Saving money is low risk, and required in its various forms, for your near-term financial needs. However, you must also take some risks through investing for your long-term security. Investing, by its nature, means taking some risk. Unfortunately, that scares off some people who do not realize the risks of not investing or think it is gambling.
There is a broad spectrum from speculation to sound investing. With investing, the level of risk and expected return are tightly related. Gamblers should expect to lose in the long run. Learn the difference between investing vs gambling to invest wisely instead.
Have you ever invested or gambled in life?
We invest a little bit every day.
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 “dropping the cheese” was part of her plan.
We also make riskier long-term investments.
We risk our capital in many forms in the hopes of developing a rewarding career and living our best life. That is a significant risk for those vying for entry to a professional school or starting a business. They invest major time, effort, and money. Even though the odds are stacked against them. For medical students, even if they succeed at getting in, they usually grow a mountain of debt. In fact, the debt makes it leveraged investing, magnifying the risk.
Still, training is a sound investment when there is a high probability of it resulting in a long-term benefit. In the case of medical school, the debt is an investment in Future-You. Even large debts can be paid off with the right strategy in early practice and then you come out ahead over your lifespan.
For those who took on student loans or business loans to advance their career, did you consider that gambling? Probably not.
We must learn to differentiate between gambling and investing.
Unfortunately, many people are afraid of taking any risk and equate that to gambling. Even when there is a reasonable expectation of being rewarded. The line can be blurred between investing and gambling which is why it is often the source of debate. However, it is important to settle that debate. Most people must invest in some fashion or they inadvertently face the risks of not investing.
There are three main characteristics to help distinguish investing and gambling. First, the time frame is a clue. Second, the odds of winning vs losing, and the magnitude of that, factor in. Finally, whether the outcome is determined more by random chance or the investment also helps. The presence of all three makes pure gambling easy to spot. However, all investments carry some mix of these characteristics.
The Investing vs Gambling Time-Frame
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. It depends on how fast the game moves.
Sound investing usually requires a longer time horizon, measured in years or decades. Markets move fast, but investors (in contrast to gamblers) ignore that short-term noise to latch onto the long-term upwards trend instead. Of course, time-frame alone doesn’t define investing. There are some good short-term low-risk investments. Like my cheese expedition.
Chance, Odds, & Mitigating Factors
The odds of winning or losing at investing in the stock market compared to casino gambling is illustrated in the figure below comparing the S&P 500 to come common casino games.
Gambling is dominated by random chance & it is hard to mitigate risk.
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 the risks by walking slowly and carefully. In contrast to gambling, stock market investing risks can also be mitigated more readily than a game of chance.
In casino gambling, the game is tightly controlled and the odds and pay-out are deliberately set. Spoiler alert – they are not in your favor. 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.
Investing has a component of chance, but favorable odds.
Investing in broad markets 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 and certainly occurs in pockets. 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. If you keep your bets on the broader markets.
Of course, lightning could strike and irreparably destroy the modern world economy. However, I would not want to be wearing a tin-foil hat in that case anyway.
Seduction & Regret: The Loss & The Pay-Out
So if you are likely to lose, then why do people gamble? Answer: The potential payout. Gambling tends to have all-or-nothing outcomes. You lose the money that you bet or you get a big payout. Recall back to Psych 101 that random intermittent reward strongly reinforces a behavior. If it is a huge payout, 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 an “investment” that is.
Aim for average, don’t be seduced by a long tail.
With more solid investments, the probable outcomes are clustered around the average return of the aggregate marketplace. For example, the annual return of the SP500 has an almost normal distribution around a slightly positive median.
The more speculative an investment is, the less of a cluster of probable outcomes there is. Instead, the distribution of returns is spread out and extreme. You may hear that referred to as a “long tail”. The more speculative an investment is the more positively skewed the expected returns are (it sounds good but it is bad). A positively skewed distribution has a high probability of a loss, but rare and huge positive results too. A lottery is an extreme example of this, but it is not so bad if the lost money supports cute waggly tails.
Individual stocks have a positively skewed distribution of returns and the more speculative they are, the longer the positive tail. We are wired to chase that tail and it is why stock picking still attracts so many people even though logic and historical performance suggest an indexing approach is much more likely to have a better outcome based on the odds.
The Speculation Spectrum
All investments fall somewhere on the speculation spectrum.
For financial investments, we can look at several features to help us place them on the spectrum. A company’s current income and assets are already known and that has been priced in. However, investments are also priced based on their expected return in the future. The further that is into the future and the less certain it is, the more that future income is discounted. This causes the value of an investment to fluctuate as the actual future unfolds relative to those predictions.
Predicting the future is always speculative and the more price volatility an asset has alludes to a higher degree of speculation. There is also 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) as the future becomes the present.
Real Marketable Goods & Services vs Ideas & Theses
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 in 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.
You could have been correct in your thesis that the internet would grow into a huge money-maker, but still lose because you picked the wrong companies. A few companies ultimately matured with huge payouts, like Amazon and Google. However, thousands went to zero. Unfortunately, you don’t know who they are in advance. Rare but huge pay-outs. High odds of losing it all. Gambling. Sadly, investing using thematic ETFs is also like lighting your money on fire. Companies make them around the time of peak pricing in response to recent fads.
Investing is less exciting than gambling.
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). Those are the same emotions that get piqued in us along the way.
Watching your portfolio slowly grow should be gratifying. Not exciting.
The large price fluctuations (volatility) characteristic of more speculative investments play to your 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 and smash your portfolio. It can also be disruptive to your personal life. If your family can tell whether the markets are up or down on the day by your mood, then that is a problem.
Deliberately Gambling With Stocks For Fun
Not everyone goes to a casino expecting to make money. They do it for fun. Few people that are truly investing find it “fun” (except for reading The Loonie Doctor blog part). Recently, the Robinhood app tried to gamify investing into something more fun.
Some people will designate a small amount of their portfolio as “play money”. They can afford to lose 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. If you do have a need to feed, then It is important to know yourself, create guardrails, and openly consult your spouse.
Pause & Reconsider If There Are Warning Flags
Normal vs abnormal fear and excitement
If an investment makes you really excited or scared, pause and consider why. If it is because it promises a high payout due to an exciting narrative, then that is a warning sign that you may be gambling. In contrast, if the excitement and fear come from investing for the first time, even after you spent the time learning to do so in a rational way – that is normal. I have built a DIY Investor’s Hub to pool education and resources to help you with that.
Facts vs fairy tales
If an investment doesn’t have real assets, products, or services – that is a yellow flag. You could be speculating or outright gambling depending on how probable and near-term progress to that stage is. Training or spending to build your practice to fill a need with a strong business plan may be investing. Venture capital in an interesting idea with a murky path forward and is much closer to the gambling end of the spectrum.
It sounds like a risk/reward-free lunch
If someone tries to sell you an investment product where the promoted pay-out seems greater than where it sits on the speculation spectrum. That is a red flag. They may be deliberately or unintentionally misleading you. Or you may be simply missing some important risks. Commonly underappreciated risks include creditor risk, leverage usage, liquidity risk, and embedded manager performance/fee structures.
Investing versus gambling is a good question. My investment history is littered with “investments’ that would be better described as exercises in gambling. I’m in no way opposed to gambling, but knowing the difference between the two is critical for investment success.
If what you’re investing in doesn’t have cash flows, you may be gambling, rather than investing. Without cash flows, it will likely be valued by supply and demand. And if you’re hoping to make money on it, that assumes someone else buys it at a higher price than you. A pejorative way of looking at this is the greater fool theory. An example would be bitcoin.
If you’re investing outside the limits of your knowledge, you are gambling, rather than investing. Possibly the most common example of this is investing with the purpose of seeking alpha. Such a goal means you’re likely engaging in market timing or security selection. You can make a case that there are individuals successful in seeking alpha, with Warren Buffett being an example. But for many, it’s more an exercise in overconfidence and recency.
Thanks, Park. Great insights! My history is similarly littered. Even knowing more now, it is still tempting at times due to human nature. Attractive narratives and long payout tails are alluring hooks. My main flag now is that if it seems too good to be true or really exciting. Then, I need to pause and look deeper to uncover the hidden risks and biases you mention. Or just revisit this post and know that they are there. They always are.
Can you ” flesh out” that S&P 1950-2017 chart in terms of win/loose percentages for shorter time frames-1 year, 3 years, 5 years, 10 years etc.
I think the periods that I can recall are
1930s-bad-depression etc( maybe a completely different time, so relevant today ?? becuse we have the Fed ??-dont know)
1970s-inflation, energy shock etc
2000s- 3 bear marets in 10 years..
More recently GFC and COVID althogh the 2010s were up , up and away.
It would give relative meaning to the concept ” invest for the long term”….. The part I am trying to grapple with is, it takes just one bad year for bonds, and all of a sudden the returns from VBAL vs VGRO and VEQT are all very similar . Thanks
In terms of rolling periods of return, this person did a nice job of it here. The probability (historically) of a positive result was 100% for 20-yr rolling periods, 96% for 7-yr, and 90% for 5-yr. It then drops more rapidly to the 70-80% range for 1-2 year rolling periods. Surprisingly not bad. Looking at actual time periods, there was a brief period around the Great Depression of the 1930s and the Financial Crisis of 2007/8 that had negative 10-yr rolling returns.
I am not too worried about the recent period of +ve correlation of bonds/stocks. They are actually relatively common and brief (a few years). However, they are scary when they happen. The eventual bounce back should put things back to usual at some point (in my opinion).
Thanks for the great link