Gambling, betting and investing

Roulette wheel While I don’t typically like to compare the investment industry to Las Vegas, there is something common and integral to both: you have to make bets. Now, before you decide whether you object to this comparison or agree with it, let’s make sure we are working off the same definition of what “a bet” is: Bet = an act of risking a sum of money on the outcome of a future event.1 While making a bet in Las Vegas is as obvious as the size of your wallet before and after your wager, in investing it takes different forms. For instance, an investor might bet that stocks will outperform bonds. Or that one mutual fund will outperform another. Or that interest rates will rise versus fall. Or that an index may beat an active strategy. That Boeing’s stock price will outpace Airbus’. That the interest on cash might keep up with inflation. The possibilities are virtually endless.

Betting on the merits of global diversification

At Russell, we make a variety of “bets” when we invest our clients’ assets. For instance, we bet that our forecasts, which are a vital part of our strategic asset allocation, will be on target. Currently, we bet that value will beat growth over a cycle and that credit will do better than U.S. Treasuries over the long term. Of course, because of our research, we believe that our bets are better informed than when you put your dollars on black at the roulette wheel. But at the end of the day, they are still a bet “on the outcome of a future event.” But, at the end of the day, they are still a bet "on the outcome of a future event - and we may be wrong." Since the day George Russell, Jr. started Russell’s pension consulting business in 1969, we’ve had one bet in particular that stands out: our bet on the value of investors participating in the emerging trend of globalization. At the time, most of our U.S. pension fund clients had no meaningful exposure to global investments when we started encouraging them to allocate 15% of their portfolios to the stocks of non-U.S. companies. And as the correlation of U.S. and non-U.S. equities has moved closer to 1 over the ensuing 45 years, we have often chosen to resist calls to “get out of the more expensive asset class,” or to “get into the asset class that is experiencing a run.” Instead, we have stuck with our conviction in the value of global exposure.

Drawing parallels: Heads Up Texas Hold 'em

In a way, you could say our global bet is a little bit like a “Heads Up Texas Hold 'em” game between two poker players. In this game, each player starts with two cards dealt facedown that only the player (and anyone watching the television broadcast!) can see. That’s followed by five cards dealt face up in three rounds: the “Flop of 3 cards,” the “Turn of 1 card” and the “River of 1 card.” After the initial two cards are dealt, and in each successive round of dealing, each player has the opportunity to place a bet. The player with the best five-card combination after all the bets are finalized is declared the winner. To examine the parallels between this game and Russell’s “bet” on globalization, let’s pretend that I’m playing Heads Up Texas Hold 'em and:
  • I’m dealt the Ace of Clubs and the Ace of Diamonds
  • my opponent, unbeknownst to me, is dealt the King of Hearts and the King of Clubs.
We both have very good hands. Based on my available information, it’s very likely that I’m going to bet – even though I have no idea what my opponent is holding. (The television audience, which can see both our hands, of course knows that I have an 81.71% chance of winning at this point in the game.) The “Flop” uncovers the Queen of Hearts, 9 of Hearts and the 10 of Spades. Unfortunately these three cards do absolutely nothing for my hand, but a lot for my opponent. That said, I still believe I have the best hand and will most likely bet accordingly. The odds are still in my favor: 72.53% chance of winning. The “Turn” reveals an Ace of Hearts. It’s a great card for me but it makes me nervous: I know my opponent, who has matched my bets at every round, has a couple of ways to beat my hand (5 Hearts or a Straight beats 3 of a Kind). The television viewers can see that at 75%, I have a higher chance of winning than my opponent does. So the question becomes: At this point in the game, what should I do: hold 'em or fold 'em? What would you do? What might this scenario look like if we applied it to investing? Let’s assume you’ve bet on global investing and you feel confident for all the reasons that make global investing a good bet. Then for the next three years, your bet doesn’t help your portfolio at all. Finally you get a period where global wins, but your competitor still looks like they’re in good shape. You don’t know what the next period will bring. Do you hold 'em or fold 'em?

The bottom line

Most people associate “betting” with gambling at Las Vegas. But in a way, investing involves a certain amount of betting, too – if you consider that betting means you’re risking a sum of money on the outcome of a future event. The advantage to betting in investing compared to betting in Las Vegas: you can make more informed investment bets than you can gambling bets. Make sure you’re capitalizing on that key difference.

1 Source: Oxford Dictionaries