The art of investing in stock market

The great economist and Nobel laureate in Economics, Paul Samuelson once said: "Investment should be more like watching paint to dry or watching grass to grow. If you want excitement, take $800 and go to Las Vegas." This statement contains the message that investment is not gambling. One should invest with a long-term vision, not for the purpose of gambling to be rich overnight, since no market offers such an opportunity for anybody in the world except the house of gamblers such as Las Vegas.
But the stock market, though not a place for gambling, involves gambling. So, should we gamble? We say 'yes'. But a simple 'yes' is not sufficient, since gambling involves the higher possibility of making an outright loss. While making an investment decision in the stock market, an investor faces the question: is he/she taking risks or gambling? If he/she gambles, then how should he/she gamble? For this reason, it is very much vital to know what risk and gambling mean in the context of the stock market. It will help one maintain the balanced investment strategy and portfolio and will help minimise the risk of making loss in the stock market. Sometimes investors need to take pure risks and sometimes they need to do pure gambling because investment opportunities come with varied information which is in most cases not complete.
For example, if an investor intends to purchase a share that is being currently traded at Tk 200, he/she needs to forecast the discounted future value of the share. Even then he/she calculates Net Present Value (NPV) of the share, he/she may find it quite hard on that basis to take a decision  as to whether he/she should purchase that share at all. This is a case of taking pure risks because his investment decision is circumscribed by calculated uncertainty and this uncertainty introduces the element of risk in his investment. On the other hand, if he/she sees that the value of a share which is a junk share has increased to Tk 250 which he/she purchased at Tk 175, he/she may conjecture on the basis of second-hand information that the value of the share may increase more than Tk 250 in the future - a silly behaviour which pauperised thousands of investors during the 2010 stock market crash - and opt not to sell the share, though the current market price offers good profit. This is a pure gamble. Now, the question is whether one should gamble on a price of Tk 250 or not. The usual advice that one analyst would give is that one should prefer one bird in the hands rather than two birds in the bush; that means, one should sell the share at Tk 250 and bag the profit.
Before we proceed to give any concrete suggestion as to whether he should gamble on Tk 250 or not, we should note down several points. First, one investor will never suffer significant losses but will make losses, if one takes risks. Second, there is the higher possibility that one will make significant losses if one gambles in the stock market. So, faced with this information, investors must find out investment strategies that minimises losses and maximises gains in the stock market. But gambling counters investors' motives minimising risks and maximising. Minimising losses along with gambling in the stock market is the foremost challenge for an investor. In view of the above example, gambling on a share price at Tk 250 puts the investors at high risks of making loss in future. So what is the solution then?
To find out the solution, we can imagine a situation like this. Let's say the person X is a stock market investor and has invested Tk 100,000 fresh capital in the stock market. To simplify the analysis more, we also can think that he has invested the whole capital in one stock called y. His prudent investment strategy has paid off, and he has made a gain equal to Tk 40,000 in the stock. Now he/she is contemplating build up of an investment portfolio by investing in different kinds of stocks. In his portfolio, there are two stocks called z and w. Investment in z involves pure risks, and the investment in w involves gambling, since he/she has no clue about the NPV of the stock and he just invests in this stock on the basis of a 50-50 chance. As he/she has in total Tk 140,000 to invest in the total portfolio including in the z and w stocks, he/she must first determine how much to invest in the w stock and how much in the z stock. Then, the very crucial one he needs to specify is which money he should invest in which stock. Though total capital is now Tk 140000, Tk 40,000 is the profit earned from selling the y stock. Since, the investor will gamble on the market price of the w stock, he should gamble in such way that his loss is minimised and gains are still maximised, even if he makes an outright loss.
How is this possible? This is possible if he/she invests out of Tk 40,000 profits in the w stock. Now even if he/she makes loss, he/she will lose the profit, not his original capital. Similarly, he/she should invest out of Tk 100,000 in the z stock. The strategy is that one should gamble in the stock market using the money collected from immediate gains or the very recent gains from the stock market.
This will help him/her minimise the loss and maximise gains in the stock market. The question now arises: what happens, if a stock market investor entered the stock market 10 years ago and currently he/she has more than Tk 1.0 million in investments in the stock market. The answer, as we have given, is that he/she should gamble using the money from very recent gains. For example, if the investor has earned Tk 100000 in profit in the recent time, he/she should gamble using this money, not using the money from earlier gains.
What is the justification for this strategy? The justification is that today's gain is tomorrow's capital and yesterday's gain is capital not only for today but also for tomorrow. In this sense, any loss from immediate gains is always less than the loss from distant gains. If we simply state the investment strategy, we say: don't destroy your capital but destroy your gains. This is what all need to do while gambling in the stock market.
The 2010 stock market crash happened mostly due to the gambling attitude of investors who either knowingly or unknowingly gambled. They mostly gambled on the price of shares which were basically junk shares. Their balance sheet hardly showed any profit, if any. If investors  had gambled using gains from the share market, our projection is that the crash which already occurred never did happen, irrespective of whether somebody was manipulating the market price or not. The reason is when somebody gambles using gains, not past capital or fresh capital, in the stock market, the size of operation will always be small; selling and buying of those who gamble will not constitute such a scale as to cause a big crash. At any point of time, gains represent a small fraction of the total capital invested in the stock market. Now even if all investors gamble, which is not true, gambling will not cause a big crash as the scale will still be too small to cause a big crash.  This lesson, very much vital one, has hardly been learnt by the investors. Rather, they gambled - whether the investors possess working knowledge about buying and selling in the stock market or not - using mostly original and borrowed or equity capital. One can gamble in the stock market, but needs to know how to gamble. Theoretically speaking, the stock market is not a place to gamble. But practically speaking, the stock market is composed of uncanny investors and sentiments which create an environment for gambling. So, the prospect of gambling will always be there. What we as investors need to know is how to gamble while minimising the prospect of loss.
The perfect strategy would be staying away from gambling as Samuelson advised in his quotes mentioned above. The irony is that reality hardly welcomes perfection and is often against it. While Samuelson has advised us to go to Las Vegas to seek excitement in investment, gambling in the stock market is more economic than gambling in Las Vegas as long as it offers the chance for gambling. Therefore, for a stock market investor knowing how to gamble is more important than learning how to resist the temptation of gambling, which, in most of the cases, is not realistic in view of the nature of stock market.
The contributor writes from the
University of Denver, USA. [email protected]