What is the difference between the stock market and the lottery? 

By Paul Scheurer © 2003

     Last October, with the Dow Jones, the Standard & Poor's 500, and the NASDAQ all hitting 5-year lows, I heard the joke, "What's the difference between the stock market and the lottery?" "At least you have a chance to win the lottery."

     A recent Powerball had an $86.5 million dollar jackpot -- that's present value, not installments over 20 years -- at odds of 1 in 121 million. In other words, for every dollar gambled, 71 cents was paid back to the bettors. Just divide the jackpot by the odds.

     Of course the lottery is a game of pure chance. For a mixture of chance and skill, there is the racetrack. Only 17 cents of every dollar is taken away, leaving 83 cents to be divided by the winners. Using a strategy described in Ian Fleming's "Diamonds Are Forever", it is possible to simply play the odds on horses. Bet on the favorite to place or show, and you could be a net winner without knowing anything except the odds. The reason why this strategy works is that the crowd's estimate of the probability of a race's outcome is accurate, as a number of statistical studies have shown.

     Unfortunately, the racetrack is a closed system of risk and return. Over time, the average bettor will lose money because the game is less than zero-sum: the track's 17% take-out makes it so.

     Is there a game which promises a return of more than 100 cents on the dollar? Yes, it's what I will call the corporate bond game. Just as the crowd at the racetrack contains information, so does the crowd in the bond market. And in both cases, the information is the odds.

     Knowing the odds is one key to making money with corporate bonds. The other is holding to maturity: bondholders have a contract that promises 100 cents on the dollar at a specified date, and can thus avoid the risk that higher interest rates will diminish a bond's value.

     But interest rate risk cannot be avoided in a bond mutual fund because the fund's manager can sell when bond prices are depressed, and it is the bond fund shareholders who suffer the losses. Furthermore, with annual fees averaging 1%, that's a loss of 14% of the income from a bond that pays 7%.

     Shortly the SEC is expected to approve an expansion of the NASD's TRACE reporting system from 500 to approximately 5000 corporate bonds. At NASDBondInfo.Com, anyone can set up a bond portfolio tracking system, free of charge. With 25 bonds in different industries, a bond holder has some diversification. And with maturities of three to five years, a bond holder limits inflation risk.

     Because financial markets are efficient, I believe that corporate bonds offer fair odds of getting the promised return on investment, and more importantly, the promised return of 100 cents for a dollar. To quote Mark Twain, who lost large sums in the stock market of his day, "Investors should have greater concern about the return OF capital than the return ON capital."