Stock markets are casinos - but unwary gamblers may still win out

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The Independent Online
Can stock market investors learn anything from the way that market speculators such as George Soros behave? On the face of it, the answer has to be no. Investment and speculation, so conventional wisdom has it, are two distinct arts.

One is about the patient accumulation of wealth through careful selection of shares for the medium and longer term. Speculation, by contrast, is all about trading short- term possibilities, where what matters more than the intrinsic value of a share is its trading momentum and the state of market sentiment.

The game, as Keynes said, is about trying to guess what the rest of the players have - not what you have yourself.

But don't be fooled into thinking that the distinction is quite as clear- cut as all that. Victor Niederhoffer, one of New York's best-known market traders, who has worked with Mr Soros for many years, wants us to know that investment, speculation and even gambling are all in fact "first cousins".

He quotes Ernest Cassel, the turn-of-the-century City financier who befriended Edward VIII and became a pillar of the financial Establishment: "When I was young," recalled Cassel, "people called me a gambler. As the scale of my operations increased, I became known as a speculator. Now I am called a banker. But I have been doing the same thing all my life."

Mr Niederhoffer, like many New York traders, is a poor boy from the Bronx who has made good, and now wants to tell us how it was done. His thesis, born of 40-odd years of experience, is that investors can profitably learn from any walk of life where people make their livings out of staking money on risk and reward.

That means studying what happens at the race track and in the casino as much as poring over the financial pages of the newspapers. His book, Education of A Speculator, has already sold 100,000 copies in the United States, which suggests he may be on to something.

It is a strange and diverting mixture, half autobiography, half esoteric trading lore, thrown together in a way which suggests that Mr Niederhoffer's mind, like the universe, and the stock market itself, is in a permanent state of Brownian motion.

But although it may sound fanciful at first sight, what he has to say about horse-racing and the casinos is perfectly pertinent to the stock market.

As many professional investors will tell you, the mental discipline required to back horses and to trade in financial markets is very similar. It is all about managing money and making the right trade-offs between risk and reward.

Mr Niederhoffer is at pains to emphasise the great importance of understanding the house "take" in any field of money-making. As even the most innumerate adult tends to know, the relentless "edge" that a casino has at roulette from paying out at 36 to 1 on what is a 37-1 bet will eventually grind even the wealthiest punter down.

In horse-racing, something like 20 per cent of the money that the punter wagers is eaten up in the various "takes" - tax, the bookies' margin, and so on. Over time, it means that the racegoer has to make 20 per cent on his money just to cover the various hidden costs.

What does this all mean for the stock market investor? Well, as Mr Niederhoffer points out, there is a "take" in the stock market too. It comes in several forms. Some are visible, like the commission you have to pay a broker to buy and sell shares, or the upfront fee charged by a unit trust group.

Others, like the bid/offer spread, the difference between the price at which you can buy and sell a share or unit trust, are less immediately apparent, but just as important over the long term.

Then there is the Government, which wants its pound of flesh in the form of income and capital gains tax.

Add it altogether and it can have a significant bearing on your investment returns. The great beauty of the stock market, however, is that it is one of the few forms of money-making where the long-run return you stand to make - say 7-8 per cent after inflation - is sufficiently large to exceed the "take" you have to pay to take part.

That is one reason why equity investment is a suitable place for pension funds and widows and orphans to put their money. Although Keynes likened it to a casino, the stock market is one casino where gambler's ruin does not necessarily await the unwary.

But note the word necessarily. If you buy and sell shares too actively, and do so unintelligently, it is perfectly possible for the "take" to erode most of the returns you make, just as it does at the race track. This is where Mr Niederhoffer's tales from the racetrack and the card table are worth noting.

The most successful punters are those who only bet where they have a clear "edge"; they make most of their money by betting against the most popular runners.

They are also shrewd enough to know that any simple betting strategy will only work for so long. Patterns always run in cycles, and there is no single Rosetta Stone which holds the key to long-run success.

And so, although you may not need to read The Secrets of Professional Turf Betting by Robert L Bacon to find out (as Mr Niederhoffer suggests), it is with the stock market.

The morals for ordinary investors are clear. Don't trade too actively; it only enriches the brokers and the market-makers.

Don't follow the crowd too slavishly into popular stocks: they will never be long-run winners.

Don't fall for simple rule-of- thumb investment adages: a strategy based on picking the highest yielding shares will work well for a while, but not for ever.

Look to put your money into areas where you believe you have some "edge", and allow time and compound interest to do the rest for you.

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