Is The Market A Casino? Yes... And You Can Be The House

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 |  Includes: DIA, QQQ, SPY
by: Gary Jakacky

If there is one market "truism" which rises from the dead during every bear market, and especially after every crash, it is the claim that Wall Street is a "casino" which is "rigged" against the small investor or the long term investor.

Like most dogma, there is an element of truth to it. In the short run and especially day to day, stock fluctuations are largely random. With millions of informed traders scouring financial, economic and other data for information, the only factor remaining in the short run is random fluctuations. Add drag from commissions, bid-ask spreads, and poor tax treatment of short term gains, and the odds sure are against you. 95% of day traders lose money. 90% of options (the favorite toy of speculators since they started trading in the early 1970s) expire worthless.

How do you beat these odds? How do you become the dealer, the house, the winner? The same way the Casinos do: give your trades enough time for the odds to be in your favor. Casinos do this by watching gamblers place millions of individual bets over the course of a year. While any one bet might mean the House faces a big payout, over the course of millions of bets, the house's return on the money gamblers give them is a sure thing. Statisticians and math folks call the Law of large Numbers, and refer to its proof as the Central Limit Theorem. Fun reading on a rainy day.

How can investor turn this law, this theorem, these odds in their favor? By doing two things:

  • investing in a diversified portfolio of high quality shares, and'
  • giving this portfolio enough time for its quality to show through.

First lets get a portfolio of high quality. Suppose you wanted to invest $50,000 equally in all thirty stocks of the Dow Jones Industrials. Back in the 1960s dark ages, this would have involved 30 separate trades with substantial commissions, fractional shares, and other hassles. In our era, it is one click away: you can buy shares in the Spyder Dow Jones Industrial ETF (NYSEARCA:DIA). Instant, low cost, high quality. Even broader is the S&P500 Trust Series ETF (NYSEARCA:SPY).

In the five minutes since you began reading this article the DIA has traded nearly 1 million shares; SPY, twice that. A lot of bets by individual investors: bets that will eventually pay off...for you! How? You must also give your investments some time to work out. If you invest for a period of only one year, you could hit it big (like in 2009, when prices soared) or you could get crushed (like in 2008, when prices collapsed). But the long term trend in stocks has always been upward. How long do you have to wait?

Click to enlarge

source: observationsandnotes.blogspot.com

The chart above shows the yearly return you would make on your investments in the Dow Jones Average (or DIA) if you held for various time periods. If you hold onto DIA for just one year, over the last century you could make as much as 92% or lose as much as 48%. But if you held for five years the range is much narrower: 32% to -15% annually over this span. Over a decade the odds are really in your favor: your maximum loss was around 1% annually while some decades showed gains of nearly 20% a year. If you hold longer than a decade you are the house: you always win.

Another way to show this effect is to look at rolling returns. Using the S&P500 as an index, going back to 1937 there have been only seven years during which the return over the previous decade was negative:

Click to enlarge

Those years were 1937,38,39 and 1940; and 2008-2010.

Given recent poor stock performance, this rolling returns data is often shown by folks who argue the market is a casino. In fact it proves the exact opposite: you are the house. In the 75 year period covered by this data, your odds of suffering losses over a decade interval were less than 10%. Even then they were modest (5% or so annually on average). In contrast, in some decades your returns were much greater.

The chart does seem to suggest that periods when rolling returns have been negative recently, are attractive buy zones. Perhaps. But this article is not about market timing. Its about how favorable the "odds" get as you invest for longer periods.

By the way...If you hold for twenty years? You never come close to a loss.

Click to enlarge

source: T. Rowe Price

Look at how volatile the blue line (1 year returns, for the gamblers) is than the tan line (20 year returns, for the house).

So the next time let someone chuckle when they claim the market is a casino. Remember your portfolio will have the last laugh.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.