|“All card playing is not gambling, all stock purchases are not investing…”|
– Jim Paul, What I Learned Losing a Million Dollars
What the heck is an investment plan? Open a brokerage account or interview a financial planner and you get handed a questionnaire intended to help determine what kind of investor you are – or will be, as a new client. But how do you answer a question like “Rate your tolerance for risk on a scale of 1-to-5?” A person willing to blow $1000 at the blackjack table while on a vacation in Las Vegas could be appalled at losing that same $1000 on a stock purchase. The glib advice – embarrassingly repeated here at Invest-Notes on occasion – that everyone should have “An Investment Plan” isn’t really much help.
Investors must know themselves
Creating an investment plan is not complicated, but it does involve some critical thinking. First, acknowledge we have no control whatsoever over the movement of investments like equities, real estate or gold. There is no way to know if a stock is going to go up, and if it does, how high it can go. On the other hand, how much money you are willing to lose is entirely up to you. In essence, your investment plan is simply a set of rules to ensure that you never lose more money than you can afford.
As an investor, you can tell yourself that the stock you just bought is going to double in price, but that’s just a guess. Deciding that you are not going to lose more than, let’s just say 20%, while waiting to see if your guess is correct is the purpose of a plan. Conversely, suppose you are right and the stock does go up 100%. A decision made in advance to sell the stock anytime it drops more than 20% as the price goes up ensures you turn some of those paper profits into real ones. Prudent investors manage risk by making sure they never let emotions influence their decision making.
Second, you have to decide who you are every single time you make a transaction involving invested capital. You will not always be the same person, and if you become someone new in the middle of an investment episode your odds of failure grow exponentially. Along with a decision on what you are willing to spend in pursuit of a gain, you need to consider who you are. In the final analysis, it’s deciding in advance whether a piece of real estate, a stock, or a poker game (there are successful professionals in this field) is an investment, speculation or a gamble.
Are you an Investor, a Speculator, or a Gambler?
An investor expects a safe return of his invested capital after receiving dividends, interest payments or rent. A government bond held to maturity or the ownership of high quality commercial real estate are examples of investments. These usually require long investment horizons.
A speculator expects to receive a gain on his invested capital through an increase in the value of the asset purchased. A return on an investment is only achieved when the asset is sold for a profit. This is not the same thing as making an investment and tends to be short-term.
A gambler uses capital to express an opinion and/or as a form of entertainment to wager on activities with unknown outcomes or with results arrived at mostly by chance. Sports events, casinos and highly speculative equities allow for effortless all-or-nothing bets.
A Cautionary Tale: The Speculator Changes Face to an Investor
It can work like this; there was a lot to like about that hot, new company, and as a speculator you took a meaningful position, buying a slug of stock that pays no dividend. For reasons you couldn’t have known the stock price drops, let’s just say 20%, but you decide to hang in there and keep your position. It takes another hit to the share price and you are now down 40%. So, you decide to hold on until you at least get back to even, and now you are a gambler.
But you tell your friends that you are, in fact, an investor with plans to hold the stock for the long-term, but without any dividends or any reasonable expectation for a safe return of your initial investment. At the same time, you’ve convinced yourself that you can’t sell now because you’ve lost too much money. It can be a long, painful ride to the bottom.
It’s okay to be an investor, a speculator and a gambler at the same time. It is not acceptable to be all three on the same trade. And when market conditions influence your identity in the middle of a trade, you are letting human nature get the better of you. An Investment Plan is intended to take the emotion out of investing, while at the same time assigning each financial transaction to an appropriate goal.
Closing thoughts for Investors
A discount broker has the account I use to gamble – currently, it holds stock in a Canadian mining company looking for gold on Japanese islands. There is nothing even remotely comparable in our retirement accounts which are mostly filled with indexed exchange traded funds and bonds. In our savings account, there is just cash, and always will be, so a trade doesn’t have to be forced to solve unexpected financial problems. My plan is to invest carefully for the long-haul, speculate on an occasional high-risk high-return activity and always have a safety net.
Your investment plan is simply a list of your current assets, each with a “Sell Now!” price (hopefully as a standing stop/loss order), what purpose it serves (long-term or short?) and a reminder about who you were when you made the investment or gamble.