Why investors can go gambling

If you're investing correctly, you shouldn't be having any fun. Since excitement is the investor's enemy, doing it right means it should be dull and boring. And as the dare-to-be-dull guy, I'm totally on board with that philosophy.

Yet beneath my dull exterior, beats the heart of a gambler. Even yours truly gets the occasional urge to buy that risky stock in search of a 1,000 percent return, and sometimes I just can't resist acting on that thrill-seeking urge.

So, I tell my clients it's OK to have a little fun and carve out a piece of their portfolio to exercise the part of their brain that wants to cut loose a bit. Typically, it's no more than 5 percent of one's total portfolio. I call it a "gambling portfolio" because that's exactly what it is.

Everybody should have their own system to outsmart the market -- it's good for the soul. Mine is buying stocks that have fallen from grace that I think have about a 50-50 chance of going bankrupt. But before I go on, let me digress for a moment. As it happens, great companies usually make lousy investments, and bad companies make good investments, because of a phenomenon known as "reversion to the mean."

The great companies Wall Street touts end up not being as great as they were touted, and the stock price doesn't keep up. Conversely, companies Wall Street shuns often end up not as bad as expected, and the stock price rises when the low expectations are exceeded.

So, if bad companies make good investments, then my hypothesis is that some awful companies near bankruptcy will make unbelievably great investments. Not a commonly held hypothesis, I'll admit.

I understand that roughly a third to a half of my companies will go belly up and become worthless, such as Kodak. It's my hope, however, that one of every 10 might be a home run like Priceline (PCLN) or Ford (F), while the rest will just have market returns. 

Here are seven rules I abide by for my personal gambling portfolio.

1. Gambling is gambling. Whether it's investing or Black Jack, I bet only what I can afford to lose.

2. 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 Wall Street.

3. Buy-signals that catch my gambler eye include:

·  Large price declines.

·  Stocks priced below $5, which forces many institutional investors to dump.

·  Media reports of money managers being fired for holding a particular stock.

·  Accounting scandals.

·  Insider trading allegations.

·  TV gurus saying the company is dead.

4. Make lemonade out of those stock lemons that went belly-up by harvesting the tax losses.

5. Keep perspective on my wins and losses, and the territory they go with. My own version of "What happens in Vegas, stays in Vegas" (or ought to).

6. Never confuse luck with brilliance.

7. Always remember rule No. 1.

As an example, in November 2012, James Cramer came out with two stocks to sell immediately, after sharp declines, of course. Those two stocks, HP (HPQ) and Best Buy (BBY) made me 22 percent in 22 days, in addition to giving me a fun column to write. 

My gambling portfolio must at least have an expected positive return. That means never trading options and avoiding triple levered anything.

Logic for a gambling portfolio

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 is the boring, low-cost, diversified, tax-efficient portfolio 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. It's just plain fun, and I've got to tell you that quick killing feels great. In fact, researchers using MRI technology report that it activates the same part of the brain as that of a drug addict being told he's about to get his next fix.

So, my gambling portfolio satisfies my emotional brain enough to keep me from messing up the logical, low-cost, boring portfolio that my family counts on to make sure we don't outlive our money.

If there's an inner gambler in you, my advice would be to go for it, with the caveat that one should go for it with rules that won't have you jeopardizing much of your nest egg. I caution clients that their biggest risk isn't losing their gambling portfolio, but rather that they do well. Because it takes just a little success to get us to thinking we're the next Warren Buffett, and then shoot for excitement with the entire portfolio.