VALUE INVESTING
What Investors Can Learn From Gambling

By Stephen Bland (TMFPyad)
February 4, 2005

My dictionary defines the noun gamble as "an enterprise undertaken or attempted with a risk of loss and a chance of profit or success". So yes, by this definition shares are clearly a gamble of sorts. Gambles though vary hugely in the range of risks and rewards available.

Games of pure chance run by casinos for example have odds that are loaded slightly in favour of the house, meaning that in the long run almost all regular players will lose. Other gambling games played against individuals rather than against a casino or bookie, such as poker, allow for some skill so that in the long run the more skilful will tend to take money off the less so.

Online poker has taken off big time and I find it interesting. In the most popular version, known as Texas Hold'Em, anyone who wishes to stand a chance at the game has to learn the value of the various combinations of the two cards dealt "in the hole". This refers to the initial first two cards dealt to each player which can be seen by that player alone. Now some hole card combinations are better than others, so much so that it is advisable in general to discard around 80% of all the cards dealt to you because they are too poor, so as to minimise the downside risks.

Minimise the downside. Sound familiar? It is the most important reasoning behind value shares. First look at ways how to minimise losses, long before considering how to make profits.

When considering investing in shares I'd say that as with hold'em, you should discard more than 80% of the various approaches that you might hear about as a beginner.

Depending on the state of the market you will hear all sorts of ideas if you look around. For example in the tech boom, day trading became popular. You hardly hear about it now, no doubt because the great majority of those who tried it lost money or made nothing in the end and pulled out. So beware of fad strategies that appear to work for a time but will let you down as soon as conditions change. There are a tiny number of people out there who are instinctive gut traders but you are not one of them.

The truth is that only a few disciplined strategies work long term for the small investor through thick and thin, regardless of the state of the market. In fact I know of only two that deliver the goods reliably and sufficiently profitably over time in this way, though there can be no guarantees of course. Long-term hold high yield portfolios for the non trader and value shares for the trader. Both of these are based on the premise that cheap shares are the best buys and on its opposite, that dear shares, even if possessed of apparently great prospects, are poor buys.

For beginners this may appear contrary to logic. Surely a share with terrific growth prospects must be attractive, no? No. The reason is that extrapolated growth has a nasty and common habit of failing to materialise at some point. People are too optimistic about growth stories and too pessimistic about ostensibly non-growth stories.

Being a contrarian is an essential feature of the high yield portfolio and value styles. As indeed it is in hold'em poker where you may sometimes vary your betting pattern to the opposite of the mood of other players round the table, the reason being to try and avoid them finding you predictable.

So maybe the value style has more in common with poker than might be thought, the more I consider it the more similarities I can see. That apart there is a worthwhile message to be learned from skilled gamblers in general, whatever the game. And that is that you don't bet on everything, but go in only when you perceive the odds to be out of line and in your favour.

And this is exactly what value shares and high yield portfolios do, tilt the odds in your favour. Call it investing, call it gambling, the descriptions don't really matter much.

You can read all about both strategies, and see the shares I pick for each of them, in my Value Investor newsletter. Sign up here for a free 30-day trial.