Handicap The Market, Rack Up Gains

By Investopedia AAA

When Kenny Rogers noted that one should "know when to hold 'em, know when to fold 'em" in the 1978 hit song "The Gambler," his gravelly-voiced words of wisdom could have just as easily been applied to buying call options as they did to playing cards. Despite the inevitable dissenting "harumphs" from old-money stockholders, investing on Wall Street and gambling on The Strip are not as different as they may seem. This isn't to say that investing is little more than gambling, but that in both of these high-stakes games, careful analysis, diligent recordkeeping and the ability to keep your cool under pressure are what contribute to long-term success.

Handicapping and Analysis
To be successful in gambling or investing, one must achieve a rate of return (odds) on winning plays that not only compensates for one's losers, but also for transaction costs. In sports betting, these costs are referred to as the "vigorish" or "juice;" in pari-mutuel wagering, they are called the "take", with "breakage," the rounding down of winning payoffs to the nearest dime or nickel, constituting another, hidden fee.

Of course, the means of deriving profitable picks vary. One who bets on horses might consider a horse's current form as well as the steed's trainer and jockey, much like a savvy investor might focus on a company's revenue growth or technical indicators like price and volume.

Against All Odds
Whatever the criteria, the goal in both investing and gambling is the same: to beat the bookies or master the markets. In this regard, sports gamblers clearly face a more arduous task than stock market investors do. In the past 20 years, the Dow Jones Industrial Average (DJIA), a perennial benchmark of market performance, has increased by nearly 19% per annum - meaning that even those relying on nothing more sophisticated than a stock listing and some darts stand a reasonable chance of profiting in the trading game. (For more on the DIJA, see Calculating The Dow Jones Industrial Average.)

Contrast this to sports gaming, where dart throwers face closed betting pools, higher transaction fees and expected returns that are less promising than a late-night visit from a hooded figure carrying a scythe.

Thus, while finding market inefficiencies is surely desirable to all speculators, it is absolutely critical to those who wager on sporting events, as what ultimately determines a sports gambler's success is his or her relative level of skill and knowledge. (For advice on becoming a savvy investor, read Ten Books Every Investor Should Read and Ten Tips For The Successful Long-Term Investor.)

Emotion in Motion
One factor that influences both investors and gamblers alike is emotion. Happy or sad, elated or mad - how we feel often affects what we do and how we interact with others. It's imperative for those who engage in speculative endeavors to find ways to control their feelings. Strategies and tactics are best formulated in advance and not in the heat of the moment, when the markets are tanking or the weight of a current losing streak is poisoning one's way of thinking. (For more on this, see Removing The Barriers To Successful Investing.)

"Speculation is an art," states Thomas Hoyne in his book "Speculation: Its Sound Principles and Rules for Its Practice" (1922). "The first principle of every art is to have at the outset a clear conception of the end aimed at. Never enter upon any speculation without clearly conceiving precisely the amount of profit that is sought and exactly the amount of loss that will be submitted to in an effort to secure that profit."

In other words, know when to quit. As the legendary trader Jesse Livermore once said: "Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit." (To learn more about this famous investors, see The Greatest Investors: Jesse L. Livermore.)

It sounds simple, but oftentimes it's not.

Hype Hysteria
Keeping one's emotions in check is also important when evaluating the latest "hot" stock or "now" betting proposition.

When Big Brown faced eight rivals in the last leg of thoroughbred racing's Triple Crown on June 7, 2008, few thought the three-year-old could be beaten. After all, Big Brown was undefeated in five lifetime starts and had captured the first two jewels of the Crown - the Kentucky Derby and Preakness - by a combined margin of 10 lengths. Even the colt's trainer, Richard Dutrow, thought Brown would deliver in the Belmont Stakes, going so far as to call it a "foregone conclusion."

But somebody forgot to tell Big Brown. Going to post as an overwhelming 1-5 favorite to become just the twelfth Triple Crown winner in history and the first since Affirmed raced to this honor thirty years earlier, the onetime wonder horse finished last after being pulled up by jockey Kent Desormeaux when hopelessly beaten approaching the quarter pole.

"To invest in something that's popular when it's popular is the kiss of death," Amit Wadhwaney, manager of the Third Avenue International Value Fund, told Time in 2005. As Big Brown proved in the 2007 Triple Crown, making a bet on something just because it's popular doesn't ensure success. Investors often bring this same mentality to investing, which can also lead to failure, particularly when large groups of investors behave in the same way.

Keeping Records
Determining what is value and what is hype is not easy. After all, if the hype is the result of a company finding a cure for cancer, for example, an increased stock price is undoubtedly justified. If, on the other hand, the excitement is due to a clever marketing campaign - one's bankroll could be sliced in half.

In order to tell the difference, it is important to keep records. Good gamblers strive to set their own lines or make their own odds; similarly, investors should come up with a means of pricing and identifying undervalued and overvalued stocks. (To learn more about stock valuation, read Peer Comparison Uncovers Undervalued Stocks.)

Once this has been accomplished, the focus can then turn to profit optimization techniques.

Final Thoughts
Whether betting on sports or wagering on Wall Street, it helps to learn the basics. Solid handicapping and analysis, the ability to separate fact from fiction, emotional balance and diligent recordkeeping are the keys to successful speculation. Gambling is a zero-sum game in which no value is ever created. The same cannot be said for investing, in which buying a share represents the purchase of an asset. However, both investing and gambling employ similar skills, and in order to profit in either, participants must understand the game and tackle it methodically and unemotionally. For investors, the old wisdom from Kenny Rogers' 1978 song still applies: "...the secret to survivin' - Is knowin' what to throw away and knowing what to keep."

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