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 pleasure and 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.
Don’t turn your investment into a gamble.
There are ways that we can take what should be good investments and make them into speculative ones:
- Inappropriate time-frame
- Bad behavior from exceeding our risk tolerance
- Bad habits that lower our risk tolerance
Let’s examine how this could happen.
Having a shorter “investment” time-frame than appropriate for the investment.
Holding stocks is a bet that the economy will grow and historically that has been a pretty safe get. However, that is an investment over a long time period. The stock markets fluctuate on a day to day basis. If you buy and sell stock with a short-term horizon, then that is called trading.
With trading, you are betting that you know which way the market will move in the short-term and try to “time the market” to buy low and sell high. To succeed at that, you need to predict the future. Not once, but twice. Once when you buy and again when you sell.
Longer-term “buy and hold” has historically performed well. No short-term trading strategy that I know of has been shown to be successful long-term. There are some people who can beat the market by trading. You and I are probably not amongst them.
A too-short timeframe makes a good long-term investment into a speculative one.
If you buy equities while you still have student debts, then you are investing with leverage by not paying those loans off instead. If you add in another loan from your brokerage to invest, that is called investing with margin. Some even use their lines of credit to plump their portfolio further. Leverage, leverage, and more leverage!!!
With both lines of credit and margin accounts, there is a risk that the lender will call in the loan. That usually happens because they are afraid that you may not pay it back. Commonly, that coincides with a market low. The worst possible time to sell.
Leverage becomes progressively riskier when there is the risk that you cannot pay it on time or if the loan is called. This risk is heightened if you have tight cash flow and limited immediate earning potential. Umm… medical school and residency. That will improve when you finish and land that bigshot attending job. However, you have no idea what will happen between now and then. It may be a bigger gamble than you think.
Even when used judiciously, leverage magnifies wins and losses. If you are using leverage in the hope of big payouts with the risk of losing big possible – does that sound familiar?
Using too much leverage risks having a short and uncontrolled investment timeframe. That good long-term investment becomes a gamble. Leverage also heightens emotions.
Making your investments more emotion-provoking through bad behavior.
As already mentioned, provocation of emotions can be a sign of too much risk – or even gambling. Further, emotion can prompt you to turn a good investment into gambling.
If you stoke your emotions, the short-term comes to the forefront and the long-term picture is pushed to the background. Your primitive brain wants more of the good feelings generated when something is up in value. It even more strongly wants to get rid of the pain caused by seeing your money-pile shrinking.
That emotional pressure could cause you to deviate from the plan. It makes you want to speculatively trade (a too-short time horizon) rather than invest for a more appropriate longer timeframe. Don’t underestimate the power of your primitive brain – it has helped humankind survive for millions of years.
Minimize emotional stimulation by not watching the value of your longer-term investments on a short-term frequency.
This is a behavioral advantage for real estate. Your house price isn’t updated daily and plastered on your front lawn. You also can’t buy or sell it for under $10 by clicking a button on your smartphone.
For better or worse, you can do that with equities and bonds. Avoiding daily financial news media or checking your investment portfolio too often helps.
You might get away with insulting your Bruce Banner Investor a few times a year, but mocking him with daily volatility is a bad idea. Combining leverage with this is like giving him a nuggie. You wouldn’t like him when he’s angry.
What should be a long-term investment can take on a too-short timeframe if you provoke the beast. Investing becomes short-term trading. Gambling.
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. Be careful to not let investments slide towards the gambling end of the spectrum due to the wrong investment horizon, overleveraging, or bad investor behavior. Be an investor and not a short-term trader.