Quit While You’re Ahead

You cannot beat a roulette table unless you steal money when the dealer isn’t looking.

– Albert Einstein

The expected return from a roulette spin is negative: -5.26%. An operation that has a negative expected return is not an investment. It’s not even an intelligent speculation. It’s simply a gamble. Of course, you might get lucky, but on average you won’t. If you insist on playing anyway, the last useful resort is to follow the advice of Baltasar Gracián y Morales: “Quit while you’re ahead. All the best gamblers do.”

Why are you taking market risk? Whether you’re investing for yourself, or you’re a member of an investment committee making decisions for a pension fund or charitable organization, you’re responsible for asking that question. The natural answer is that you expect positive and adequate investment returns to compensate you for the risk. The next questions are then a) on what basis do you expect that investment return? and b) on what basis do you believe that the expected return is adequate and proportionate to the risk you’re accepting?

In their classic 1934 text, Security Analysis, Benjamin Graham and David Dodd described “investment” as buying a security at a valuation that is associated with a reasonable expectation of acceptable long-term returns, based on a careful analysis of the relationship between the current price and the assets and cash flows of the business. As Graham observed, “The habit of relating what is paid to what is being offered is an invaluable trait in investment.” In contrast, “speculation” involves buying a security simply on the expectation that its price will advance. If you are not using well-defined and historically reliable valuation measures as a basis for investment, and you don’t have a well-defined and historically validated basis on which to expect speculative behavior from other investors, you’re probably gambling.