Picking a stock or a mutual fund gives some people a similar unease to betting chips on a poker hand. Isn’t making money in the stock market mostly just luck?
Investing vs Gambling
Although gambling and investing might produce similar feelings of nausea for the super risk-averse, there are a few crucial differences.
- Investment results depend heavily on information. There are ways to limit losses and risk. Gambling results mostly depend on probability.
- Investing allows for diversification to mitigate losses.
- You can always cash out your investments and prevent a total loss. With gambling, you can’t fold in the middle of a hand and get back your money.
If you invest smartly, it’s much less risky than gambling. Gamblers seek to earn a big reward in a short amount of time. Investors want to earn a positive return over a long period of time.
Investors achieve this goal in various ways.
Ben Graham, who holds the title of “the father of value investing,” splits investors into two groups: the enterprising investor and the defensive investor. If you’re investing with an enterprising approach (aka value investing), you think about investing as having a slice of ownership in a company. You spend a lot of time investigating if a company is worth your dollars for the long haul.
Graham fell into the latter camp and wrote a book all about his approach called “The Intelligent Investor.”
If you take a defensive investor approach, you invest in big stable companies selling things that never go out of style, like food and toothpaste. Alternatively, you could invest in the market via an index ETF or mutual fund, owning tiny slices of the biggest companies. Either way, you don’t want to spend long hours analyzing company financials.
Both approaches assume you’re investing for the long term. Day to day fluctuations in the market matter less – meaning less stress for you.
The Enterprising Investor
There’s a long line of successful investors who make money using an enterprising/value investing approach. They’re seasoned professionals, but that’s not to say regular people can’t be enterprising investors too. Value investing requires more work but potentially more reward.
However, normal people can totally be value investors — and many are. Since so much information about companies is free and public, anyone with internet access can read company’s latest earnings report, learn about industry dynamics, and stalk the LinkedIn and Glassdoor profiles of executives and regular employees.
The enterprising investor asks, “Will this company continue to make money over the next five to ten years? And does their stock price already account for that growth, or no?”
If the answer to the first is yes and the second no, things are looking up. Obviously, to actually answer these questions
Some famous value investors include Warren Buffett, Peter Lynch, Seth Klarman, among others. These guys have gotten very, very rich by investing in companies they believe, after doing a lot of research, will be successful long term.
Enterprising Fiona
Fiona fancies herself an enterprising investor. To make smart investments, she researches companies in-depth to understand the management team, the culture, the business strategy, the competition, and the financials. Basically, she buys stocks of companies that she believes have cheap or fair stock prices and will grow in the future.
In her selection process, Fiona filters out the media’s chatter about “hot” stocks and instead finds companies with good business models that have valuable assets (read: cash & stuff that can turn into cash), low amounts of debt, and positive historical sales growth.
The Defensive Investor
Being a defensive investor is like going to a buffet and carefully selecting little bit of many dishes. Since you’re not exactly sure what will taste the best or the worst, you take a conservative spoonful of all the dishes that seem safe. (Except the Jell-O. Always skip the Jell-O.)
On the plus side, if something tastes terrible, you only eat a little bit. On the downside, if something tastes great, you still only taste a little bit. Both the good and the bad are somewhat minimized.
At the casino, the outcomes are skewed in favor of the house. With the stock market, history shows it wins more than it loses. Aka the buffet usually has more tasty dishes than disgusting ones. Defensive investing is popular because of this. (Many aspiring-FIREers use a defensive approach.)
Although history doesn’t predict the future, defensive investors believe the market will win more often than lose. Mostly because people always will need to buy certain stuff, so companies that sell those things will always earn some money. Not to say the market will never crash again, but, more importantly, market growth will never stop over a long period.
Defensive investing is great for the risk-averse person who doesn’t want to spend time researching companies. You probably won’t experience crazy gains every year by owning an index ETF, but hopefully – if the market, on average, continues its historical trend – your portfolio will increase over time.
Defensive Trisha
Trisha views herself as a defensive investor. She’s too overwhelmed with life, work, and her horse-racing hobby to spend time analyzing stocks. She’s also very risk-adverse and has no tolerance for major portfolio losses.
As a defensive investor, she buys shares of a S&P Index ETF, a diversified bond fund, and a diversified large-cap global equity fund. Since she’s still far from retirement, she holds a 70/30 split between stocks and bonds. Meaning 70% of her money is in the stock funds and 30% is in the bond fund. Besides readjusting every so often, she doesn’t do much else.
Defensive investing doesn’t mean you’re lazy. It’s for people who are serious about money management but perhaps are very risk-adverse, time poor, or simply uninterested in researching stocks.
Be Who You Wanna Be
No need to take sides here. Although Graham warns not to take a middle ground between the two in his book, it’s totally possible to use a defensive and enterprising investment approach within your portfolio.
If you’re new to investing, maybe you start by dedicating 90% of your investments to diversified investments, like an S&P 500 index fund and US government bonds: the defensive part. Then, with your last 10%, you try your hand at making some stock picks: the enterprising part.
All Investing Takes Time
Whether your portfolio is more defensive, enterprising, or a mix of the two, seeing results takes time. There’s a reason why financial advisors are constantly lecturing America’s youth about starting to save for retirement early: building wealth and earning returns will take decades. The good news is that thanks to compound interest, the more money you have, the faster it will turn into more money.
By contributing more money to your retirement account and other investment accounts and getting positive returns, your money will grow.
RECAP
Gambling ≠ investing
Gambling is about risky bets to make big gains in a short period. Investing is about small, consistent gains over a long period.
In a simple world, there are two types of investors: enterprising and defensive.
Enterprising: Picks their own stocks, looking for companies with value. Potential for bigger gains but also bigger losses. Somewhat sheltered from general market volatility. Must be willing to put in the time and energy to analyzing companies.
Defensive: Invests in diversified funds, places bets on stable industries with less risk. Less potential for big gains. Somewhat sheltered from big singular losses, though still subject to general market volatility.
