Investing vs. Gambling
Risk,
uncertainty and the unknowable are subjects that most investors ignore until
they lose money; even then they may simply write it off to bad luck. Most
investors think they “know” something about a potential investment when they
make the initial purchase; gamblers, on the other hand would rarely state they
“know” something, but they might tell you that they have a “hunch” or that the
cards or dice are “hot.” Similarities between investing and gambling are mostly
confined to how one manages the money or how one determines the bet size
relative to the investment capital or stake. Investors and gamblers start out
with an investable sum or a stack of chips.
The
difference between investing and gambling lies in the nature of the risks involved. Investable risks are risks that are inherent
in the ownership of an economic asset like a stock, bond, bushel of wheat, or
ounce of gold. Risks that are taken at
the casino do not exist independently of their creation but are created solely for
the purpose of betting.
Let’s
examine the risks inherent in owning an economic asset, like a bushel of wheat.
Whoever owns the bushel of wheat also owns the risks associated with it, e.g. price
risk and deterioration in its quality. These risks are not created for the
purpose of betting on the future price change.
Instead, these risks are intrinsic and can be transferred to someone
else, but the risks themselves cannot be eliminated by society as a whole. Many commentators on commodity futures
markets do not understand this principle of inherent risk or how modern futures
markets work to transfer this inherent risk of ownership. They frequently equate futures markets with
gambling, which it most definitely is not.
Investing
vs. Speculating
Free
markets and exchanges are mechanisms which allow the efficient transfer of
risks from those that do not wish to hold them to those that do (known as risk
transference). These individuals and/or organizations are variously called speculators
or investors. The difference is usually defined by the economic asset in
question and the expected duration of the holding period. Speculators may hold the risk for seconds,
hours, days or even weeks. Investors
typically would hold these positions for months or years. Speculators are frequently disparaged and
blamed by the press or politicians whenever prices are “high” or “low.” In fact, speculators are crucial participants
in the process of risk transference.
Speculators hold the risk during the time period between Investor A’s
decision to sell the economic asset and Investor B’s decision to purchase that
same asset. Without speculators markets
would lose liquidity and price differences between trades would be larger, with
greater bid-ask spreads.
From
the point of view of society as a whole, free markets and exchanges result in
the minimum amount of capital invested in the process of price risk
transference while, at the same time, this function is performed by those most
skilled in the process. Less skilled speculators and investors lose money and
either henceforth have a smaller economic influence or leave the business. Free-market
mechanisms minimize the capital invested in transferring risk and remove poor
decision makers. When no exchanges exist or the government socializes the risk,
those mechanisms are dismantled. When the government rescues failing financial institutions
they circumvent this invisible hand, leaving in place the bad decision makers.
Capital
Allocation
One
way of thinking about risk-taking is that you wish to ensure that you do not
lose all your money, or so much of it that you no longer have enough money to
invest or gamble again; this type of loss is called “permanent impairment of
capital.” Capital allocation requires careful consideration if we are to avoid
this catastrophe. Intuitively we know that making large investments, relative
to our total capital, in a small number of stocks is risky. We might suspect
that betting half our chips on the next throw of the dice or turn of the
roulette wheel is also risky, assuming we wish to play the game many times in
the future.
In
gambling, many games of chance are designed so that each event is independent
of the one preceding it and following it. These are true games of chance. But this is not always the case. It is the
author’s view that both blackjack and poker are games of skill because, among
other things, the past cards played from the deck(s) affect the probable future
outcomes and, therefore, the decision to take additional cards and the betting
strategy to be employed. It is possible
to win at casino blackjack but it requires memorization of past cards played
and a sophisticated betting strategy. The bettor must also have enough capital
to stay in the game for hundreds of hands, retaining a seat at the table until the
cards suggest a high probability of a win.
Professional poker demands even more skill than blackjack; it also
requires enormous physical stamina to endure hours of continuous play. In addition to keeping track of the cards,
the player must combine his knowledge of probability, his assessment of the
other players’ skill, and his betting strategy (to reduce the chances of
permanent impairment of capital). Thus,
while both blackjack and poker risks are created for the purpose of betting,
they are games that require skill to maximize return and minimize risk and are
different than most casino games of chance.
Investing
in economic assets is different from most gambling games in one important way: economic
assets frequently are correlated with each other over time. Another way of
thinking about this is that if two stocks are affected by the same third
variable there is additional risk compared to the case if they were
unrelated. To minimize the risk of your
investments being highly correlated with one another, invest in a diversified
portfolio of hundreds, or even thousands, of stocks. Investing in the entire world’s stock markets
through an index fund or funds accomplishes the same thing in a very cost
effective manner. This method of investing, assuming the investor has not
borrowed against his portfolio, is sometimes referred to as long passive equity
and short cash. While this approach minimizes the risks associated with
specific stocks or industries, it is frequently criticized as only producing
the “market return.”
Returns
are influenced, sometimes profoundly, by the date you enter the market. Investors
often time the initial and sometimes subsequent investments in hopes of improving
returns. Buying when assets are cheap is both very difficult and very rewarding.
In the long run, most professionals are unsuccessful at timing the market, as
are most individual investors.
The
extreme other side of index fund or passive investing is called “stock picking”
and might be described as “…put all your eggs in one basket, and watch the
basket.” This approach to investment
management results in a less diversified portfolio and requires considerable
skill and constant attention but does have the advantage of creating great
wealth if done successfully. Analysis of
historical investment performance, net of fees, taxes and transaction costs,
does not suggest that many investors are able to “…watch the basket” or perhaps
even to select the right eggs for the basket.
This last point is far more significant than generally realized. Consider that only one of the original 12
stocks in the Dow Jones Index (started May 26, 1896) remains; that company is
General Electric. Nevertheless, GE was “…removed in 1898 and added back in
1899, removed in 1901 and finally added back for good in 1907.”[1] Remember
Penn Central; or Polaroid and Kodak? Do
you recall Wang Computer and Digital Equipment?
A few years ago everyone in
business carried Blackberries and the common folk carried Nokia phones; both
companies lost enormous market share to Apple’s IPhone and to various phones
using the Google Android operating system.
Look at what one company, Amazon, did to the great bookstores of
America. Did you invest in Apple, Amazon or Google? If you study the returns to
investing you will find that a substantial portion of the return comes from a
short list of stocks. This is similar to our finding [2] that in an analysis of
the daily returns in the market, most of the return comes from a small number
of days and you had to be in the market for those days or your total return was
minimal.
The
evidence would seem to support two critical points: 1) own a lot of different stocks,
hundreds or even thousands, and 2) hold them through thick and thin. With the passive index approach to investing
you will own Google, Apple, Facebook and Twitter alongside Penn Central, Kodak,
Blackberry and Nokia. In other words, you
will own the winners, losers and everything in between. You will earn the
market return; it can be done in a very cost effective manner with index funds.
Alternatively, if you choose to put some or all your eggs in one basket, you
need to be extremely skilled, disciplined and attentive to successfully
outperform the overall stock market over a long period of time.
Conclusion
Risk,
uncertainty and the unknowable can be overcome to a certain extent. While
placing all your eggs in one basket or all your gambling money on one bet may
make you rich, it also courts complete disaster and total loss due to one
outlier of bad luck. Bad luck happens
just like good luck. The overriding goal
of investing is to try to avoid a permanent impairment of capital.
Therefore, the best way to
manage uncertainty is to avoid big bets relative to your total capital and to rebalance
or adjust your position periodically to maintain an asset allocation aligned
with your risk tolerance. Investing based on predictions about the future
direction of the financial markets may be tempting, but there is little
evidence that anyone can accurately and consistently call turns in the
financial markets or in the styles and asset classes that will be in favor or
lose value. This is, unfortunately, unknowable. Our advice? Stay with a
knowable, broadly diversified array of investments for the long term.
Endnotes
General Disclaimer
The
information and materials presented herein are provided to you for
informational purposes only and are not intended to be and should not be used
or considered as an offer, recommendation or a solicitation to sell or an
offer, recommendation or solicitation to buy or subscribe to any financial
instruments, investment management services or advisory services. An offer or solicitation may only be made by
means of an investment management agreement, prospectus, private placement memorandum
and other offering documents. This site
is not intended to provide investment, tax or legal advice.
Labels: Opinion