My friends at Buckingham Asset Management in St. Louis like to mix sports with investments. Invariably, they set up an analogy that proves itself quite accurate. For example, they talked recently about a point spread citing the 2001 NFL champion St. Louis Rams. They said that if the team were playing a weaker opponent, there might be a 20-point spread to bet on them. Accordingly, for the bet to pay off, the Rams would not only have to win, but would have to do so by more than 20 points. Note that the initial point spread is set by the market (not the bookies) that determines its direction. On Monday morning, the spread might be set at 15 points but if this brings in more betting on the Rams than on their opponent, the spread would widen until supply and demand equalize.
Stock prices are set along the same lines. An investor might pay $30 for each dollar of earnings (or perhaps 10 times book value) for a certain high-flying stock while paying just $7 for each dollar of earnings for a distressed value company. And keep in mind that fund managers and stockbrokers, just like bookies (who also don’t gamble their own money), get paid, no matter whether you win or lose.
Buckingham also likes to show the correlation between gamblers and investors.
For instance, gamblers who are winning treat their winnings as if it were house money, not their own, until it comes to the point when they decide to cash it all in. Gamblers who are losing usually continue playing, figuring they will eventually recover, notwithstanding the fact that the odds are always in the house's favor.
Investors seem to run along the same track and make the same mistakes. Take a winning investor who buys a stock at $30 per share and watches it rise to $90, but doesn't sell. There is "house money accounting" here where the investor believes there is no risk in continuing to hold the stock. Think about it. The investor only paid $30 per share and now views the $60 profit as house money rather than his or her own earnings.
The same holds true for the investor who pays $30 per share for the same stock and watches it plummet to $1 per share. That investor won't sell until the stock returns to its break-even point. You ask a behavioral finance specialist about this and you will probably get back the term "loss regret avoidance." In effect, we all shy away from admitting an investment error by believing that as long as we have not yet sold the miserable-performing stock, there is no real loss.
So, the bottom line, whether gambling or investing, is to know when to "hold 'em or fold 'em." According to Buckingham, the dominant factor should be the present risks of the current holdings versus the desired risk that you have defined for your portfolio within a carefully designed investment policy. Also, while not necessarily the dominant factors, you must weigh the impact of taxes on taxable accounts and transaction costs.
What should you be doing? Base any buy and sell decisions on a solid long-term investment policy. That will be your best chance of beating the odds.
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