In a recent column I exposed my own portfolio and its daring dullness. It is that very dullness which, I believe, is the key to its success. Still, beneath this dull exterior beats the heart of “The Gambler.” Even yours truly gets the occasional urge to buy that risky stock, offering the possibility of a 1,000 percent return, and sometimes I just can’t resist acting on that thrill-seeking urge.
That’s why I carve out a small piece of my portfolio for, perhaps, the only fun I have in investing. I call it my gambling portfolio. It satisfies a piece of my brain that buying a low-cost diversified index fund can’t.
Now, everybody should have their own system to outsmart the market. Mine is buying stocks in companies that have fallen from grace and that I think have about a 50-50 chance of going bankrupt. As it happens, great companies typically underperform markets, and bad companies, on average, make good investments. This results from a phenomenon known as “reversion to the mean.” In other words, the great companies touted by Wall Street end up not being as great as they were touted, and the stock price doesn’t keep up.
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Conversely, companies shunned by Wall Street often end up not as bad as expected, and the stock price rises when the low expectations are not met. So if bad companies make good investments, then my hypothesis is that awful companies near bankruptcy will make unbelievable investments. Not a commonly held hypothesis, I’ll admit.
For example, CNBC Mad Money’s Jim Cramer named Best Buy (BBY) as one of two companies to “sell sell sell immediately” in November 2012 for less than $11 per share. It was not such a stretch to imagine Best Buy hurtling down the path toward extinction like Circuit City, and it perfectly fit my criteria as a bad company unloved by Wall Street. So I bought it. I also, by the way, bought Hewlett-Packard, the other company Cramer said to sell. Let me tell you, The Gambler was one happy camper when Best Buy and Hewlett-Packard turned out to be the third and fourth best-performing companies of the S&P 500 over the next year.
Of course, as I reveled in my brilliance, I conveniently blocked out of my mind my purchases of United Airlines, Delta Airlines, Eastman Kodak and others that didn’t make it — making my stock now worthless. I was not going to let all that inconvenient reality get in the way of basking in the glow of my 1,000 percent successes in the past, with Priceline, IBM and a few others.
How has it worked out?
In my emotional mind, The Gambler convinces me that I have kicked market booty with the return I’ve received. I don’t really care what my logical mind says. I could easily go back and evaluate my return versus the market, but why do that? I prefer to keep my parade unrained on.
What does this mean to the gambler in you?
In his book The Lazy Person’s Guide to Investing, Paul Farrell notes that the brain loves thrills and chills. He writes, “If you have two brains — you may need two portfolios.” As for my two brains, I use my logical one for the vast majority of my portfolio that I count on to meet my financial goals. This portfolio is in the boring, low-cost, diversified and tax-efficient category that I know will win by harnessing the powers of compounding and inertia.
My emotional brain is in the driver’s seat for my gambling portfolio. This is invested in a strategy that I feel will win by picking ultra-risky individual stocks that Wall Street doesn’t want.
I call my total portfolio a “core and casino” approach. The core part is in the logical, dull, own-the-whole-market approach. The casino part is in the risky-business stocks I pick from the emotional side of my brain, or The Gambler’s approach. Viva Las Vegas!
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Rules for my gambling portfolio
If you want a gambling portfolio, here are seven rules I play by that you could consider:
- Gambling is gambling, whether it’s investing or blackjack, so I only bet what I can afford to lose.
- When I’m looking for that risky stock to buy, I go so far off the beaten path that I need a machete. Look for me on the wrong side of the Wall Street tracks.
- Watch for buy signals. Ones that catch my gambler’s eye include:
- Large price declines.
- Stocks priced below $5, which forces many institutional investors to dump.
- Media noting money managers being fired for holding a particular stock.
- Accounting scandals.
- Insider trading allegations.
- TV gurus saying the company is dead.
- Make lemonade out of those stock lemons that went belly-up by harvesting the tax losses.
- Keep perspective on my wins and losses and the region of my overall investment portfolio they dwell in. It’s my own version of “what happens in Vegas stays in Vegas” (or did before smartphones).
- Never confuse luck with brilliance.
- Always remember rule No. 1.
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