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The Melbourne Cup of investing

We’re only days away from the race that stops the nation – and the race that transfers millions from the once-a-year punter to the smart or lucky (with the bookies clipping the ticket on the way through).

For my part, I don’t really follow horse racing, but I enjoy the fun of the day and I make my obligatory ‘donation’ – I haven’t ever backed winner of the Melbourne Cup.

Thankfully, I don’t make my living picking the winners of horse races, but the Spring Carnival and its showpiece event on the first Tuesday in November got me thinking about the lessons investors can take from the spectacle.

Buy what you know
When it comes to horse racing and my annual trip to the TAB, I’m the archetypal mug punter. I don’t know the horses (other than a name or two I might recognise) and ditto for the jockeys and trainers. While luck doesn’t discriminate based on knowledge, I’m certainly starting a long way behind the field when it comes to a positive return on my $10 bet.

Famed US investor Peter Lynch gave us the exhortation to ‘buy what you know’ as a way of reducing the risk of investing. By selecting companies you are familiar with – whether because you work there, you use the company’s products or you’ve seen the popularity of the stores or brands – Lynch argued you had a better chance of doing well, compared to investing only by the numbers.

When it comes to the Melbourne Cup, there’s not much harm in a $10 punt on a whim – but investors are well served to simply keep their wallets closed until they feel like they know enough to tilt the odds in their favour.

Take the long view
The Melbourne Cup is one of the longest horse races in Australia, being held over 3,200m, and so there’s more to winning this particular race than just getting to the front as soon as possible and leading the whole way.

A good mate of mine often reminds me that ‘life’s a marathon, not a sprint’, and that’s particularly true in investing. Warren Buffett has beaten the market comprehensively over his investing lifetime, but has suffered periods of underperformance. When the tech boom was in full swing, Buffett was left in the market’s dust a couple of years in a row and people were wondering if he’d lost his touch.

In the wash up, it turned out that like some of the runners who lead the field early in the Melbourne Cup, many investors burned early and bright, only to crash to earth as Buffett calmly moved back to the front of the field.

Speculation ends badly
It’s often said of casinos that that house always wins. Not each hand, or even each night, but over time, the odds are stacked firmly in favour of the dealer. The same is true of bookmakers, who have made a profession out of understanding the chances of each horse, and – arguably more importantly – managing their risks by hedging their positions as the circumstances require.

For every story of someone winning big by speculating on an obscure mining company, there are many, many stories (usually untold) of loss from exactly the same activity. Gamble on these companies if you must, but history shows that most of the money is made from sensible investment in quality businesses that consistently beat the market – sometimes by only a couple of percentage points each year – the compound effect of that performance can be truly staggering.

Foolish take-away
Done properly, investing has very little in common with a flutter on the Cup. Yes, in both activities the outcomes aren’t certain, but investing isn’t a zero sum game – you don’t have to lose for me to win. In addition, whereas gambling is a prediction on which horse will make it around the track faster, investing is participation in the upside from the productive capacity of companies such as BHP Billiton Limited (ASX: BHP), Wesfarmers Limited (ASX: WES) and Coca-Cola Amatil (ASX: CCL).

Enjoy the Melbourne Cup – I hope you pick a winner. I’m hoping to finally win some money this year. Just remember the words of Warren Buffett: “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy”.

Are you looking for more quality stock ideas? Motley Fool readers can click here to request a new free report titled The Motley Fool’s Top Stock For 2012.

Scott Phillips is The Motley Fool’s  feature columnist. Scott owns shares in Coca-Cola Amatil. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article authorised by Bruce Jackson.

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