Why winning investors know that stocks are money machines, not slot machines

How do you make money in the stock market? Easy: Buy stocks before the market goes up; sell before the market goes down. All you need to do is predict whether the market is going up or down.

If only things were so perfect. But too many investors waste time and money trying to discover reliable patterns in the market. Here’s just a sampling of what people have tried:

• The market does well in years ending in 5: 2005, 2015.

• The market does well in years ending in 8: 2008, 2018

• The market does well in Dragon years in the Chinese calendar.

• A stock broker studied comic strips in a newspaper; another broker let his dog pick stocks.

• The Boston Snow (B.S.) indicator monitors snowfall in Boston on Christmas Eve.

• Chartists looking for support and resistance levels, “head and shoulders” patterns, and more.

• Inscrutable black-box algorithms mining for inexplicable patterns.

The problem is that while seductive patterns are easily found in past data, they have a nasty habit of disappearing just when we try to use them. They are a rear-view mirror when we need a crystal ball. Yet many investors remain hopeful that they will crack the “secrets” of the market.

There is a better way. The stock market is often compared to a casino. The market is like a casino in two important ways: the short-run outcomes are unpredictable, but the long-run results are a near-certainty.

Casino enthusiasts in Las Vegas, Atlantic City, and elsewhere look for streaks, overdue numbers, and more complicated patterns. One hapless gambler recorded the outcomes of 50,000 dice rolls at a Las Vegas casino and studied the sequences in which the numbers appeared. He found that the sequence 4–4–11 occurred 31 times, even though it was only expected to happen 20 times in 50,000 roles. He consequently advised betting on 11 whenever 4 came up twice in a row. He also found that on 10 of the 38 occasions when the sequence 7–12–7 occurred, the next number was either a 2, 3, or 12.

His calculations were all done by hand, before computers, let alone data-mining software. I shudder to think about how many months — maybe years — he spent searching for fortuitous patterns. The only consolation is that the more hours he spent studying the numbers, the fewer hours he spent betting on coincidences.

Casino gamblers who follow patterns, hunches, and guesses may win or lose substantial amounts in the short run, but they are guaranteed to lose money in the long run. If the house has a 7% edge, it will make a 7% return in the long run — and gamblers will lose 7% of what they wager.

The stock market is like a casino in that hopeful investors are often seduced by worthless patterns. The market is also like a casino in that many overly cautious people stay away, fearful that they might lose money if stock prices dip. Finally, the stock market is like a casino in that Gamblers Anonymous welcomes compulsive stock traders with open arms, and recommends abstinence as the path to recovery.

The crucial difference between roulette and stocks is that the stock market in fact is a benevolent casino. Meaning, it is investors who have the edge — not the house. Corporations, as a whole, make profits and distribute a portion of their profits to investors in the form of dividends and share buybacks. Stock investors may win or lose in the short run, but they will surely make money in the long run.

The real secret to successful investing is to keep our eyes on that long run — to not be distracted by wishes and dreams, and not be excited or upset by short-term price fluctuations. Don’t think about next week — think about the next 30 years. It is hard for investors to think about holding a stock for 10-, 20-, or 30 years, but it is worth trying. John Burr Williams, the father of value investing, analyzed stocks by assuming that investors would hold stocks not 30 years, but forever. Following Williams’s lead, Berkshire Hathaway’s

BRK.A, +0.70%

BRK.B, +0.37%

 Warren Buffett has famously declared that, “My favorite holding period is forever.”

Concentrate on dividends, earnings, free cash flow, and other measures of the cash generated by companies.

Williams and Buffett never literally planned on holding stocks forever. And we don’t have to hold stocks 30 or more years to be value investors. Their intention was to help us focus on what really matters — the cash that companies generate. If we assume — no matter how unrealistic it is — that we will never sell our stocks, then we won’t try to predict zigs and zags in stock prices. We will concentrate on dividends, earnings, free cash flow, and other measures of the cash generated by companies. We will think of stocks as money machines, instead of slot machines. We will buy stocks because the prices are reasonable relative to the corporate cash flow, not because we expect stock prices to go up next week, next month, or next year.

If we think this way, we won’t try to buy stocks before the market goes up and sell before the market goes down, because we won’t try to predict future prices. Instead, we will recognize that the stock market is a benevolent casino where we have the edge. So we can ignore temporary ups and downs and be assured that, in the long run, we will make money buying stocks as long as publicly traded companies continue making profits.

By most value-investing metrics, stocks are reasonably priced now relative to dividends, earnings, and free-cash-flow, once low interest rates are taken into account. This is not a bubble, nor a buying opportunity of a lifetime. It is a time when stock prices are sensible, not wacky.

The S&P 500

SPX, +1.08%

 dividend yield is approximately 2%, while the longest-term U.S. Treasury bonds yield around 3%. If dividends grow by more than 1% a year, the broad U.S. stock market will beat Treasurys in the long run. If dividends grow at their historical 5% rate, stocks will give about a 7% annual return over time, which is a satisfactory edge that will double the wealth of patient investors every 10 years.

Gary Smith  is the Fletcher Jones Professor of Economics at Pomona College and author of “ Money Machine: The Surprisingly Simple Power of Value Investing .”

Read: Don’t cheat yourself with the 4% rule

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