The Grand Illusion

Years ago, during a much smaller market bubble burst, I hit upon the analogy that investing is the same as gambling. Hardly an original insight. But what drew me to the analogy wasn't the simple mathematics - risking a loss in exchange for a possible reward. It was the mentality of the investors. This came home in a much, much larger way during the stock market meltdown of 2008.

For weeks on end we heard about how much money people had “lost” in the stock market. The problem with these tales of woe and gloom is that almost everyone involved hasn’t actually lost a damn thing. What almost all of them lost was perceived value.

In January 2007, you handed $1000 over to your broker and had her invest it in something. In August of 2007, you got a report that showed that your investment had increased to $1278. In August 2008, you got a report that showed your investment had tanked to $622. Did you lose 50% of your money in that year?

At 8:45 pm, you handed $1000 over to the dealer at a blackjack table and she passed you $1000 in chips. At 9:22 pm you had hit a couple of good hands and held $1278. At 10:22 you’d been on a slow slide of losers, winning a couple and then losing four or five and then winning a couple, and found yourself holding $622. Did you lose 50% of your money in that hour?

The answer is no. You haven’t lost 50% of your money. You haven’t even lost the $378. Because it isn’t your money. It is just casino chips. In either scenario.

The only way you can ‘win” or “lose” the money is if you cash out. While you are playing, it isn’t your money. The fall from $1278 to $622 wasn’t 50% of your money, it was 50% of your stack.

For most people, though, their investments don't feel like gambling. The hardly original insight somehow disappears from view. And they feel like they are losing real money.

In 2008, the impact was much more dramatic because, unlike in any casino, almost everyone who has money invested had been raking in the chips during the years running up to 2008. Everyone who had money in the market while the the Dow climbed all the way to 14,000 was way ahead, in chips. And so when it fell all the way to 8000, it was a disaster of perception, and has certainly aided in the recession we are all feeling. But the fact remains that they haven’t actually lost any money.

The Lessons of the Casino
And that’s why there are two lessons of the casino to apply to your investment portfolio. The first lesson is psychology - while your chips are on the table, you can’t act like the chips are your money. The play of the hand has to decide how you bet, not the “money” that you are risking - if you need to split that pair of aces, the fact that it might cost you double can’t govern the decision. It’s not your money; acting like it is will only make you crazy.

The second lesson is common sense. Don’t bet money you can’t afford to lose. Never bring your rent money to the casino. You bought the chips to try to grow the stack, knowing that you might not win. If you can’t afford to cash in for less than you started with, don’t even start.

And so we return to the fact that “almost everyone” has not lost anything. There are some true losers in the market crash. People who actually need the money, for retirement or for investment capital, for any use that people put actual cash to. People who had to cash out for less than they put in, are true losers. But even most of these people “lost” because they ignored the second lesson. If you can’t afford to lose, don’t play. The grand illusion of the go-go Nineties and Aughts has been that somehow investments couldn’t lose. People who got caught up in that illusion are paying the price.

It is the people who didn’t have a real choice about playing - when their company pension was invested in company stock, for instance - who deserve our sympathy. And there are some. And they are the real story. But that story is not told nearly as often as the scary headline about the billions being lost by people who haven’t lost anything yet.

The grand illusion has been exposed. But for most of the players, their billions are still right where they were. In casino chips. Time to remember lesson number one.