Buy Right Sit Tight - 2018

Stock Market: Play by the Rules!

By Amit Rupani

“Stock market is a casino. No one wins at a casino. Investing in the stock market is just like gambling at a casino. " I am sure most of you have heard these lines from your parents, relatives, friends or a well wisher. Let's try to understand the difference between a casino and the stock market, and how you can lose your shirt if you try to mix both of them.

A casino has a pre-defined business model with a clear goal to ensure profitability. Its business model is very simple – take in more than what you give out. The expected return (derived by probability math) is negative for most games where one is playing against the house. The longer you play, the greater the odds are that you will lose against the house. Even in the game of Poker where the house is just facilitating the game for players – the house cut is generally 5 pecent of each pot. My point is that all games in a casino are designed in a way that odds are stacked in favor of the house. It is a place where one can go only broke if your goal is to make it big.

In the stock market, the stock exchange is just a platform for a buyer and seller to determine fair value of the security. The stock exchange is “the house" guaranteeing clearance for all transactions. A stock broker acts as a dealer and takes a cut every time you buy or sell. All participants collectively make the market and are playing versus each other. For every buyer there has to be a seller. Here odds are equal for everyone participating. You don't have to be first to win this game. Just “play by the rules." It is a place where investors get an opportunity to buy ownership stake in finest businesses and get rich slowly.

Some brave souls treat stock market as a casino and think of it as a place where they can become multi-millionaires overnight. Their wild leverage, over-confidence, and excessive trading helps stock brokers to make a lot of money through commissions and fees. They bet blindly with the hope that they will get another fool to purchase their shares at higher price than what they paid for. At some time, brave souls run out of fools and the only fool left on the floor are themselves. No wonder why they lose their shirts as they break the stock market rules by mixing the stock market with a casino.

So the stock market can be both a casino for a brave soul or a paradise for an investor. It all boils down to which side of the street you come from. I come from the investor's side. Below I will cover how you can play by the rules to succeed in the market.

The table may look intimidating, but even an eighth grader can understand above numbers. The table shows performance of the BSE Sensex index from April 1979 till March 31, 2017. The index grew from 100 to 29620.5 in the last 38 years at 15.07% compounded annual growth rate. I will walk you through column titled “1 Year" which should help you understand rest of the columns. This column shows the annual return of the index for any given year. There were 12 years out of 38 when index gave negative annual return which is marked in red. Highest single year return is highlighted green as you can see 266.88% in year 13. The range between highest and lowest return for 1 Year column is 266.88% to -46.78% (which is huge). The bottom rows show that the probability of loss as 31.58% for any given single year; as market gave negative annual return 12 times out of 38 years.

Pay close attention to the bottom rows. Notice that the probability of loss decreases as your time horizon in the market increases. A brave soul with the intention of becoming quick millionaire had a high probability of 31.58% to lose in any given single year. The probability of loss for the patient investor with horizon of 10 years went down to 3.45% and further went down to 0% for 10+ years. So you were almost certain to not lose your money if your investment horizon in equities was 10+ years.

So here are the rules of the stock market: As investment time horizon increases: The return volatility decreases, return range decreases, and probability of loss decreases.

Now next time if anyone tells you that investing in the stock market is just like gambling at a casino, tell them that today one would be sitting on Rs. 2.07crores (without even considering annual dividends) if Rs. 1lakh was invested in the BSE Sensex index 38 years back. Explain them that equities asset class is not risky in the longer run; you come from an investor's side of the street and will play by the rules.

Happy investing!

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com