What price ownership? Hit for six

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A three-legged horse

This article originally published in The Northern Daily Leader on 15 September 2012.

As a financial adviser, I often hear the comment that investing in the stock market is just too risky, that you may as well just go to the racetrack than invest your money in shares. It may surprise you to hear me agree that there is an element of truth in this statement, but it’s not what you think. You see, investing and having a bet on the horses do have a lot in common, but only with respect to the trade-off between risk and reward. In my experience investing doesn’t usually involve champagne, suits, summer dresses and fascinators. Unless of course I’ve just been working at the wrong company all these years.

At the racetrack, every gambler is faced with a fairly simple proposition: do they opt for the heavily-backed favourite, pick a horse somewhere in the middle of the pack, or choose to back the long-shot, where the risk is greatest but so are the rewards? Investors face a similar dilemma: do they opt for a reliable, profitable and established business that offers reasonable returns with appropriate risk (Woolworths might be an example here), or do they put their money into a highly-speculative mining exploration company that could be either bankrupt or worth a billion dollars within twelve months? It’s clear that long-shots exist in both horse racing and investing and have a similar allure for gamblers and investors alike.

The bad news is that human beings have a natural affinity for long-shots, both at the track and on the stockmarket. Recent research by two American academics, Snowberg and Wolfers, confirms that both investors and gamblers think the long-shot is going to pay off far more often than it really does. At the racetrack this means gamblers are prepared to accept lower odds on a three-legged horse than they should, while investors are prepared to pay more for that risky mining exploration company than they should. So not only does the long-shot turn out to be successful less often than we expected, but investors and gamblers pay more for the opportunity to lose their money than they should, once the risk and return are taken into account.

The message is fairly clear – don’t be tempted by long-shots in investing. Betting or investing in the long-shot is simply an efficient method of making dollar notes disappear into thin air.  You may get lucky and it may work once or twice, but the odds are against you in the long run. Real investing is not gambling, though speculative investments do exist to tempt your gambling urge. If you want to gamble, give your bookie a call; if you want to invest, give your adviser a call.