Wall Street Craps – 2012 Global Ebook Finance Award-Winner

A SIMPLE GAMBLING ANALOGY:Choosing a stock to buy is like selecting where to place a bet at a Las Vegas Craps table. Every stock has its own risk and reward potential, just as there are different bets with varying mathematical odds and payouts in Craps.

The amateur Craps player will most likely place random bets of varying amounts on an assortment of numbers on the Craps table layout. He or she usually doesn’t have any kind of organized system for selecting their number(s) or controlling the size of their bets. His or her success or failure is dependent entirely on the roll of the dice.

On the other hand, the savvy Craps player fully understands the mathematical odds and plays accordingly. As a result, he or she knows what bets to consistently make and which ones to always avoid. You’ll rarely if ever see a savvy Craps player making careless large bets in the hope of snagging a lucky number. However, you will notice that savvy players know how to take full advantage when the table gets “hot” by being diversified on enough high-percentage numbers.

In a similar way, the amateur stock investor will dabble in an assortment of individual stocks – without a system for diversifying risk over enough companies and market sectors. Unless the amateur is lucky in his or her stock choices, he or she is likely to suffer greater losses in a downward trending market. The amateur will also receive smaller gains in an upward market cycle than a savvy individual or professional investor.

Like the savvy Craps player, smart investors know what to buy and what to avoid. They fully understand the risk and reward of each position that they take. And while they may have a few speculative individual choices in their portfolio, savvy investors find a way to be sufficiently diversified in order to full take advantage of hot streaks in the general stock market.

DON’T TRY TO PLAY THE PRO’S GAME: Professional stock investors (big-time hedge-fund, mutual fund, and private equity managers) are usually well-diversified over dozens of companies in several different industries. While potential returns are always a strong consideration in their evaluation processes, the accurate assessment of risk is equally important to them.

But it’s worth remembering that the professional stock investor who manages other people’s money as an occupation is really in the business of getting and keeping customers by having superior performance relative to their competition. They are also paid to maintain positions in the stock market and to spend most, if not all, of their new inflows of money on additional stock purchases. What the pros are not paid to do is hold their customers’ money in cash or cash equivalents for an extended period of time. And unfortunately for professional public investors, they have the added pressure of having to report their performance and stock positions on a regular quarterly basis.

On the other hand, individual investors are only in the business of satisfying their own needs on their own timetable. They’re not in competition for any customer money. An independent investor can learn how to buy stocks and manage risk like a professional, without having to report their actions and results to anyone outside themselves.

This means that as a savvy independent investor, you don’t have to spend most or all of your money on stocks in order to play the game. You have the option of holding large amounts of cash for any length of time, whenever the risk/reward ratio doesn’t appear attractive enough for you to invest.

DON’T PLAY LIKE AN AMATEUR: When it comes to investing in the stock market, most under-capitalized amateurs seem to be in a constant search for the ideal stock. Since this is a difficult thing to do with any level of certainty, the amateur will tend to pick only a small sampling of stocks in the most popular sectors of the market.

What often happens to amateur stock players is that they develop a special liking to only one sector of the market – such as technology, gold, or energy. In doing so, these naive investors are not spreading their risk over enough different companies and industries to handle any unforeseen problems that may be unique to that issue or sector of the stock market.

As a novice fresh out of college, I served as the classic example of an amateur investor who was focused on only one industry. Since I had very little stock market experience at that time, I was heavily influenced by whichever analyst or advisor communicated with the highest degree of conviction. For me that person was Joseph E. Granville, a maverick stock market advisor who strongly recommended gambling stocks in the late 1970s. Like most of his followers at that time, my stock portfolio became too heavily weighted in gambling issues. As a result, I got caught in the nasty stock market crash of January 1981 that was triggered by Mr. Granville’s famous “sell everything” announcement.

In retrospect, I see that I made the mistake of thinking that diversification was a sign of not knowing what to buy. I didn’t understand the deeper wisdom behind lowering risk by diversifying assets in a wide variety of areas. As a young man, I was too focused on getting the highest possible returns. At the same time, I was almost completely unaware of the corresponding risks involved with incorporating that kind of investment strategy.

Of course, we all have the natural desire to own the single best stock over the near term so that we can make the most money in the shortest period of time. Yet the indisputable fact remains that no one really knows for sure what that would be. Instead, amateur investors are suckered into following those advisors who cater to our craving for certainty by giving us the most convincing story about their favorite stock or market sector to buy.

In order to succeed at stock market investing over the longer term, an investor must move beyond the unwise idea of owning the stock of just one company in a single industry. The stock market has historically proven to be too uncertain for risking all of your money in just one company. Instead, the proper course of action for investors is to spread their risk over several companies in a wide variety of industries and sectors of the market.

A Savvy Investing Take: The winning formula for successful investing in the stock market can be simplified into three steps: (1) confine your selections to a well-diversified list of top-performing high-quality stocks, (2) buy them when they are undervalued and under-loved by the public, and (3) sell them when they become overvalued and over-loved by the public.

If you choose to speculate in anything else, make sure that it only represents a tiny portion of your portfolio. That way, those positions won’t make you lose your primary focus or cause you to take a major financial loss. If you don’t possess the discipline to follow this advice, then you’re better off not playing the stock market at all.

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Consistent winning in the stock market requires that you buy correctly. You can accomplish this by purchasing investment vehicles that collectively make your portfolio diversified, liquid, and attractively valued. In a game built around the elements of uncertainty and probabilities, the stock market must be played with close attention to both risk and reward. The natural habit to avoid is the unsound practice of maintaining a concentrated investment portfolio – the kind of portfolio that leaves investors open to excessive and unnecessary financial risk.

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“Behold the fool saith, ‘Put not all thine eggs in one basket’ – which is but a manner of saying, ‘Scatter your money and your attention’; but the wise man saith, ‘Put all your eggs in one basket and – WATCH THAT BASKET.’”

Mark Twain ~ American author & humorist (1835-1910)

diversification:

1. the act of placing money in a number of different investments in order to reduce the risk of overall poor performance caused by having too much money concentrate in any one investment.

2. when investors spread money around in a variety of investment classes in an effort to create more safety and less volatility in their results.

3. what many part-time amateur stock players fail to create when they concentrate their bets on the stocks of too few companies, industries, or market sectors in the naïve effort to achieve greater financial gains.

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“Behold the fool saith, ‘Put not all thine eggs in one basket’ – which is but a manner of saying, ‘Scatter your money and your attention’; but the wise man saith, ‘Put all your eggs in one basket and – WATCH THAT BASKET.’”

Mark Twain ~ American author & humorist (1835-1910)