One of the challenges of life is dealing with uncertainty. This can involve a number of things, such as someone’s health, what college a child may attend, future income from a job, and how one’s investments may perform.
As a general rule, it is better to have less uncertainty rather than more. That is why riskier investments would normally have a higher expected return versus those investments that are more secure.
Given that financial theory assumes that people are risk averse, some may wonder why there are individuals who gamble. The best explanation would be that many see gambling as a form of entertainment, and realistically do not expect it to be a profitable endeavor,
A person may have a $5 wager with a friend on a sporting event. However, if someone were faced with a choice of having a 50% chance of receiving $10,000 and another 50% chance of receiving 0 versus a 100% chance of obtaining $5,000, most people would take the sure thing of $5,000.
In essence people are oftentimes willing to “gamble” with relatively small amounts, but as things become more significant individuals become more risk averse. People do have varying degrees of risk tolerance, where one investment might be suitable for one person, but someone else may perceive the same investment, as too risky.
What is bothersome to many people is the uncertainty that is continually present in the world. This uncertainty can be a forthcoming election, international tensions, or the economy in general. Some people might think once these various issues clear up, then I’ll put some money in the stock market.
There are a couple of problems with this approach. For one, there is always some level of uncertainty in our economy and tensions throughout the world are always present to some degree. There have definitely been times in our history where uncertainty was much greater, such as World War II.
The idea about investing when things are relatively calm essentially means that investors will be paying higher prices to be in the market. When uncertainty is at its greatest, such as during the depths of the last recession is when investors would have achieved their best returns. Trying to time the market, and only being invested at certain times will lead to poorer investment results.
There are some investors who tend to equate the stock market to gambling. If someone is only in the stock market for short periods of time, or holds only a limited amount of stocks that approach is more like gambling. However, a well diversified portfolio held for many years is not gambling despite there being uncertainty about the future outcome.
On a given day or week the odds of the stock market producing gains is about 50%. However, for a given year, history over the last 70 years has shown the stock market to have achieved gains about 80% of the time. Extend that time period to 10 years, and the odds of losing money in the stock market are very low.
This explains why it is very important to have a longer time horizon, if you are investing in the stock market. The longer someone is in the stock market the better one’s odds are of achieving positive returns.
For example, someone who is saving for a down payment on a house that they would plan to purchase in a year’s time should not be investing in stocks. While odds of 80% that the investment would be successful seem to be quite good, the consequences of the other 20% occurring would likely be too costly to undertake the risk.
People need to be aware that there will always be uncertainty with regards to their investments. If individuals want to achieve a rate of return greater than what can be earned from a savings account there will be some degree of risk and uncertainty. Even the person with the savings account has some uncertainty, because with inflation their future purchasing power will be impacted.
Investors should be aware of events impacting our economy, and adjustments should be made in one’s portfolio from time to time. However, uncertainty will always be present in the investment world, and a fear of the unknown should not prevent people from maintaining a well diversified portfolio. Keeping a long term investment outlook significantly increases the odds of successful investing in an uncertain world.