The Casino With The Best Odds
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Even before the recent stock market wobble many people in the UK remain scared stiff of investing. It's not hard to see why. The market lurches up and down on a daily basis. Well-known companies such as Northern Rock have seen their share prices decimated. Then there are tales of boiler rooms, where fraudsters prey on investors and deceive them out of thousands of pounds.
Cash is king
When it comes to ISAs you can see plenty of evidence regarding our reluctance to invest. Last year, we put £10bn into share ISAs but over twice this amount, £22bn, into cash ISAs. It looks like we'll see a similar mix for this tax year too, meaning we'll have put more money into cash ISAs than share ISAs for seven years on the trot. And, with the cash ISA limit rising to £3,600 next year, I wouldn't bet against an eighth year.
Saving isn't a bad thing of course but a lot of this money seems to be staying in cash ISAs for several years when part of it at least could be put in more appropriate long-term investments. At the end of last March we had £128bn in cash ISAs but only £80bn in share ISAs.
Learn to love volatility
Part of the problem many people have with investing is what is known as loss aversion. This is the concept that the pain of a loss outweighs the joy we get from a gain. It's reckoned that we feel losses twice as acutely as gains so, psychologically, a £200 gain is the mirror image of a £100 loss. But in order to invest successfully you have to learn to accept these regular ups and downs. They're a necessary part of investing.
The casino aspect of the stock market is something else that puts people off too. Stock market movements are pretty much random, in the short term at least, because they depend on some many different factors and the various ways people react to them.
Even so, some people are surprised by the fact that even those who have been investing successfully for decades still have little idea what the market will do next. But what the market does next is irrelevant. What matters is the fact that, picking a random point in time, it is more likely to go up than down.
Winning the game of chance
Take an ordinary game of chance, such as Blackjack or Roulette. It's widely known that the odds of playing these games are stacked against the players. The house advantage, as it is known, is around 1% for Blackjack and 3% for Roulette. It's a small margin but everybody appreciates that the more you play, the more likely it is that you'll lose money.
Investing in the stock market can be thought of as a similar game of chance. The difference is that the odds are in your favour. For simplicity, let's assume we have a game where there are two outcomes - either you win £10 or you lose £10. However, the chances of winning are 60% and the chances of losing are 40%.
After one game, there is a 60% chance you'll be ahead. Play three games though, and your chances improve to 64.8%. Play five times and it's 68.3% and so on. When you're faced with these odds, your best strategy is to play as often as possible.
As it happens, the odds of stock market investing have historically been better than this example. Over the last 100 years, shares have beaten the rate of inflation 63 times. Moreover, the average annual gain has been about 20% while the average annual loss has been about 12%. So not only are your odds better than in our example, the individual potential wins are greater than the individual potential losses.
Plugging these figures into a basic spreadsheet and using my even more basic maths shows that the chance that you would have beaten inflation over the course of five years is 70%. There is a 23% chance you would have more or less broken even and a 7% chance you'll have lost to inflation.
Admittedly this is a very simplistic way of looking at investing. But the basic idea still holds. To get the best possible returns you need to invest each and every year, playing the game over and over and over again. The more you take part, the better your chances get. So, does anyone want to play?
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