
Until next time,
The post Wall Street Has a Secret Weapon, and Here’s How You Can Beat It appeared first on Total Wealth.
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