Letter To A Friend. {Conclusion}

Finally I’d like to briefly elaborate on what we discussed regarding risk the other night. I think that insurance, investing and speculation are similar concepts. All three deal with an unknown variable which is the future. All three to some extent deal with odds. All three deal with risk of economic loss. The difference though is that investing, if done properly, let's you work when the odds are in your favor with less risk of catastrophic loss. Let me explain.

Insurance of any sort seeks to mitigate economic loss. Life insurance seeks to compensate your heirs should something happen to you. {I often use the example of getting hit by a dark bus}. Similarly health insurance helps protect against the cost of catastrophic illness.

Gambling however is a binary event. Strategies can be developed based on probabilities in different games but at the end of each turn gamblers either win or lose. Further each loss is a catastrophic loss in that you lose 100% of what you have on the table. There is no game in a casino where the odds are in the customer's favor. Since every bet in gambling involves potentially a 100% loss and with the odds stacked against gamblers, it should be no wonder that casinos are very profitable enterprises.

This same concept also applies to cards. Card games like Texas Hold-em have similarities to investing in that players are looking to make strategic decisions based on mathematics and psychology. Card games also remove the issue of the “house”. However each loss is still a 100% loss. You can develop strategies to minimize this risk but you can never take it completely out of the equation. Not playing all of your chips for example still does not take away from the fact that each bet is a potential catastrophic loss. Only one person wins a Texas Hold-em tournament.

Investing, particularly if it is pursued along a longer term, well executed strategy does not have to be that binary event. Warren Buffett who we discussed earlier once said, “The stock market is a no called strike game. You don’t have to swing at everything-you can wait for your pitch.” That is you can wait for when the odds are in your favor. Investing with the odds and with a sound strategy also gives you the opportunity to cut your losses when things go bad. This is often without it being a 100% loss of principal that happens with a gambling bet.

To put it another way, think of this example. You are playing black jack. You have an ace down and a face card. The dealer is showing a queen. In my example the dealer only will get one more card. He then gives you this option. You can double your bet on the table. If you do and the bet ends as a tie {meaning he deals an ace} then the worst you can do is lose 10% of what you have put on the table. Gamblers would take that bet any day! These kinds of opportunities appear time and time again in the markets particularly if investors use disciplined risk/reward investment strategies.

Anyway I hope this helps and answers your questions better than I could back a few weeks ago.

Chris