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Post  Max Sun Feb 20, 2011 1:53 pm

Just got back from Vegas, and I gained some fresh new insights into why I don't like to gamble.

1) The game is rigged. We know this for a fact, that the odds are fundamentally not in our favour (generally -5% or worse). The law of averages dictates that over the long term we will lose.

2) The law of averages can be beaten, but only over the short term, with the same probability. Over 1 round, your win/loss record will be either 100% (gain) or -100% (loss). Over the long term it will approach -5% as you win some and lose some, but in the short term, average performance is not possible, and you will see an extreme result.

3) In gambling, there is no edge. There is no way to tilt the odds in your favour, and you rely on luck over skill. In statistics, luck = probability, and applied to gambling in vegas, the probability is and will always remain negative (a losing bet).

So I took my theory to vegas and applied the logical conclusions:

The game is rigged over the long term, but over the short term I can be ahead, so I should play for the least amount of time possible. If I win, I walk away, if I lose, I lose what I would have lost over the long term anyway.
I had to bet a game that would have the highest possible short term payout regardless of probability of winning. I chose slots, since all other table games have max payout of about 36:1, while slots can be more than 1000:1. Slots also do not offer just a single payout, but a range of payouts, so the odds of striking a win on one spin are not as extreme as they appear.

I had $100 to spend, so I found a machine with the highest possible limit ($10 x 3 credits = $30 per spin).

The result: I did 3 spins and lost my $100 in about 30 seconds and walked away. Gambling is not fun or entertainment, it is just losing money, so I see no value in playing for a longer period of time trying to spread out my loss to the point where law of averages takes over.

In investing, you recognize some similarities, but also some important fundamental differences. The game is rigged, this is likely true, but the game will be rigged by many different groups each with opposing interests. The law of averages does not apply, because the statistical odds of winning are more or less incalculable. We know two things: The rest of the market is against you, so there is a fundamental bias for you to lose, but also that the stock market is an ever expanding pie. As corporate earnings stay positive, all fundamental stock valuations tend to rise in the long term. The market valuation may also expand and contract with the interest rate expectations, since investors will want a lower PE ratio (greater potential return) in times when the interest rate is higher.

Since the law of averages does not apply, we cannot expect short term deviations to recover and rise along with the average stock valuations over the long term through random chance. Only by picking a sector with constantly rising earnings (blue chips). Therefore, it is dangerous to apply buy and hold philosophies to sectors that do not have consistently rising earnings.

In picking stocks, we have the possibility of an edge, but almost certainly that edge is not information. I believe in a semi-efficient market in terms of information. I do not believe in an efficient market in terms of investor attitudes, emotions, etc. I think the only way to have an edge is to act in a more rational manner than the rest of the market. I try to use fundamental analysis as the basis for my decisions and therefore have a more rational valuation of a stock than the market. Then it is a matter of waiting for the market to price the stock incorrectly (in my view anyway).

I was doing quite well until one big loss on CCME, and I am beginning to have the debate: Have I just been lucky so far (will I fall victim to the law of averages), or do I truly have an edge at investing? With a period of rising interest rates ahead, it will be a difficult endurance test to survive the reduction of market value as average PE multiples shrink.

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