“Don’t gamble away all your money!” my mother often warns me, when the subject of the stock markets is broached.
To be fair to her, it’s good advice – you shouldn’t throw away all your money on gambling after working so hard, or at the very least, after trading your time for money in the form of good ol’ wage slavery.
But is it also fair to say that investing in the stock markets is the same thing as gambling – after all, there is risk involved, and you could end up losing everything that you put into it?
In the traditional sense at least, the answer is an emphatic “no” – the two are not completely equivocal – even though, as mum is quick to point out, you could lose your shirt when you take your chances in either of these worlds.
But then, if they aren’t the same, how exactly do they differ, can either, or both, be profitable in the long run, and is there any reason to favour one over the other?
Let’s delve a bit deeper to find out…
Without getting overly technical, gambling is what is known as a negative sum game, at least as far as most casino games and gambling events are concerned. A simple way of putting this is that if you bet equal odds on all possible outcomes (e.g. you bet on both heads AND tails for the same coin flip), you would inevitably win with one of your two bets, although in a casino or bookies your winnings would be less than what you staked in total. That small difference between what you placed on those two bets (to cover all possibilities), and what you win is the houses edge, and it’s why casinos and bookies will always make a profit in the long run, so long as people keep on gambling.
Generally speaking though, most people who gamble don’t tend to deliberately lose money by backing all possible outcomes – instead they back the outcome that they think is most likely to occur, and then if they win that bet, they get back their original stake plus some additional winnings, dependent on the odds they received when taking the bet. But if they lose that bet, they lose their entire stake.
Returns in gambling are therefore seen as following a binomial distribution (where the “bi”, like in binary, relates to the two possible outcomes – you either win or you lose).
Investing on the other hand, depending on how it’s done, can be seen as a zero sum or even as a positive sum game. Each exchange of shares or contracts involves a buyer and a seller at the same price (let’s not consider commissions paid to the broker at this time).
Taking a simple example again, if you were a buy and hold investor, then you would buy some shares of a company, and wait a potentially long period of time for the worth of those shares to (hopefully) increase. In general, if the returns themselves (whether positive or negative) are random, then this favours the upside over the long term. But why, you may ask?
Well, imagine that you invest $100 in the stock market, and that in the first and second months you make 10% returns each month…
After the first month, your $100 has grown to a whopping $110 (100 + 100/10), but after the second month has passed, when you make another 10% return, it has grown to be worth $121 (110 + 110/10) – because unlike in the first month, you didn’t just make 10% on your initial investment, you also made 10% on the 10% that you made in the first month!
In total then, you made $21 from your $100 investment in a two month period.
But what if the returns were the complete opposite? What if you lost 10% two months in a row?
Well then, maybe trading just isn’t for you – kidding…?
After the first month of losing 10% on your $100, you are down to $90 (100 – 100/10).
But after the second month of losing 10%, you are only down to $81 (90 – 90/10) – meaning that in total you lost $19 from your initial investment.
Even though the only thing that we changed was whether or not we made or lost money, and not the percentage value that we made or lost, in the example where we made money, we ended up making $2 more than the amount that we lost in the losing example – $21 vs $19.
This is the reason that compounding is such a powerful tool in the stock markets, and why gambling is not the same, neither mathematically nor conceptually as investing.
Therefore, due to the wonders of compounding, it is said that returns in the stock markets follow a logarithmic distribution.
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Albert Einstein
Obviously, you also want to invest in shares of a company that has great long term prospects – but for today, let’s not get into how you could go about evaluating that.
For now, all that we should take away from all this is that gambling and investing in the stock markets are fundamentally different, even though both require putting your money on the line to try and make some more money.
Both require some kind of an “edge” in order to at least mathematically guarantee some kind of profit over time, and while your level of success depends on this edge, due to the effect of compounding, it should (at least in theory) be much easier to find such an edge in the stock markets, rather than in the bookies or casinos.
So, whether or not she knew it, mum was right all along – gambling should be avoided, because mathematically, it’s much more likely that you’ll make money in the stock markets.
But still, I do like to enjoy the odd bet on a football match, or game of Poker – purely for the enjoyment of it all.
And yes, I understand that my chances of winning aren’t so great – especially when it comes to Poker night!
I may be terrible at knowing when to hold, fold or run away – but it doesn’t matter so much.
I’ll leave winning at cards to the seasoned gamblers and lucky people.
In the stock markets, I don’t need to gamble or rely on luck – not with statistics on my side.
