April 26, 2012 at 06:00 AM EDT
Investment Advice: 5 Ways to Conquer Gambler's Ruin
The relationship between investing and profits seems simple enough. You buy low, sell high and your portfolio grows -- or so goes the story. In reality though, success comes down to something called " G ambler's Ruin ." Most investors have never heard the term but understanding its implications can mean the difference between heartache and success, especially now. Gambler's Ruin is a mathematical principle that deals with the preservation of assets - or, more accurately, the probability that you'll lose them over time. Here's how it works: Imagine that Player One and Player Two each have a finite number of pennies, which they flip one at a time, calling "heads" or "tails." The player who calls the flip correctly gets to keep the penny. Since a penny has only two sides, it would seem on the surface that each player has a 50% probability of winning - and that's indeed the case for each individual flip. But, if the process is repeated indefinitely, the probability that one of the two players will eventually lose all his or her pennies is 100%. In mathematical terms, the chance that Player One and Player Two (P1 and P2, respectively) will be rendered penniless is expressed as: P1 = n2 / (n1 + n2) P2 = n1 / (n1 + n2) In plain English, what this says is that if you are one of the players, your chance of going bankrupt is equal to the ratio of pennies your opponent starts out with to the total number of pennies. While there are wrinkles in the theory, the basic concept is that the player starting out with the smallest number of pennies has the greatest chance of going bankrupt. In the stock market the player with the smallest number of pennies is you ... and me...and any other individual investor, for that matter, who is up against the big boys. Investment Advice: Playing to Win If you've ever been to Las Vegas or Monte Carlo, chances are you understand this at some level, if for no other reason than that the longer you stay at the tables, the greater the probability that you will lose. Investing is much the same. To continue reading, please click here...
The relationship between investing and profits seems simple enough. You buy low, sell high and your portfolio grows -- or so goes the story.

In reality though, success comes down to something called "Gambler's Ruin."

Most investors have never heard the term but understanding its implications can mean the difference between heartache and success, especially now.

Gambler's Ruin is a mathematical principle that deals with the preservation of assets - or, more accurately, the probability that you'll lose them over time.

Here's how it works:

Imagine that Player One and Player Two each have a finite number of pennies, which they flip one at a time, calling "heads" or "tails." The player who calls the flip correctly gets to keep the penny.

Since a penny has only two sides, it would seem on the surface that each player has a 50% probability of winning - and that's indeed the case for each individual flip.

But, if the process is repeated indefinitely, the probability that one of the two players will eventually lose all his or her pennies is 100%.

In mathematical terms, the chance that Player One and Player Two (P1 and P2, respectively) will be rendered penniless is expressed as:

• P1 = n2 / (n1 + n2)
• P2 = n1 / (n1 + n2)
In plain English, what this says is that if you are one of the players, your chance of going bankrupt is equal to the ratio of pennies your opponent starts out with to the total number of pennies.

While there are wrinkles in the theory, the basic concept is that the player starting out with the smallest number of pennies has the greatest chance of going bankrupt.

In the stock market the player with the smallest number of pennies is you... and me...and any other individual investor, for that matter, who is up against the big boys.

Investment Advice: Playing to Win If you've ever been to Las Vegas or Monte Carlo, chances are you understand this at some level, if for no other reason than that the longer you stay at the tables, the greater the probability that you will lose.

Investing is much the same.

Since Wall Street casinos (read that as investment houses, hedge funds, mutual funds and the like) have more pennies than their individual patrons (retail investors), they can play the game longer.

More often than not, that means they come out ahead because the smaller players get wiped out or, as is the case over the past decade, give up.

That's why, unless you have some means of protecting your assets-- whether you're at the gaming tables or in the stock market -- the principle of Gambler's Ruin dictates that you will eventually give them up.

It may be through losses or the attrition of accumulated commissions and fees, but if you do not change your behavior, it will happen. The only question is when.

If you start with lots of money, it may take several generations, but the fact that it takes extra time doesn't invalidate the math.

But again, and I can't stress this enough -- that's if you do nothing but play the odds.

To win you just need to change up your game in such a way that the odds reflect the strengths we bring to the table.

Let me explain.

When you're going through periods of high growth, opportunities come at you so fast that it seems almost incomprehensible.

In that kind of environment, an investor can easily conclude he or she is a genius. That's very dangerous because the principle of Gambler's Ruin is still at work.

Even in the best of times, the markets move with alarming regularity to the downside. In fact, over time about one in every three days is a down day. That's why profits just aren't simply a matter of finding opportunities and going along for the ride.

I like to think in terms of what I have on the table with any investment:

• Is it a "glocal" - meaning does it have a strong global operation with highly localized demand for its brands?
• Does it have consistent growth including an emphasis on international expansion?
• Does management have an international vision? In today's day and age I don't want to own any company that doesn't.
• Is there a strong commitment to paying back shareholders?
• Can I realistically call its balance sheet "fortress like"?
• What countries is this investment tapped into and why?
• Does it cater to or help me recession-proof my portfolio with ongoing demand for its products?
Why are these questions important?

They're odds-eveners -- for lack of a better term -- that help me avoid Gambler's Ruin by exploiting weaknesses that take away the advantages of size and scale enjoyed by the big boys.

Instead of going to the tables with the mindset that I am only going to lose so much money today, I am concentrating on what I believe are winning characteristics that will change the house's odds. And mine, too.

How to Grow Your Pile of Chips Going Against the Pros Then, I actually concentrate on bending the rules to my advantage. Here are five things to think about to help you level the playing field when going up against players working with a nearly infinite amount of chips:

1. Institutions are very "name driven," but they are hampered by their size. Very few individual investors are. Think about it. They just can't waltz in a pick up a cool million shares of Microsoft, for example.
2. As a result, institutions are likely to wait until everybody is selling, then begin picking up shares of quality companies on big down days. These big traders are especially active at or near big bottoms or market tops.

On the other hand, most individuals don't have to worry about picking either. Unless they're trading something in the ultra-microcap range, they can afford to be early or even a little late to the party and still do just fine.

3. Traders are paid to win and hate losing money no matter how much of it they've got. If you understand that, you will understand what I am about to say next - pros would rather hit singles and doubles than home runs all day. They know that's what pays the bills.

4. That's not to say they won't go for the homers. But if a professional manager can lock in profits with one or two big name investments backed by trillions worldwide, he'll do that instead. For him, it beats trying to make 30-50 companies "work" by trading them into the ground.

This is a distinct advantage for individual investors because big companies matter-- not just in terms of potential, but in terms of being defensive, too.

5. The big traders tend to stick with their winners. They may trade around them, but most build a core portfolio then guard it like a hawk depending on their market expectations.

6. Individuals, on the other hand, seem obsessed with the thrill of the chase. It's sexy, it's fun to talk about at cocktail parties and it makes for great dinner table conversation. That is until you get into a pissing match with a big trader who is determined to hammer you into submission. Then it's downright unpleasant.

7. In the old days, institutions owned the markets. These days, thanks to the advent of electronic trading and platforms that are available at nearly every online e-brokerage firm, individual traders can.

8. It may not seem that way given the computerization and high frequency trading in the headlines of late, but simply using limit orders or selling puts to "buy" a stock, bond or ETF can put you at the table rather than on the menu.

The big boys count on uninformed individuals making trades at the market. Take away that advantage and you even the odds considerably.

9. Small investors can avoid the noise. After a day like last Monday when the markets got carried out feet first, this is hard to imagine, but it's very real.
10. Institutions are under extreme pressure to trade actively. They can't just step aside. That's why if they can offload their risk to unsuspecting individuals, they will. But guess what?
This works in reverse. If you refuse to play the game and confine your investment decision-making to the criteria such as I just outlined, you're automatically on your terms rather than theirs -- no matter what kind of day the markets are having.

Learn these things and practice them so "Gambler's Ruin" won't rob you of your retirement.

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