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Wall Street's Secret to Investing Success

InvestorEducation / Learning to Invest Apr 10, 2009 - 01:32 PM GMT

By: Money_Morning

InvestorEducation Best Financial Markets Analysis ArticleKeith Fitz-Gerald writes: Studies show that most investors - even ultra-wealthy ones - lose money over time because they don't, or can't, stick to a well-defined set of rules. For some, this is driven by reckless personal behavior in search of profits. For others, it's the constant shift between bad decisions and bad advice that creates whopping errors and poor performance.


But most of the time, investors incur these losses simply because they've never had what I'm about to explain to you explained to them - the concept of the Gambler's Ruin.

Most investors are unfamiliar with Gambler's Ruin. But they need to understand it for two simple reasons, especially now. First, Gambler's Ruin can represent the difference between long-term financial success and outright failure. Second, the negative outcome it produces is a foregone conclusion from a mathematical standpoint - unless you know the secret to beating it.

The Anatomy of the Road to Ruin

Imagine that two players (Player One and Player Two) each have a finite number of pennies. Now, flip one of the pennies (from either player), with each player having 50% probability of winning and taking the penny after correctly calling heads or tails. Repeat this process until one player has all the pennies.

If the process is repeated indefinitely, the probability that one of the two players will eventually lose all his pennies must be 100%. In fact, the chances that players One and Two (P1 and P2, respectively) will be rendered penniless are:

P1 = n2 / (n1 + n2)
P2 = n1 / (n1 + n2)

In plain English, this tells us that if you are one of the two players, your chance of going bankrupt is equal to the ratio of pennies your opponent starts out with to the total number of pennies the two gamblers have between them. While there are some wrinkles in the theory, the basic concept is that the player starting out with the smallest number of pennies has the greatest chance of going bankrupt.

Most folks who have been to Vegas understand this at some level. They also understand that the longer they stay at the tables, the greater the probability that they'll lose.

But what most people fail to understand is that Gambler's Ruin also applies to the stock markets. That's because the casinos (or the investment houses, hedge funds, and large private investors and other big institutions that together comprise Wall Street) typically have more pennies than their individual patrons (retail investors), meaning they can play the game longer. And that's why, more often than not, the big guys come out ahead.

The little guys get wiped out - or just give up.

The other thing that most people don't realize about the Gambler's Ruin is that unless you have a means of protecting your assets, you will eventually give them all up - no matter whether you are at the gambling tables or in the markets .

Losses will do most of the damage. But fees will do their part, too. If the markets start out with more money than you do, and if you don't change your behavior accordingly, this outcome is preordained. It may well take several generations to achieve actual ruin but that doesn't invalidate the math.

Readers frequently ask me why I'm such a vocal critic of Wall Street's approach to diversification . And now you see why.

Diversification, as it is typically presented (at least to retail investors), is nothing more than spreading the pennies around. In reality, it's how you concentrate your money and what specific steps you take to protect your assets along the way that matters most.

Most people think they have this covered, which is why during my worldwide speaking engagements I often ask my audience to try this simple - but very telling - experiment: Call your broker or financial planner and ask at what point on the Standard & Poor's 500 Index they would have you go into total protection mode. Chances are good that the response you'll receive is either a stunned silence or some sort of bumbling reply. Not all the time, maybe, but I'll wager it happens often enough to suggest that not one in 10,000 investors has thought this through.

While some would consider that a blessing, I think it's a curse because it suggests that the vast majority of investors are still taking risks that are hugely disproportionate to their potential gains - even at this stage of the game, when the S&P and other major indices have staged the strongest four-week rally we've seen since the early 1930s.

So how do you dodge the Gambler's Ruin?

Beating the Street at its Own Game

Any seasoned gambler will tell you the only way to consistently beat the house is to not play the game. But when it comes to investing, that's obviously not practical. Longer term, history suggests beyond a shadow of a doubt that we need to invest in the markets in some form to help secure our financial future.

Wall Street is acutely aware of this, which is why everything from its asset allocation models to its research - and even its commissions and fees - is set up to keep you in the game. The last thing Wall Street wants you to do is stop playing because that would rob its advantage from the Gambler's Ruin principle.

That's why savvy investors should take matters into their own hands.

One of the simplest - but most effective - ways to do this is to establish a properly structured portfolio like the 50-40-10 allocation we advocate in The Money Map Report , the monthly newsletter that's published by this company. I developed this portfolio structure to minimize risk as much as possible so that individual investors can stay in the game while minimizing the risks of loss posed by the Gambler's Ruin. The way out of this problem is not, as I say so frequently, from being right all the time, but rather from the principle of “positive expectancy” that is a byproduct of the 50-40-10 discipline.

If you've never heard the term, positive expectancy means how much money an investor can expect to make for every dollar placed at risk. This is very different from the concept of how often you win, which is how most retail investors are programmed to think about their money. They are more concerned about winning a certain percentage of the time when what really matters is that they win more money than they lose over time - no matter how many times they lose.

Most investors who have never thought about investing this way are shocked to learn that the best traders or investors may make winning trades only 40% of the time, yet still rack up huge gains consistently. They do this because they have a positive expectancy .

For more-experienced investors, there's also the ability to use a technique known as “ fixed fractional sizing .” Fixed fractional sizing can further help increase returns and minimize risk by varying position sizes based on the risk associated with each trade. The simplest explanation here is that fixed-fractional-position sizing helps increase investment size and return potential when on a winning streak, while reducing it accordingly when conditions or results aren't so great.

No matter which path you choose, the thing to understand is that by taking steps to protect your assets and improve your expectancy, you can overcome the Gambler's Ruin. But you have to make sure you stick to your discipline all the time - and not just when it's convenient.

[ Editor's Note : Ten trades. All profitable. Since launching his Geiger Index trading service late last year, Money Morning Investment Director Keith Fitz-Gerald is a perfect 10 for 10, meaning he's closed every single one of his trades at a profit. And he did this in the face of one of the most-volatile periods since the Great Depression. Fitz-Gerald says the ongoing financial crisis has changed the investing game forever, and has created a completely new set of rules that investors must understand to survive and profit in this new era. Check out our latest insights on these new rules, this new market environment, and this new service, the  Geiger Index .]

Money Morning/The Money Map Report

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