Last Updated September 5, 2013
Once you step away from the cosy world of fixed rate investments it becomes much more difficult to tell if you’re an investor or if you’ve become a gambler.
For fixed rate investors the difference is clear. They save money into an account and the value of each pound saved never changes. The account then provides an income which is known in advance and drops into the account several times a year. The chance of an adequate return is high and the chance of a permanent loss is effectively zero. None of this sounds remotely like gambling.
A fine distinction
Ben Graham said that an investment should provide safety of principle and an adequate return. Of course, adequate return is subjective, but if you’re happy with the lower and more certain returns of fixed rate investing then it certainly fits Ben’s definition.
Gambling on the other hand offers the chance of an adequate return and perhaps a life changing return in the case of the National Lottery, but it also offers a meaningful chance of a permanent loss and even a total loss; that is the key distinction.
Both investing and gambling can provide adequate returns and better, but only investing can do this with little or no chance of a permanent loss. Strangely enough, the stock market can be a place for both investing and gambling.
Short-term gamble, long-term investment
If you had some money to invest for a year while you travelled the world, putting the money into the stock market would be a gamble. This is true because returns from the stock market in a single year can range from perhaps 30% up to 50% down. With a possible 50% loss in a year the stock market over such a short time-span is a gamble.
If instead you were investing a lump sum for 20 years then the FTSE 100 becomes an investment. That’s because over 20 years the returns from the stock market are almost always positive, even in inflation adjusted terms, so the chance of a permanent loss is virtually zero and the similarity to gambling fades away. The same thought process can be applied to individual stocks so that they become investments rather than gambles.
Stock picking for investors, not gamblers
In most cases investors don’t look for a 20 year holding period in an individual stock, so let’s take something a little more typical. Say my investment horizon for each stock is 5 years. It might be more, it might be less, but that’s the general ballpark. If I was to invest in Balfour Beatty today at 290p I’d get a stock that pays a dividend of around 4.5%, which is well covered by earnings and is expected to grow at least in line with inflation.
If I owned this stock for 5 years I might receive dividend payments totalling around 25% of the purchase price. For this to be a gamble rather than an investment I’d have to say that there was a meaningful chance of a negative return over the expected holding period. To have a negative return the share price would have to drop by more than 25% (i.e. the capital loss would negate the dividend income).
If the share price fell 25% to 220p then the dividend today (at 12.7p) would be 5.7%. That’s high, but far from impossible. In 5 years however the dividend could easily be nearer 15.5p (growing at an unspectacular 5% a year) and in that case a 220p share price would give a dividend yield of 7%; again, that’s not impossible but it is unlikely.
With almost no chance of a total loss, only a small chance of any loss at all and a good chance of ‘adequate’ returns (perhaps 10% a year), Balfour Beatty looks to me like a sound 5 year investment as part of a diversified portfolio of similar stocks (in fact I do already own it).
When you’re stock picking it’s critically important to differentiate between investing and gambling. Knowing one from the other can mean the difference between achieving long-term investment goals and missing them by a country mile.