Permit me to illustrate the difference between gambling and investing, which is one of the many investing lessons that my forthcoming stock advisory newsletter, The Liberty Portfolio, will deliver. When you go to a casino, you are betting money on games that are all designed to give an advantage to the casino. You may have heard the term “house edge,” which refers to the ratio of the average loss to the initial bet. What does that mean exactly?
Roulette has a house edge of 5.26%. That means that, over time, you will likely lose $5.26 of every $100 you bet. You may walk up to a roulette wheel, put $100 on a number, that number could hit, and you’d win $3,600. Not bad! It’s also a great time to run out of that casino, because if you keep playing, over time, that win is going to erode. It may take hundreds or even thousands of spins, but over time, you will end up losing $5.26 for every $100 you bet.
With gambling, you have a negative expected return over time.
Investing is very different. Investing has a positive expected return over time. The reason for this is that earnings grow over time, and like Peter Lynch says, stock prices follow earnings.
However, a lot of people are so taken by some exotic investment vehicles in the market that they think they are making great investments when in fact they are making the worst investments that exist in the market. That’s because the worst investments aren’t really investments at all, but gambles.