Is Investing in Individual Stocks Merely Gambling - Or Something More?

I have a lot of fun following individual stocks in my spare time. I keep tabs on a small handful of companies that I have a personal interest in - Apple, Nintendo, Herman Miller, and Ford, namely. I watch for news articles on the company, read their annual and quarterly reports, and stay up to date on pretty much everything about the organizations.

For a short while, I owned individual shares in Apple and Herman Miller in mid-2007. I bought into Apple in late July, purchasing about 40 shares when the stock was at 140. Over the following three weeks, I watched Apple drop like a stone to below 120, then I sat there through late August and early September as it rose back up to 140. I sold immediately. Over the same rough period, I bought 50 shares of Herman Miller at 32, watched them sink and struggle to rebound, and sold the shares in late September at 29.

In the end, I didn’t lose too much money. What I did lose is a lot of sleep. The second I owned those stocks, I became obsessive over those two companies. I read every single morsel of information that came out about them, read reports, studied numbers, sweated, didn’t sleep at night, and a few times I even queued up panic sales of these stocks.

The second I finally sold all of them, I felt much better, and I walked away with a bitter taste in my mouth. Individual stocks are basically gambling pretty much sums up the way I felt and since then, I’ve barely written or even thought about individual stock investing.

But is that the right lesson to take away from the experience? Let’s dig into the idea a bit.

Information Games

Most forms of gambling that aren’t merely chance, such as blackjack and poker, are games of partial information. You know some of the information out there - the cards you hold, perhaps some of the cards the dealer holds, any revealed cards, and the “tells” that the other players have shown you. At the same time, key pieces of information are hidden - what the others are actually holding.

The same statement is true of stock investing, except the story is a bit different. Most of the information you’d really need to know - in fact, virtually all of it - is right out there for you to see. The only problem is that it’s like trying to find a water droplet at Niagara Falls - there’s so much information out there that processing it all is impossible.

As a result, stock investors often choose specific pieces to focus on. Perhaps they look at the P/E ratio for a company, or maybe they look at the backgrounds of the company leaders. I’ve read tons of books about different strategies, but most of them boil down to isolating a few key pieces of information about companies and using them as a judge about when to buy and when to sell.

The problem is that no individual metric is perfect. One can’t ever boil down the complexity of Apple’s entire business into just one factor. What would happen to Apple’s stock if tomorrow morning Steve Jobs dropped dead of a massive heart attack? Do you have any idea? Obviously, it would go down, but how far would it go down? Would Apple weather that storm? Those are both huge unknowns, but investing in Apple stock means you’re making some sort of prediction on those questions. You’re using one view of the information to make a judgement about a whole company.

The Investor Mindset

Some people respond to this glut of information and the inherent risks quite well. They focus in on specific things and just blot out everything else. They do the homework they need to do and walk away from it. Are these people gamblers?

What about others, like myself? When I was invested, I was almost driven crazy by the desire for more information. I knew that there was more to know about where my money was sitting, and I needed to know it. Am I an information addict?

Personally, the risk itself didn’t bother me so much - I was merely overwhelmed by the actual level of information in that information game. But what about a person who knows why he’s investing, but is ready to throw up after a 1% drop? I have a close friend like that - he basically can’t invest in anything that isn’t fully guaranteed. Is that person far too conservative?

It all comes down to personal makeup and psychology. Some people are predisposed to play this information-rich game; others simply aren’t. I put myself into the “not predisposed” category - I could invest if I had money that was truly “play” money, but not if anything of any importance relied on that money. It would move from being a dalliance to being an obsessive information hunt - and that’s the result of my psychological makeup, not the game itself.

Mister Market

So far, all I’ve really done is convince myself that stock investing really is gambling, but there’s one big factor that draws me back from making that leap. It’s the fact that the stock market as a whole grows in a positive direction, not a negative one.

In a typical gambling situation, the house “rakes” - meaning that the house takes some small fraction of the winnings. In stock investing, the “house” (in other words, the stock market as a whole or, for that matter, capitalism as a whole) adds to the pot over time.

How does that happen? Over time, innovations make it possible for companies to produce more and more with the same amount of resources. Think computers, for example - they’ve radically changed almost every industry. Innovation has a lot of different effects, but one of the big ones is that it constantly adds more value to the company itself in the form of increased productivity. The result is that all companies gradually become more valuable over time, simply because they can produce more with what they have - or produce the same amount they always have with less resources.

Think about a patch of farmland. Two hundred years ago, a farmer grew whatever corn he could lay his hands on, tilled a few acres with a horse drawn plow, tossed the seeds into the ground, and hoped for ten bushels of corn production per acre. Fast forward to today: tractors, fertilizer, and hybrid corn now make it possible for that same patch to produce 150 bushels of corn per acre. That means the entire farm is more valuable - and thus shares in that farm are more valuable now as well.

Over time, value is constantly added to the stock market (assuming everything else stays the same - when the market goes down, something else is changing). This addition of value is the one real difference between stock investing and traditional gambling.

My Conclusion

Individual stock investing is something like playing blackjack at a casino where, on every hand, the dealer is wagering just a little tiny bit more than you, but there are thousands of people around you shouting out suggestions. If you can concentrate enough and take the time to sift through the information overload correctly, you can potentially go on a very nice winning streak - and the odds are slightly in your favor. At the same time, though, as with any game where you don’t have all the information, you can very easily go on a losing streak.

My solution to all of this - and the solution that leaves me sleeping well at night - is to buy index funds. That’s kind of like going to that casino and playing 5,000 hands at once with earmuffs on. Because of the huge number of hands, the luck of any individual hand is negated and eventually you end up with a small overall win without the stress, time, and focus needed to win at an individual hand.

I think investing in individual stocks is a fine diversion and a potential way to earn a lot, but far from a guarantee and the work needed to get those earnings is tremendous. For the casual investor who hasn’t invested the time to really learn the game and the investment and learned how to fight through the information noise, individual stock investing might as well be gambling.

 


The Simple Dollar chronicles a man's road to recovery from "total financial meltdown." As author Trent Hamm puts it, "The Simple Dollar is a blog for those of us who need both cents and sense: people fighting debt and bad spending habits while building a financially secure future and still affording a latte or two." We'll post a couple of entries a week, but you can check out his writing daily at www.thesimpledollar.com

 

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