Play Averages to Succeed at Investing? Deal!

NEW BERLIN, Ill. ( MainStreet) -- You know the TV game show Deal or No Deal, right? Contestants face 26 shiny metal briefcases, each with a dollar amount inside ranging from one penny up to $1 million. At the beginning of the show, the contestant chooses one of the cases as a prize.

The amount in the case stays secret until the end of the show. Then the contestant begins eliminating the remaining 25 cases. As the cases are chosen, the amount in each is revealed. At the end of each round of "reveals," a character called "the banker" offers the contestant money to drop out of the game.
A winning strategy for the TV game show Deal or No Deal can also win in your retirement investing.

The amount the banker offers is statistically relative to the amounts that have yet to be revealed -- if more high-dollar amounts remain (which means a high-dollar amount could be in the contestant's prize case), a relatively higher amount is offered. If the amount offered is attractive enough, the contestant can choose to take that amount and quit the game. If not, the contestant will have to choose another case and reveal the amount.

As the match progresses, often we see the contestant choosing cases that reveal high dollar amounts in them, which prompts the banker's offer to reduce. Even when faced with seemingly impossible odds, when this situation occurs, the contestant often becomes a risk-taker -- more so than you would normally expect.

This is because contestants feel as if they have already lost something (the earlier offer from the banker) and somehow must "make it up" by continuing the game in spite of the odds dictating less and less that they'll be able to. Statistics will rule, and on average the contestant walks away with a much smaller prize than expected.

So what does this have to do with investing?
Quite often we see the same sort of behavior in the stock market: always trying to do better than the average, folks will use all kinds of methods (including paying extra to get the top dog stock picker's advice) because they're sure they can beat the market. If a chosen stock shoots up in value the investor hangs on, "knowing" that if it went up 10% it is bound to go up another 10%. And what happens when the stock goes on up to 20%? Yep, they hang in there again.

Then suddenly the stock pulls back, and now is down 5% from the original investment -- what happens now? This is just like when the banker on the show reduces his offer: Investors feel like they've lost something already in hand, so they begin to take more risks, perhaps buying more of the stock -- again, "knowing" they'll "make it up." But it rarely works out.

The problem is that the investor didn't go into the investment with a plan -- and the same would hold true for a contestant on the game show. If you decided you were shooting for a 10% return from this particular stock, you'd have sold out at that level and could have gone looking for the next great option. Without a plan, you never know when to get out of the position.

A plan!
If contestants were to go into the show with a plan to do better than average: The first time the banker offered more than $131,477.50 (the average of all the amounts in suitcases), they would take it. It's an excellent strategy, especially when you consider that 20 of the 26 cases have less than the average amount inside.

As an investor, the odds are much better for you using history as a guide. The investor could choose to take a shortcut and get a return that is the average of the stock market. Since in the past four or five decades the stock market has returned a negative roughly 20% of the time, using the average would assure you of a positive return 80% of the time. That's much better than the results of the average Joe or Jane who plays the active stock-picking game.

To get the average of the overall marketplace, the investor can choose to invest in broadly diversified indexes. This is very cost-effective -- and you don't have to worry about when to get in or get out, or even shout "no deal." Go for it. And if you want a Deal or No Deal-style fist-bump, fine, come by my office. But I won't be afraid to actually shake your hand.

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.