As an investment advisor, I'm not supposed to admit that stock investing amounts to gambling. The industry line is that if you invest in good companies or mutual funds, keep a long-term perspective and ignore the dips along the way, everything will turn out fine. For a long time I tried to ignore that little voice in my head that said "something's not right." After all, stocks have outperformed all other asset categories over the last 100 years, the stock market always recovers from crashes, Warren Buffett is a buy-and-hold investor. Most of the conventional wisdom and rules-of-thumb have a sizable element of truth or they never would have become so widely popular and embraced, but something still doesn't seem right.

There is an ugly side of investing that creates that uncomfortable feeling. According to market data put together by Kenneth French at Dartmouth College, large cap stocks have experienced drops of 25% or more about 10 times over the last 85 years. That averages once every 8.5 years, although there are some long stretches where there were no steep drops and other stretches where they came in clusters. If you started investing shortly after a market drop (say, 2002) your investments performed significantly better than if you began your investment life shortly before a drop (2000 for example). The Nikkei-225 index (Japan) is currently down about 75% over the last 22 years, which has ruined the retirement plans of an entire generation. Of course, Japan's problem was an over-heated real estate market, multiple recessions, excessively high debt, and an aging population. That could never happen in the U.S. Finally, it is very difficult to invest like Warren Buffett. Goldman Sachs has never offered me perpetual preferred stock with a 10% yield. I also can't afford to buy a business, install the management, and hold them accountable for superior performance.

The truth is that investing in stocks is a gamble regardless of your timeframe. The best fundamental indicators can be rendered meaningless by hedge funds doing flash trades with super computers or a change in governmental policy that alters the rules of investing (see General Motors). Like any casino, someone has the "edge." In Las Vegas, the edge in every game belongs to the house, which means if you play long enough the house will eventually take your money. With respect to stock investing, you may not actually lose your money, but if you play long enough you will eventually experience a significant down market that will take back a chunk of your wealth. As an average investor, you do not have the edge. Hedge funds can have an edge by front-running stocks with flash trades. Politicians can have an edge by legally using inside information. Warren Buffett can have an edge by taking advantage of deals that are not available to normal people. The average investor is on the other side of these trades and is completely exposed to the whims of the market.

An Example: Covered Call Strategy

To demonstrate what the lack of an edge looks like, let's use a typical Covered Call option strategy, which is becoming very popular as investors look for sources of income and additional yield. A Covered Call strategy involves buying shares of stock and selling Call options to generate additional income. A typical position might look like this:

Buy 100 shares of Apple stock for $450/share

Sell a $475 Covered Call option contract for $9.20/share

In this example, the prediction markets Covered Call option will expire in 75 days. If Apple stock stays flat for the next 75 days, the investor will pocket $9.20/share for an annualized return of 9.9%. If Apple shares rise above $475 on the option expiration date, the investor keeps the $9.20/share and participates in another $25 of share price appreciation for an annualized return of 36.0%. If Apple shares fall, the sale of the option provides $9.20 of price protection, so the investor would not start losing money until Apple drops lower than $440.80. The argument for this strategy is that selling Calls provides additional income in a flat or rising market, and some amount of downside protection in a falling market. It's the best of both worlds. So why would a casino take the other side of this trade?