It is conventional wisdom to assess your risk tolerance and invest accordingly. However, I have also heard a number of criticisms of this approach. Much can be learned from examining both sides of an argument. There are often some nuggets of truth.
In the next two posts, I will examine one of those arguments that people use to stop the discussion cold before it even starts…
Why bother taking any risk investing?
I’ll paraphrase two of the statements that I’ve heard trotted out to enforce this sentiment:
- Investing is all a bunch of Ponzi schemes and gambling.
- You don’t need to risk money investing. Just spend less and save more over a long period of time. You can safely put it in the bank where it is insured. Or in your mattress where you can be reassured by the lumps when you roll over in the night.
This week, let’s examine statement number one. We’ll tackle number two next week.
Investing vs Gambling
Have you ever invested or gambled in life?
Investing, at its core, is taking a risk with the reasonable expectation of being rewarded. We take risks and invest all of the time just to live.
I just invested my time and effort in walking over to the fridge to get a slice of cheese. On the way back to my desk, I risked tripping over the excited dog dancing around my legs. That could have resulted in injury and/or dropping all of my cheese. I actually believe that the “dropping the cheese” part was her intention.
We also risk our time and effort (human capital) in the hopes of developing a rewarding career. That is a significant risk for those vying for a spot in medical school where the odds are stacked against them. Once in medical school, we also risk significant financial capital. We anticipate that we will make more money to pay it back later plus benefit from that higher income for the rest of our working lives. For those with student loans, that is actually investing with leverage! Did you consider that gambling?
With money, what differentiates investing from gambling?
The line can be blurred between investing and gambling which is why it is often the source of debate. Some of the items that we can look at to differentiate gambling from investing are:
- “The Odds” and “The Pay-Out”
- Random chance versus underlying value
Gambling usually has a “short-term” time-frame. That could be seconds for a slot machine, hours for day trading, weeks or months for a speculative stock trade, or a couple of years for a speculative real estate purchase.
Investing usually has a longer time horizon measured in years or decades. Of course, time-frame alone doesn’t define investing. There are some good short-term investments. Like my cheese expedition.
Chance and “The Odds”.
The odds of winning or losing at investing in the stock market compared to casino gambling is illustrated in the figure above.
Like investing over decades in the stock market, my cheese trip was very likely to end well. I get to eat my cheese and my dog gets a little despite the failure of her sabotage plan. The odds were greatly stacked in favor of a good outcome. I could also tangibly mitigate risk by walking slowly and carefully. Stock market investing risks can also be mitigated more in contrast to gambling.
Gambling is usually about chance. It’s hard to mitigate against random chance.
In casino gambling, the game is tightly controlled. The odds and pay-out are mathematically calculated. Spoiler alert – they are against you. Even if you take all of the precautions to play perfectly, the odds for popular casino games favor the house by 0.5% to 25%. While the outcome of each individual round is uncertain, the result of an expanding number of rounds will eventually be a loss. My old high school math teacher used to call gambling a tax on the mathematically-challenged.
Investing in stocks and bonds is a bet that the economy and humankind will generally advance over time.
While that is not guaranteed, the odds strongly favor it. In contrast to a casino, with financial markets, the chances of a favorable outcome increase the more time that is consistently spent there.
Market manipulation is possible. However, it is much more difficult to control financial markets on a broad scale in a complex intertwined world of freely-flowing information than a casino game. The tin-foil-hat-wearing-folk may dispute that. However, we have many years of data showing that it has worked out well so far. Of course, lightning could strike and irreparably destroy the modern world economy. However, I would not want to be wearing a metal hat in that case anyway.
So if you are likely to lose, why do people gamble? Answer: The potential pay-out.
Gambling tends to have all or nothing outcomes. You lose the money that you bet or you get a big pay-out. Recall back to Psych 101 that random intermittent reward strongly reinforces a behavior. If it is a huge pay-out, then even more so.
Good investing is not all or nothing. Your investments will go up and down in value. However, they should be highly unlikely to go to zero or shoot to the moon. The greater the chance of that, the more speculative of an “investment” that is.
All investments fall somewhere along the speculation spectrum.
Less speculative investments tend to fluctuate to less extreme values because they represent something with assets and productivity.
A company that makes a product or provides a service would be an example of this. A rental property bought at the right price with good cash flow in a stable area would be another example. Similarly, government bonds are backed by the government’s assets and powers of taxation.
A company that has an idea (however revolutionary), but has not really made tangible progress to delivering a product or service would be much more speculative.
Here’s lookin’ at you dot.com bubble. It was fueled by the potential of the internet. Yes, there were a few companies that ultimately matured with huge payouts, like Amazon and Google. Thousands went to zero. Rare but huge pay-outs. High odds of losing it all. Gambling.
Whether an investment is highly speculative or a safer investment can change over time.
At the time of the dot.com bubble, investing in many of the companies with “potential”, but no actual product/service was speculating. Now that the survivors have been selected out and provide services, it is investing. There is a constant sliding along the spectrum based on the potential for growth of a company (more speculative) and the value that it already provides (less speculative).
Highly speculative “investing” has a high risk of winning or losing big. It is where there can be an overlap between good investing and gambling. Don’t turn your investing into gambling.
How can we recognize that we are gambling with an “investment”?
With a highly speculative investment, you are betting that someone in the future will want what you have. Moreover, they will want it badly enough to pay more for it than you did. That relies on the emotions that it generates (mostly “fear of missing out” or greed).
Big price fluctuations (volatility) play to our investor emotions. If you find yourself being emotionally affected by your investments, then you have exceeded your risk tolerance. You may also be gambling. Gambling is exciting, but it is also like poking your emotional investor beast in the eye. If Investor Hulk takes over, you’ll make costly behavioral mistakes.
My fellow blogger at Investing Wisely knows about both gambling and investing. He describes the insidious rise of the beast beautifully during his bitcoin experiment. Watching your portfolio slowly grow over time should be gratifying. However, it should not be exciting or scary. It should be boring.
Deliberately Gambling With Stocks For Fun
I also personally don’t think that investing should be “fun” (except for the reading the Loonie Doctor blog part). Some people will designate a small amount of their portfolio as “play money”. They don’t mind losing it all and they invest in things for fun. The thrill of the hunt. It is similar to going to a casino to enjoy the games and the process without worrying if you win or lose.
That is ok if that is how you look at it. Just consider whether it gives you good value in “pleasure units” for the money spent. It could be a potentially expensive way to play when you think of the time/money spent. Personally, I would rather spend my “play money” wisely for maximum long-term impact.
Pause To Reconsider If There Are Warning Flags.
If an investment promises huge short-term pay-outs or makes you really excited or scared – that is a red flag that you may be gambling. The excitement and fear of investing for the first time could be a notable exception to that – that is normal. If an investment doesn’t have real assets, products, or services – that is a yellow flag. You could be speculating or outright gambling. If someone tries to sell you an investment where the promoted pay-out seems greater than where it sits on the speculation spectrum. That is a red flag that they may be deliberately or unintentionally misleading you.
Are you planning to invest or gamble?
Investing and gambling both have the potential for risk and reward. Good investing has better odds and less extreme wins or losses. Investments reflect some underlying value rather than simply random chance. The timeframe for investing is usually longer. Gambling evokes strong emotions and investing should not.
Just like with building a rewarding career, you cannot reap rewards without taking some risks. All investments fall somewhere along the speculation spectrum. Try to invest and not gamble. Learn how to avoid morphing investing into gambling in a future post.
Excellent post LD.
The key is investing should be boring. It is a set it and forget it kind of deal and works best if you can automate it and remove human interaction/emotion from the equation completely.
I have a good, and very smart friend, who despite my insistence of investing in index funds, wants to invest in specific holdings and tries to jump in and out of the market (ie. Time the market) even with his retirement accounts. I asked why and he said the other way is too boring for him. I hope he does well but chances are he is wasting time and money doing this and could have been better served with boring.
I like real estate for the reason you mention, it is less volatile and allows you to stomach the volatility of the market better when your portfolio doesn’t swing as wildly. Plus it is a good source of income that is inflation indexed.
I agree. Although, I will say that some people find their entertainment with trading. An expensive hobby I think. But to each their own as long as they recognize it for what it is. Reflecting on it, I did it in the past when starting out. The problem was that I didn’t fully realize it all of the time.
Real estate is an interesting one. I started writing about it in this post, but the complexities made the post way too long. The time frame is longer, but the price swings are still there. The costs of maintaining the investment and barriers to entry/exit are also higher. Leverage is commonly used. Some properties are cash flow positive. However, others are not. Some people buy property here assuming it will rise over a few years enough to turn a profit from the capital gain. You can even buy futures contracts by purchasing a condo at pre-build with the intention of selling it before closing. Put together, real estate can be a fantastic investment or highly speculative. It slides along the spectrum just like a financial product. It is also steeped in cultural and emotional pressure which heightens the danger for the unwary. The key I think is that if you are looking at real estate as an investment (even your house), then you must consider it as a business right from the first moment. Many people don’t take that care or have the experience to do it well.
Remember, if you are investing in the stock market, there is no reason to look at it’s daily value. If you are looking at the value frequently you are trying to, or planning to, time the market. Timing the market is gambling. Stop looking at your fund values, especially when you see the market drop.
Dr. Cory S. Fawcett
Prescription for Financial Success
Hi Dr. Fawcett. Thanks for your comment. It is sage advice that I wish I had listened to early on in my investing experience.
Investing is risky. Unless someone can guarantee it, it will have inherent risks.
I have also come to believe that when one is younger, barely anything is risky. Especially with a high income, most mistakes can be replaced quickly.
There is a reason that seniors will spend about 1% of their nest egg. They understand intuitively that even a large nest egg can be depleted. The math has born that out with SORR. Each time I read a study, the safe withdrawal rate keeps getting lower and lower and lower…
Risk comes in so many ways LD.
Hey Dr. MB! Risk is everywhere. Most risks (financial or otherwise) are more forgiving when younger. Your financial bones are still more bendy than crunchy 🙂 We are very fortunate with our high incomes in the financial robustness that gives us. Of course, we did take risks to get there.
Great post LD!
I love the analogies.
Risk is everywhere in life and that includes doing nothing.
To Dr MB’s point, avoiding investing is even riskier than doing nothing!
Inflation is gonna keep coming after your saving dollars whether you like it or not!
Thanks FFMD! That is where I plan on going next week regarding saving, investing, and inflation. High-income earners are fortunate to have options – of course, the optimal option is individual.
Example : 2 million nest egg : odds of lasting 30 years – drawing down 100k (5% per year)
100 % bonds – 28%
20% equity – 57%
40% equity – 73%
50% equity – 76%
60% equity – 77%
80% equity – 78%
100% equity – 77%
If you play with this calculator it shows that being too conservative will lower the odds of your money lasting.
Results for 50/50 – 80/20 are quite good and show that taking on more risk may not be worth it especially if you like to sleep at night.
Agree. Extreme approaches at either end of the spectrum come with their own problems.
I love the bendy/crunchy analysis.
Early investing and financial mistakes are greenstick fractures – no surgery, just ketamine the kid, bend it back into alignment, splint, and give ’em a popsicle before they leave the ED so they go with a positive association.
Look forward to your upcoming lesson on inflation risk,
It seems that when the market has a few bad days, all the fear-based conversation appears again talking about how much they’ve “lost” in the market and how investing is risky. A little financial education is helpful here and the REAL risk is not investing at all. I’m bracing myself for conversations over the holidays with the uninformed. 😉
Thanks for stopping by and the comment Jon! Totally agree. Ready the spiked eggnog.
Great post! love the concept of the speculation spectrum.