Gambling vs Investing
One of the concerns that clients express about investing in the stock market is their worry that it represents a type of gambling and the last thing they want to be doing is metaphorically betting their retirement savings on Wall Street’s version of a roulette table. We believe that while some people do gamble with their money on stocks, investors can also participate in the market as “the house” rather than as one of the players at the table hoping for a lucky win. At a casino, “the house” isn’t actually gambling. They are offering a service for a fee and while their results may fluctuate (just as the results at all businesses fluctuate), they are making rational long-term decisions with a positive expected return, not just hoping to get lucky.
The very smart Patrick O’Shaughnessy explored a version of this “gambler or the house” concept in a recent post. Patrick posited that buying the cheapest stocks in the market offered a positive long-term edge while buying the most expense stocks offered a higher chance of a big win, but a negative long-term expected return relative to total market returns. His argument was that buying cheap stocks was a way to be “the house” while buying expensive stocks was a form of gambling.
While Patrick’s post is statistically sound, it doesn’t address the core concern expressed by clients when they worry that Wall Street is a form of sanctioned gambling. Their worry is not about which strategy offers the best risk-adjusted returns, but rather it questions the underlying principals of public market investing. Their questions are about the purpose that stock markets serve and whether the system is rigged in a way that offers a chance at big wins, but in the long-term doesn’t serve the interests of everyday investors.
Patrick’s post shows that over one-year time frames, buying either cheap stocks or expensive stocks can result in highly erratic outcomes. Despite cheap stocks offering a statistical advantage over expensive stocks, in Patrick’s words “investors sometimes get destroyed” buying cheap stocks. From a client’s standpoint, the potential to “get destroyed” is exactly why they fear that investing is simply a form of gambling.
So how then can investors participate in the stock market without engaging in “gambling”? The answer lies in the time-frame over which you think about the activity of investing.
Here are a pair of charts put together by Ben Carlson of Ritholtz Wealth Management showing rolling one-year returns for the S&P 500 and rolling ten-year returns.
What we see here is that over one-year time frames, investing in stocks produces highly variable outcomes with a material risk of losing money. That sounds like gambling. While the average return has been on the order of 9%-10%, the best one year return was 169% and the worst one-year return was -69%. This is the sort of return profile that everyday investors rightly worry are a form of gambling.
But when we look at ten-year time frames, the picture changes dramatically. While the average return is still around 9%-10%, the best ten-year return was an annualized 21.5% and the worst was -6.1%. The only two times the market has produced negative ten year returns has been as a result of the Great Depression and the more recent Great Recession, with the two events separated by seventy years. Ben goes on to show that over thirty-year time frames (certainly a very long time to wait, but still highly relevant since investing is a lifelong activity), the worst return has been a positive 7.4% per year.
So what this all means is that investing money in the stock market that you will need a year from now certainly is a form of gambling and not something rational investors should do. But investing money in the stock market that you won’t need for ten years or more, while not without risk, is a highly rational behavior that bears little resemblance to gambling.
But wait a minute, all we’re looking at here are historical results. Just because something has happened in the past does not mean you can count on it to happen in the future. In order to make the leap to extrapolating the past into the future, you must have a reasonable explanatory thesis for why the past behaved the way it did and why this will continue into the future. So let’s look at what drives market returns.
The return that a stock market investor earns is made up of three components, 1) dividends, 2) earnings per share growth and 3) changes in the price to earnings (PE) ratio.
The first two components are driven by the corporate performance of the companies whose stocks make up the market. But the third component is driven by investors’ collective sentiment towards the future. Over the short and long-term, dividends are highly stable (they’ve been positive every year) with an average of around 3%-4%. Earnings per share are less stable, with declines occurring during recessions (and occasionally outside of recessions), but when viewed over ten-year periods, earnings per share growth have been positive in each of the last six decades with an average of around 6%. Note that adding together the 6% earnings growth rate and the 3%-4% average dividend yield gets you the 9%-10% long-term average return experienced by stock market investors.
But what about changes in the PE ratio? Over the short term, the PE ratio (and other measures of investors sentiment about the future) swing around pretty wildly. But over the long term, there’s been no change. Over a hundred years ago investors were willing to pay on average about 16 times the most recently reported yearly earnings for the market as a whole. While it has varied in a range of between about 5x and 25x from year to year, over rolling ten year and longer periods, the PE ratio is pretty stable. This makes intuitive sense, because while we know that people’s hopes and fears about the future vary from year to year, there’s no reason to think that people today are sharply more optimistic or pessimistic than they were decades ago or than they will be decades into the future.
What this means is that when thinking about ten-year and longer returns, the primary driver of stock market returns is the corporate performance of the companies in which you invest. But over one-year periods, the primary driver of stock market returns is the change in how optimistic or pessimistic other investors are. Guessing about other investors future state of mind is almost impossible and could certainly be called a form of gambling (see the one-year rolling return chart above). But investing your money in the idea that companies will earn more in the future than they do today and pay you a dividend while you wait is a rationale, high probability activity that bears little resemblance to gambling (see the ten-year rolling return chart above).
So in essence, the stock market offers two activities in which you can choose to engage. You can try to guess whether other investors will be more optimistic or more pessimistic in the months ahead, which in our opinion is rightly thought of as a form of gambling, or you can ignore other investors and play a long-term game of investing in the idea of long-term growth in dividends and earnings, which we think is nothing like gambling.
The choice is yours. Do you want to be “the house” and engage in the business of investing or do you want to roll the dice and hope you get lucky?
(Note: this post is focused on market returns not the returns of individual stocks. At the market level, corporate fundamentals are very likely to improve over time while investor sentiment is cyclical but likely to be stable over the long term. Due to changes in the underlying companies that make up the market and changing economic conditions, it is difficult to make precise estimates of market level intrinsic value and so recognizing when the market is over or under valued is challenging.
Individual companies on the other hand exhibit far more indiosyncratic fundamental trends driven by their particular business characteristics and investor sentiment is generally not best described as stable or mean reverting over time. We believe that investors in individual stocks should seek out companies that offer competitively protected businesses and buy those companies when they sell at a PE ratio — or other measures of investor sentiment towards future performance — that is lower than the company reasonably deserves.)
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