After the worst yearly start for stocks in history, many investors are feeling some concern. That old myth resurfaces, “Investing in stocks is just like gambling.” Investing in stock is a lot like buying a lottery ticket.
Gambling addicts would probably agree. In the 1990s, scads of obsessive day-traders seemed to gamble themselves into personal and financial ruin.
Jim Parker, regional director of Dimensional Fund Advisors Australia, has a similar perspective: “When investors insist on concentrating their exposure to the equity market in one or two or even a handful of stocks, investing this way, particularly over the long term, is just speculation. It’s just like buying a lottery ticket.”
Speculators making non-diversified bets will experience higher highs and lower lows in any given year. However, there is little empirical evidence that speculators consistently outperform diversified investors when long-term results and risks are taken into consideration. The top markets or individual performers change almost every year. Often, this year’s diamonds become next year’s dogs and vice versa.
In 2015, the S&P 500 index was up a modest 1.4 percent, but most of the year’s gains were concentrated in a small number of individual stocks such as Facebook and Netflix.
While some investors enjoyed outsized returns from these high-fliers, many may not be aware of the risk this creates. Plenty of the stocks in the S&P 500 index posted negative results last year. Energy companies fell 70 percent to 80 percent in value. Watchmaker Fossil Group and chipmaker Micron Technology fell 60 percent each as consumers turned toward fitness trackers and the Apple Watch and away from personal computers.
Owning only a small number of stocks exposes long-term investors to a wide variability of returns. By contrast, diversifying over many stocks increases the odds of investors achieving their financial goals by capturing long-term market performance.
Diversification does not improve the expected return, but it does reduce risk. Essentially, while you are sacrificing a small chance of a huge reward, the lottery ticket, you are also reducing the chances of a terrible outcome.
Disciplined stock investing is not gambling. Gambling takes money from a loser and gives it to a winner. No value is ever created. With long-term investing, as companies develop products and services that can make our lives better, then over time, the value is created.
What is next for stock market investing in 2016?
According to John Bogle Sr., the founder of the Vanguard Group, “Nobody knows. That’s the point. If you’re among that small cadre of extremely high-level traders who can throw loads of cash at a short-term fluke, fantastic. If you have a mind for numbers like Warren Buffett that allows you to buy companies on the cheap and hold them forever, excellent.”
For the rest of us, the common sense plan is to assemble a globally diversified, all-weather portfolio to carry us into the future. We should strive for consistency and avoid dramatic changes during periods of dramatic short-term volatility.