“Our favorite holding period is forever.” – Warren Buffett, Super-Rich Guy
Is Investing In Stocks Gambling?
I vividly remember a day during my junior year of college when the professor teaching my introductory finance class proclaimed that there was no way to predict the stock market.
In his words, “It’s a total crapshoot.”
My immediate response was to wonder why on earth I was bothering to take a finance class.
If this guy (who got his Ph.D. from an Ivy League school) thought the basis of the American investing universe was basically a legalized casino, what’s the point?
Thankfully, he provided context that clarified his ultimate point, which was in the short-term, the purchase and sale of stocks is exceptionally risky and can be likened to gambling.
(The polite characterization for this in the world of finance is “speculation”, btw.)
However, what I ultimately learned in his class, and others, is that investing in stocks over the long term is a very safe way to build wealth.
In this article, we’ll illustrate how we know this to be true, but first I want to clarify what I mean when I use the word “stocks”.
Clarifying Types of Risk
Stocks are individual shares of ownership in a company.
For the most part, when we refer to stocks in this article, we mean common stocks which are most often traded on exchanges like the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotations (NASDAQ).
However, when we use the word “stocks” we do not necessarily mean the purchase and sale of individual shares.
You see the ultimate purpose of this post is to show how the ownership of stocks over many years can greatly reduce the impact of market risk. That is, the risk of fluctuations in the prices of stocks due to outside forces that influence financial markets.
Some examples include interest rates, unemployment, or other economic circumstances.
What we won’t focus on is concentration risk which is the risk that exists when a large portion of one’s invested assets are concentrated in a single stock or asset class.
For example, just a few weeks ago a side panel from a Boeing aircraft dislodged itself from an Alaskan Airlines flight shortly after takeoff.
Thankfully, no one was seriously injured, but Boeing’s stock has taken quite a beating in the last couple of weeks.
If a large portion of your investment holdings were in Boeing alone, your entire investment portfolio (and your net worth) would have seen a sharp and painful decline in value.
To avoid this risk, one can simply diversify his or her holdings by purchasing the stocks of many companies. Most often, people do this by buying mutual funds or exchange-traded funds that consolidate a large variety of stocks into one equity holding.
A very popular example is the Vanguard Total Stock Market Fund (VTSAX).
It’s important for us to make this clarification because we don’t want you to read this and assume it’s safe to go out and put all of your investment eggs in the basket of a single company.
With that out of the way, let’s talk about why owning stocks over the short term is akin to gambling.
Short-Term Ownership
Visualizing the risky nature of owning stocks in the short term is simple.
Just go to any search engine and look up any stock you want. The current price of the stock will probably appear on your screen with a lovely chart recording the increases and decreases in price over some period of time.
If you set this chart to display the changes in price over the last one to five days, it will probably look similar to a heart rate monitor readout on a hospital ECG.
For example, here is a five-day lookback at Coca-Cola’s stock that I just snatched from Google.
Up and down, up and down.
In the short term, that’s what stocks do.
But what’s important to understand is why they go up and down. And it’s important to understand that because that can’t be understood.
You see, the short-term price of stocks is dependent on the number of buyers relative to the number of sellers at a given price and time.
On January 22, 2024, the day I wrote this, there were more sellers of Coke stock than buyers, so the price fell due to the nature of supply and demand.
If there are suddenly more buyers than sellers, the price of Coke stock will go up because the demand for the stock has increased.
And why would the demand go up or down at a given moment? There are an infinite number of reasons. Here are a few examples:
- A roach could be found in a kid’s soft drink, sending the price down due to bad PR.
- A famous athlete could be spotted drinking a Diet Coke while on vacation, causing the price to go up.
- The Federal Reserve could say something positive about interest rates, sending the price of all stocks up.
- A terrorist group could attack some city, boat, or industrial facility none of us had ever heard of sending the stock market through a sudden swoon.
- Unemployment could rise sending all stocks lower (Or higher. I promise it has happened.)
- Coke could purchase another beverage company leading to either an increase or decrease in their stock price depending on how Wall Street interprets this strategic decision.
- A Democrat could be elected to some important office…or a Republican. And the result could push stocks in either direction based on their views of beverage products.
- The Mayo Clinic could publish a study about the positive or negative health impacts of corn syrup, again, pushing the stock up or down.
- A flood could damage a bottling facility in Des Moines.
- Aluminum cans could skyrocket in cost.
- Coke could find itself in a labor dispute.
- A Coca-Cola executive could tragically die unexpectedly.
- China could invade Libya.
- The famous Coca-Cola polar bears could go on strike.
- They could bring back New Coke?!?!
- And on, and on, and on…
I intentionally made this list long, and even a bit silly, because the key thing to understand is that there is an endless number of things that could happen, all completely beyond your control, that could all impact the value of any stock at any time.
In other words, you can’t predict the prices of stocks in the short term.
At this point, there are usually a few folks who will claim (or at least think) to be able to react to news that would impact the market before there is time for said news to settle into the price of the stock.
Yeah…about that…
The stock market is exceptionally efficient, which basically means as soon as news is public the price of the stock will change to account for it.
How does it do that?
There are thousands of people who watch the ticker every second of every day, waiting to make a buck from sudden shifts in the market.
They sit at very fast computers and don’t need to log in to E-Trade or call their broker to process a trade.
If you think you can outrun them then you are sadly mistaken.
The bottom line is there are no guarantees in trading stocks and your odds of failure increase as the duration of your ownership in a particular stock decreases.
To me, there is little difference between trying to quickly flip a stock for profit and walking into the Bellagio and putting it all on black.
You might win. You might lose. But either way, the result can’t be explained by anything other than good fortune or bad luck.
(Though, honestly, the odds of a stock increasing at a given moment are slightly better than you hitting a black number on the roulette wheel. 53% vs 47.37%.)
Short-Term With Diversification
Earlier I spent some time explaining how we weren’t going to focus on any one stock because I didn’t want anyone to assume I was endorsing single stock ownership.
Then I promptly splashed a graphic of the price fluctuations of a single stock.
Sorry about that.
In the interest of illustrating the same effect on a large basket of stocks, I give you the performance of the S&P 500 index over the same last five days…
As you can see, it has done a little better than Coca-Cola.
You can also see that the value of the index is not quite as volatile as Coca-Cola stock.
I primarily attribute this to the fact that the S&P 500 is comprised of 500 individual stocks. The diversification provides a smoothing effect to the changes in price.
That’s also known as the effect of diversification.
With that said, the price has still gone up and down, up and down.
If you had bought in on January 17th, you’d have entered the week of the 22nd smelling like a rose.
But what if you bought on January 16th and sold on the 17th. Or what if you bought on the 22nd? Will it go up or down from here?
Who knows?
The same list of things that could impact the price of Coca-Cola would also impact the 500 member companies of the S&P500, though all differently of course.
To further drive home this point, it’s worth noting that on average, the S&P 500 closes above the previous day’s close 53% of the time. Of course, the other 47% of the time it closes down.
It’s not quite a coin flip, but that’s pretty close.
You can’t fully escape market risk through diversification. The only anecdote for that is time (or not being in the market).
Long-Term Ownership
So, what was I saying at the beginning of this post about the safety of owning stocks over the long term?
Well, the good news is the longer one holds stocks, the more one’s portfolio builds resiliency against market risk.
The fact of the matter is people are emotional and do not always make rational decisions. This includes people who own stocks.
When bad news comes it is difficult for us to ignore it and focus on the bigger picture.
Because behind all that bad news is a steadily growing economy full of people getting up each day to discover new ways of doing things, inventing life-changing technologies, and slowly pushing the capital machine forward.
Of course, this is very boring to talk about, so it gets ignored.
But over time all those little negative events that cause sudden dips in the price of a stock get absorbed by the big economic growth machine and all the good, boring things that are happening that we hear very little about.
To illustrate, here’s another screenshot of the S&P 500 over the last five years.
I didn’t really mean to capture this on a day that the S&P 500 hit an all-time high. Of course, this means any time you would have decided to purchase an S&P 500 index fund before today would have led to a profitable outcome.
That isn’t always the case, but it is most of the time.
In fact, over the last 25 years, the S&P 500 has only closed the year lower than its open on 6 occasions.
So, just by looking at stock ownership in units of years instead of days, one increases the odds of success from 53% to 76% while owning the same asset.
Furthermore, In all the years since 1978 that the S&P 500 has decreased in value, only twice would you have had to wait more than two years to recover your investment if you were unfortunate enough to buy at the absolute worst time.
The first was in the years preceding the dot com bubble of the late 90s and early 2000s. The other was in the years leading up to the Great Recession in 2008.
If you buy and hold for more than 7 years, then it would have been impossible to lose money in an S&P 500 index fund.
That’s a 100% success rate, btw.
And if you’re curious about the annual rate of return for the S&P 500, it’s been rewarding investors at an average of 10.67% each year since its inception in the 1950s.
That’s doubling your money a little better than once every 7 years.
And here’s the chart as far back as Google will take it…
Obviously, buying anywhere along this timeline would prove profitable for those who are patient enough to let their investment grow.
I hope the point is clear enough.
By simply prolonging the period one holds an investment in stocks, the greater the odds of success.
In other words, time converts a gamble into a very prudent investment.
I’ll also add that we didn’t even touch how dollar-cost averaging (which is how most of us invest) improves the odds that your portfolio will increase in value over time.
Conclusion
So, for daily ownership of stocks, the success rate was about 53%.
For annual ownership of stocks, the success rate was about 76%.
If you held a broad market index for 7 years or more, you would have made money through every period going all the way back to the Great Depression.
Clearly, it pays to be a patient investor, and furthermore, time in the market gradually moves our choices from short-term gambles to long-term prudence.
The lesson, then, is this. If you have many years to allow your investment to grow, then investing in a diverse basket of stocks is a wise choice.
