I've been managing client accounts for more than 17 years and one of the most interesting lessons I've learned is that people make the mistake of accepting an equal relationship between risk and reward. Clients hate to lose money, even one dollar. A simple way to understand risk and reward is to analyze the game of blackjack. On a typical hand you bet a fixed amount and if you win, you double your money. If you lose, you lose the entire bet. This is an equal relationship between risk and reward; in this case, it is 100%. One of the reasons people like to gamble is because of the thrill of winning, but they seem to discount the pain of losing.
So why do clients feel differently about their investments? The reaction to loss and gain in investing is the opposite. Clients remember the times they lost money much more clearly than the times that they had winning years. There are many explanations for this, because, of course, the psychology of gambling is different than the psychology of investing.
When you ask most people what their ideal investment would be, the answer is obvious -- one that is risk free, tax free and earning a consistent double digit rate of return. Sounds great, but this ideal investment doesn't exist. Sound investing is about attempting to lower the risks while maximizing the potential return. In essence, the idea is lowering or eliminating luck as part of the equation. Wise investing does not rely on luck, although it's nice to have some.
Investing in the stock market is not gambling, although many people believe it is. Unfortunately some people do gamble when they invest in the market but they do not apply the principles of investing that help move the advantage to them. Unlike Vegas, when you invest wisely you can move the odds in your favor. For example, according to the S and P, over any one year period the S and P 500 has had positive rates of return 75% of the time, In theory, if you only invested in the S and P over one year periods, you would win much more often than in Vegas. It would seem that with a record like this everyone would invest their money in the stock market.
But this is the problem. People remember the one time out of four years that they lost money much more clearly that the three years that they gained money. This is when risk aversion kicks in and causes people to allow their emotions to rule their investment decisions. In theory, there is a better chance of positive returns on investments made when the market goes down.
So why don't clients just buy low and sell high? It sounds so simple. Why are so many people risk adverse? I believe it is because they do not understand risk and reward. The following recommendations should help investors increase their odds of success.
1. Don't bet on one horse. Diversify by investing in 10 or more. Why? Because there is more chance that one will be a winner.
2. Sell the losing horse quickly. It's rare for a loser to become a winner.
3. When your horse has a big lead, take some profit. Don't be greedy.
4. Follow your horses closely. Make sure that nothing has changed such as their health, the jockey, etc.
5. Never bet too much on one horse, even good horses can break a leg.
6. Don't bet on too many horses. If you make too many bets than you will have very mediocre results.
7. It takes a lot of work and time to follow each horse. Have a professional help you. They really know the horses well.
8. When in doubt, just skip a race. There is no reason to make hasty decisions.
9. Don't bet based on the name or disposition of the horse. Bet on the fundamentals. It is not a beauty contest, it is a race.
10. If you do not play, you cannot win.
Gerber Kawasaki Wealth Management
2716 Ocean Park Blvd #2020
Santa Monica, CA 90405
Securities offered through LPL Financial, member FINRA/SIPC. Investment advisory services and fixed insurance offered through Gerber Kawasaki, Inc., a registered investment advisor and separate entity from LPL Financial.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved. Investing involves risk including potential loss of principal.