British entrepreneur Ashley Revell recently made an extremely risky bet. He sold everything he owned, took the cash to a Las Vegas casino, and bet it all on one spin of the roulette wheel. Luckily for him, his bet paid off and he doubled his money, as the ball landed in a red slot, in line with that bet.
Lucky is the key word, of course. Statistically speaking, Revell’s bet was a loser, which is why the casino let him make it in the first place. After all, a typical roulette wheel has 37 or 38 slots, 16 red, 16 black, and one or two green (the “0” and perhaps the “00”). Those green slots give the house its edge and are what make “even money” bets like Revell’s “put it all on red” money losers for gamblers, on average.
A better way to play
The reason roulette tables exist at all is that, over time, they make money for the casinos at the expense of the gamblers. The odds are stacked in such a way that every bet a gambler can make has an expected payout that favours the casino. Not all the bets go the casino’s way, of course — otherwise very few gamblers would actually wager their money — but enough do so that on average, the casino wins. So if you’re going to play roulette, do so as the casino, not as the gambler.
That might seem rather flippant, until you realise that many casinos are actually owned by publicly traded companies. The right way to profit from a roulette wheel just might be to own shares of a casino that offers them. That way, as the gamblers on average spin away their savings, you as an investor could see some of the casino’s take, in the form of dividends or share price appreciation.
Of course, that — like any investment — has risks associated with it, too. Shareholders in James Packer’s Crown Limited (ASX: CWN) have seen their investment fall around 35 per cent in the last 5 years. Echo Entertainment (ASX: EGP) owns and operates casinos in Sydney, Brisbane and the Gold Coast. Although the shares have had a good run in recent times — as James Packer flexes his corporate muscles and his father’s wealth — it doesn’t mask the struggles in the underlying business.
Remember, casinos are in the business of stacking odds in their favour, which says something important about investing — you’re taking a risk every time you put your money in the market, no matter how much of a sure thing you think you have.
Run your own investing roulette wheel
As a result, you absolutely need to consider diversification as part of your investing strategy. Think of it, as Benjamin Graham — the father of value investing and the man who taught the concept to Warren Buffett — did, as a way to turn the stock market into your own roulette wheel.
Sure, any individual stock can still go to $0. With a smart diversification plan in place, however, even if one of the companies you own happens to become worthless, your overall portfolio can still survive or even thrive. And, at the end of the day, isn’t that what really counts? Much like a roulette wheel in a casino, not every spin goes in the house’s favour, but over time, the odds are stacked so that the house tends to win.
Here’s how it works in investing: Say you own an equal position in each of 20 stocks in different and unrelated lines of business, each purchased based on an expected long-run 10% annual return. If 19 of those stocks perform as expected, but one becomes absolutely worthless, then at the end of the year, you still wind up with more than you had when you started — about 4.5% more, in fact.
Yes, you would have been better off had you not bought that 20th pick, but think about the flip side. What would have happened had that now-worthless company been your only investment? Rather than still making money on the other 19, you would have been left with absolutely nothing. Just like in a casino, not every spin will work out for the house, but with enough spins, the house wins.
As an investor, you have the choice: Be the gambler and hope for the spin to go your way, or be the casino and be virtually assured that over time, it will. Proper diversification is the tool that lets you go from being the gambler that might get lucky to being the casino that almost definitely will.
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This article was originally written by Chuck Saletta, and published on Fool.com. It has been updated.