The following is a guest post from the Dividend Ninja. A couple of weeks ago, Y&T mentioned she was going
back to school full-time, and was worried about not being able to write enough material while studying (which is a valid concern). She was asking for guest posts – how could I say no to a fellow Vancouverite?
A few months ago I downloaded backgammon app on my Blackberry to play when I’m really bored and don’t feel up to reading or working on the web. Of course I chose the “Expert” level since I think I’m a pretty savvy player. I also figured it would be pretty easy to beat a basic game of backgammon – especially since it’s a just a blackberry app (if it was an iphone app I’d think twice). Well beating the game wasn’t as easy as I thought! And even more difficult as I discovered, is to consistently win a number of games in a row.
So what does that have to do with the stock market? You might be surprised to find out more than you think. Many investors approach the stock market and their investing strategies like a game of backgammon. Here’s why gambling and investing shouldn’t have anything in common, but as we often see for many investors they do.
I Feel I Can Win
Feeling positive or negative about a game of backgammon before it begins has absolutely no influence on the outcome of the game. Sounds silly doesn’t it? But many investors apply this logic to investing. They buy stocks or make decisions based on their feelings about a particular stock or the market in general. The bottom line is your feelings about a stock or the market in general, has no effect on the outcome. For example, right now I think Pepsi (PEP-N) is a good buy. Does that really mean it will influence the outcome of the price?
The luck of the Dice
The main factor in backgammon of course, is simply chance itself, the luck of the dice. This is simply the result of random events, which adds an element of unforeseen risk. As soon as you decide to play the game, you take on the risk of receiving bad or good rolls, winning or losing, and everything in between. I can be as calculating and as careful a player as I can be – scrutinizing every move I make. But in the end it’s all pointless if I get unlucky rolls and my opponent gets 3 double-sixes in a row, or vica versa. In other words chance will influence the game enormously.
In a similar vein, there is much more chance and random events which occur in the stock market. Sure the markets move in waves of high and lows, but even the academics and pundits can’t tell you what the market is going to do tomorrow or next month. There is simply no way to know what the market will do from one day to the next. Simply put the events of the stock market, and stock prices for that matter are random. If it wasn’t everyone would be wealthy, because the market would then be predictable.
What I did notice was anytime I took a chance and left my pieces open, or made an aggressive move against my opponent (a dumb blackberry app) I ended up getting behind and often lost the game. So I determined that in backgammon, regardless of dice-rolls or “ability” of my opponent, taking chances rarely pays off. That means that risk in backgammon comes from taking chances.
The stock market of course is far more complex than a simple game of backgammon. The levels of risk in the stock market are many and varied, and layered in complexities. I have come to the simple conclusion that when you take a chance in the stock market, your outcome is more likely to be a loss than a win. That’s why it’s important to have a strategy in place, whether that is passive index investing or passive dividend investing, that you apply in a logical and unemotional way.
Improving the Odds to Win
Can you improve your odds of winning in backgammon? If risk in backgammon is associated with taking chances, then what if I eliminate that possibility? So I changed my tactic and decided to play the safest games possible, by not taking undue risk. In other words I always played the safest moves possible.
While employing that method certainly improved my number of wins, it certainly wasn’t a deal breaker. I still ended up only improving my wins only marginally over time. So what does this indicate? It indicates that calculating your moves and trying to make a decision on every move, has no real effect on the outcome of the game. While it sounds absurd, picking stocks and paying constant attention to the market, or on the details of specific stocks, is also meaningless. Really, it is.
Why Logic Doesn’t Work
What about eliminating any chance and always playing the most logical move, as determined by mathematical odds? Surely that is the deal-breaker! If one only had to apply pure logic and math to backgammon to win, then that would be a no-brainer. In fact this is exactly what the blackberry backgammon app does, and probably with some human moves programmed in, but it doesn’t win every time! This is simply the result of the unknown. It is impossible to know what dice-rolls the future holds, or what moves your opponent or yourself will make in the future.
In similar vein it is impossible to know what the stock market will do one day to the next, or a month from now. You may purchase a stock at 52 week lows, with great fundamentals, and there is no guarantee. Yet you may take a chance on a stock and make a 300% gain over the year. Once you realize that the stock market has no possible logic that can be applied to it, and is completely irrational, the less likely you will be to bet against it. After all if the market was based on logic, then all the mathematicians and physicists would be millionaires and the rest of us would live our lives in poverty – but it doesn’t work that way, does it?
It’s Impossible to Consistently Win
The other possibility of course, is that it is impossible to consistently win in backgammon. In other words the more times you play, the higher your chances of losing. That means there is a large element of chance, and that playing it safe doesn’t always pay off, and taking a risk rarely does. Consider that the stock market is even far more complex than a simple game of backgammon, and you can see why taking a chance in the markets is a loser’s game!
So what’s the solution? Simply resign yourself to the fact that if you play backgammon you cannot consistently win every time. Forget about playing the game at all, and buy your opponent! In other words buy the market instead of betting against it. That strategy is called index investing.
Index Investing with regular contributions, something Andrew Hallam points out in his new book Millionaire Teacher, is one way to beat the game. He also reiterates this point in his recent post in MoneySense magazine. By employing this strategy you simply take all the guesswork out of investing. And of course one of the best resources for Canadian Index Investors is the Canadian Couch Potato.
Passive dividend investing is another strategy that takes the guess work out of investing, and I reiterate the word passive. Purchase solid dividend paying blue-chip stocks, regardless of price, with a set-it and forget-it attitude. Reinvest your dividends (DRIPS) and compound your returns. A passive dividend strategy will pay off many years down the road in terms of ROI (return on investment).
The following was a guest post from the Dividend Ninja. Thanx for reading!