One of the great investing rules to live by comes from poker: if you can’t spot the sucker, it’s probably you.
One of my most valuable investing rules resembles something I learned decades ago, as a teenage poker player.
When you sit down to play poker, the first thing you do is try to spot the sucker. This is the weakest player at the table who continually “feeds the pot”—throws more money in than he or she takes out. The better players quickly recognize the sucker(s) and try not to take too much advantage of them too quickly, to keep them in the game.
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Thanks to contributions from the suckers, the better players tend to break even or win more often than not.
One of the key investing rules you can learn goes like this: If you can’t spot the sucker, then you should quit playing, because chances are you’re it. You should only continue to play if the stakes are so low that the game qualifies as reasonably priced recreation.
That’s because poker is an example of what mathematicians refer to as a “zero-sum game”: you can only win if somebody else loses.
Obviously the winners will tend to be the players who have more native poker talent than you, and who spend more time playing it and studying it. Of course, suckers do tend to have lucky evenings from time to time. That’s what keeps them in the game.
Investing rules to live by: be honest with yourself, and never rely on luck
One key difference between suckers and better players is that the former generally have an unrealistic or at least inflated opinion of their own poker-playing ability. If they think about it at all, most view themselves as “above-average” poker players, in the same way that many people think of themselves as above-average drivers or joke-tellers. When suckers lose, they attribute it to a run of bad cards or a handful of poor playing decisions.
In contrast, better players are brutally honest with themselves. They understand that luck evens out over long periods. They know they will always lose in the long run to players who have more native talent for the game and who spend more time playing it and studying it. Consequently, they try to find poker games in which they are among the better players. They understand that this is what makes it possible for them to win.
This basic idea also applies in certain areas of investing, where the average investor just can’t win. These include stock options, short-term trading, new stock issues, and concept stocks.
As a part-time amateur, it is virtually impossible to become so good in these areas that you overcome the competition you face from full-time professionals. You can get lucky from time to time, just as in poker. But you are virtually certain to lose money in the long run.
This same kind of luck is why some aggressive investors like to get into fast-growing stocks at what they describe as “the ground floor.” They think the best way to profit in stocks is to buy them when they are just barely starting out on a growth phase that can last for years if not decades. Ideally, they want to buy the future top performers when they are still near or close to the penny stock range and have yet to be discovered by the broad mass of investors.
These investors rarely find what they’re looking for. That’s because there’s a large random element in investing, especially at the ground floor. Many promising junior stocks fail to thrive as businesses for one or more of any number of reasons. To borrow from the opening lines of Tolstoy’s Anna Karenina, successful stocks tend to have a lot in common, whereas unsuccessful stocks tend to suffer from their own unique sets of risks and faults.
When investors lose money in these high-risk areas, they think up at all sorts of reasons why—they got in at the wrong time, listened to the wrong people, or made some other error that in retrospect seems obvious. They hate to accept the real reason: they were in the wrong game. They got in a poker game where they were doomed from the start.
Fortunately, in the stock market, long-term growth takes the place of the sucker.
One of the big investing rules that never changes is that the stock market tends to go up 8% or so every year—on average—over long periods. That potential average profit of 8% yearly provides a cushion and a source of profit for average investors. However, that gain is not spread out evenly throughout the stock market. Instead, you’ll find clumps of potential profit in some market areas, and an absence of potential profit in others.
To succeed as an investor, you need to learn how to spot and avoid the areas where you’re likely to lose money, like the four I mentioned a few paragraphs back.
Instead, focus on areas where you have a chance of tapping into that yearly 8% profit, if not more. A great deal of investing success comes down to learning how to play in a way that puts the odds in your favour.
Investing tip: Use our three-part strategy
No matter how you invest for retirement, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.
By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.
You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.
Our three-part Successful Investor strategy:
Invest mainly in well-established companies;
Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities);
Downplay or avoid stocks in the broker/media limelight.
What investing rules have you learned in business or everyday life? How do you know when you’re likely to lose money? Share your experience with us in the comments.
Note: This article was originally published in February 2015 and has been updated.
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