Gambling vs investing

 

Sep 5, 2016
Financial Safety

Is the picture above gambling or investing? How can we spot whether something is a gamble or an investment? Is blackjack a gamble or investment? What about stocks? A business? If you ask different people in different situations, they will tell you a different answer for each of those examples. Gambling and investing has a lot in common but one small difference but important difference makes it wildly different. 

Both gambling and investing involve risk. Whether you put your money on a blackjack table or into an index fund, there is always the risk of walking away with less money than when you started.When you go to a casino to play blackjack, the odds are against you. Just being forced to act, having to decide whether to get dealt another card or not, before the dealer increases your risk of busting and you losing. Most people would consider money you put in at a casino gambling because the odds are greater that you would lose money than you would win money. Stocks and even index funds have risk as well. On any given day, a stock or index can go up or down. Index funds consists of hundreds or thousands of stocks, and attempt to reduce the risk of losing all of your money all at once. The argument is that historically index funds have always increased over time, however even the best investors will tell you that past trends are not indicators of future performance. Historically, stocks spend more time in a bear or slow market than a bull or rising market. That means if you own an index fund, you would need to know if your stocks are in bear or bull mode. Eventually you will have to sell that index fund to make money, which means you will have to time the market, trying to figure out if your stocks are ready to sell or being sold prematurely. Timing the market is a big taboo for people who do buy index funds. So now you have a bunch of stock, that you believe we will increase over time, but not know how long to hold it for or when to sell. Also  most people have no idea the make up of an index fund. If your index fund is full of junk stocks, then you will simply have hundreds of well diversified junk stock. You only have to look at the stock market crashes of 2009 and 1987 to see recent examples of the magnitude of risk involved when you put money in the stock market. There is an inherent risk in either blackjack or stocks.

Gambling and investing also involve reward. People play blackjack at a casino because they want to win money. If they just wanted to have fun, they can easily pick up a deck of cards for $1 and do the same thing at home; it sure would be much less expensive. Each time the player decides whether to hit or stay, they are hoping that they will win money. Each time a stock trader or investor buys or sells, they are hoping that they had bought and sold the stock at a good price. In either situation, there is no guarantee that the gambler or the investor will come out ahead, but they are certainly hoping that they do. That reward is what they are playing for, and they take on the risk of losing their initial investment in order to achieve that potential gain.

The biggest determinant that separates a gamble from an investment is knowledge. Knowledge of the product and risks and rewards involved.Warren Buffett, one of the richest men in the world, often advises the average investor to put their money into low cost index funds. However, Warren Buffett does not put his money into index funds. Is he being hypocritical? No. That's because the average investor does not have the knowledge and resources that he has. Warren Buffett spends much more time and energy analyzing companies to figure out which has the best return on investment. The average person would have no idea, and therefore would take on a much larger risk betting on individual companies than a large swath of companies that represent the overall economy (such as the S&P 500). In the case of blackjack, if you are playing blackjack, chances you are gambling. If you are new to the game, then you may not be fully aware of the rules or strategies that you can utilize. However if you are the casino, then you invest in blackjack.  You know that on average the gambler will lose 5% of whatever they play with. In the picture above, it did not matter whether the player wins or loses that one hand, the casino knows that if enough players keep playing, the casino will make money. 

Knowledge can mitigate and change your risk therefore altering your risk to reward ratio. In blackjack a player can learn to odds given what they have in their hands versus what the dealer is showing. They know for example that the dealer has to abide by certain rules such as staying on a 17. If the odds are that the dealer has 17, and the player has 18, then he is more likely going to stay. He is able to use that knowledge to his advantage to reduce his risk of busting and losing. The advanced players can even make use of surrender bets where they would give up their bet for half of what they bet initially and even keep track of the number of each card that has been dealt to mitigate their potential loses. They are able to utilize these advantages such that when they play for the long term, they will win overall even if they end up losing any given hand. These advanced players have changed the game of blackjack from gambling to investing. In the stock market, Warren Buffett is able to analyze the companies he wants to invest in. He does not rely on someone else to create a batch of stocks, instead he has the knowledge necessary to pick individual stocks and companies. So even when Warren Buffett buys individual stocks, he is investing and not gambling.

In any situation that comes to money, knowledge is the key. If you do not understand where your money is going, and the full business of what you are putting your money into, then you are gambling. It does not matter if you are buying bonds, stocks, indexes, housing, rentals, commodities, or commercial buildings, if you do not know the business, then you are gambling. You are putting in money, just like the blackjack player, and hoping that money comes back. To be an investor, you must put in time to gain the knowledge needed to mitigate your risks and maximize your potential returns.