About a dozen or so friends from school and I have a WhatsApp groupchat which has now been running for over 10 years. It started as a way for us all to keep in contact as we started university, and has carried on ever since. I was trawling through the hundreds of unread messages on the chat recently, when I noticed that someone had casually dropped into the conversation that they thought all investing was gambling. There was a murmur of agreement from a few others. This was apparently an uncontroversial opinion.
I rarely contribute to this groupchat, but by likening investing to gambling it had strayed towards a useful and interesting conversation which I had a relatively informed opinion on, so in I stomped.
I’m not sure whether the combination of my surprise appearance and my half-baked arguments managed to make anyone reconsider their opinions, because it wasn’t long before the chat devolved into “JUST STICK IT ALL IN TESLA LOL”.
Still, it gave me the inspiration for this post, and an opportunity to clarify whether investing is the same as gambling.
Contents
Putting it all on black
Similarities
- Investing vs gambling according to the dictionary
- Investing vs speculating vs gambling
Differences
- Expected return
- Time horizon
- Improving your odds
- Worst case scenario
- Is investing a zero sum game?
Conclusion
Putting it all on black
Before we get into the similarities and differences between the two, it’s probably worth defining what I’m talking about when I say gambling.
For the purposes of this article, gambling is playing pure games of chance, like roulette or the slot machines. It’s not games where the gambler can make choices which affect the outcome, and the games therefore involve an element of skill in decision-making, such as poker or blackjack. These are interesting to compare to investing as they involve statistical (and in poker’s case, behavioural) decision-making, and are therefore more similar to active investing than games of pure chance. But that’s an article for another day.
So when you envision a gambler in this article, imagine him or her playing roulette or slot machines. This is, I think, what most people are referring to when they compare investing to gambling. Their argument tends to be, “Investing is based on luck and I could lose all my money” and not, “Active investment management is in some ways similar in its decision-making to some games involving chance, such as poker.”
Let’s start with the similarities then. Why do people conflate investing with gambling, and how similar are they?
Similarities
Investing vs gambling according to the dictionary
We’ll start, as all good research pieces do, with Wikipedia. According to Wikipedia, gambling is:
“The wagering of money or something of value on an event with an uncertain outcome, with the primary intent of winning money or material goods. Gambling thus requires three elements to be present: consideration (an amount wagered), risk (chance), and a prize. The outcome of the wager is often immediate, such as a single roll of dice, a spin of a roulette wheel, or a horse crossing the finish line, but longer time frames are also common, allowing wagers on the outcome of a future sports contest or even an entire sports season.”
If we’re using the dictionary definition of gambling, then investing seems to tick all three boxes. Investing has consideration (the amount you invest), it has risk (markets go up and down), and it has a prize (positive returns).
So according to the dictionary, technically investing is the same as gambling. But the definition misses a few important distinctions, including the different levels of risk between the two as well as the size of the prize, which we’ll get to in the ‘Differences’ section.
Investing vs speculating vs gambling
We’re clear on what gambling means, but what about investing?
Here, investing means buying a well diversified portfolio, and holding it for a long period of time – a minimum of 10 years. Putting all your money into Bitcoin and expecting a quick doubling of your money isn’t investing, it’s speculation. And it’s with speculation where investing can start to look like gambling.
When investing in a single stock, or a very small number of stocks, the chances of making a lot of money, and equally the chances of losing a lot of money, are much higher. You could get lucky, like Brandon Smith, who invested everything he had into Tesla shares and became a millionaire in three years. He bet the house on black, and won.
Or you could get unlucky, this the father of this Redditor, who held 90% of his portfolio in General Electric then watched the stock halve in value over the next year. He bet the house on black, and lost.
As a side note, the top comment on that Reddit thread advises the poster’s father to remain invested in GE and not diversify because “He has already ridden it down to near all time lows”. This is why you don’t take financial advice from Reddit.
The fewer stocks you own, the higher the variance in your outcomes. Every company has risks specific to that company. It could be a volatile CEO, reliance on one supplier or customer, subpar cybersecurity – anything, really. And that’s what diversification aims to mitigate. By owning enough stocks, you reduce the chances that one company’s failure will torpedo your portfolio.
By investing in one/very few stocks, you’re betting that those risks (which every business has) don’t materialise. If they don’t, great – you could get lucky. But if they do, there’s a huge downside, too. The variance in returns is much greater than with investing in a diversified portfolio, and the returns are much more influenced by luck. Investing in very few stocks is therefore much more akin to gambling than it is to investing.
Similarly, only having exposure to a single country’s economy is taking on more gambling-like risk. You could’ve been born in America 20 years ago and thought that where you were born was a great place to invest (as most people do, by default). You would’ve been lucky, and right.
Or you could’ve been born in Greece 20 years ago and thought that where you were born was a great place to invest. You would’ve been unlucky, and wrong:
Source: Bloomberg
Over the last 20 years, Greece has returned -93% total return. You would’ve lost almost your entire investment, and would need a return of over 3,000% to break even. Over the same time period, the US has returned 362%.
Investing in a single country is undoubtedly preferable to investing in a single stock, but there’s still huge dispersion in outcomes, and it’s still not diversified.
Most importantly, though, is time frame. The shorter period of time you’re investing for, the more you’re gambling.
In the short term, market movements are unpredictable, and the variances in outcome are again very high. You could get lucky and experience an exceptional year, like in 1975 where the MSCI World returned 50%. Or you could get unlucky and experience a terrible year, like 1990 where the market fell 32%. The longer you invest for, the lower the variance in your annualised returns will be, and the more likely it is that they’ll converge on the long-term market average.
If you’re investing for the short run (when you’re speculating rather than investing) what you’re doing is gambling. But in the long run, when you’re actually investing, it’s very a different story, as we’ll see below in the ‘Differences’ section.
To summarise, investing is similar to gambling only when it’s speculation – not investing. Speculation becomes more like gambling if you buy very few assets, are exposed to very few regions, or have a very short time horizon.
If you imagine a sliding scale for the amount chance plays a role in outcomes, where 100% chance is on one end, and 100% certainty is on the other, then gambling sits at the furthest point on ‘chance’ end, and investing would sit somewhere between the centre and the certainty end. Speculation falls somewhere between investing and gambling, depending on how egregious the speculation is. The more you’re speculating, the closer you are on that sliding scale to gambling.
They key here is diversification. In short, the less diversified your portfolio is, the more you’re gambling, and the more diversified you are, the more you’re investing1.
Differences
Expected return
The first, and probably most major difference, is the expected return of gambling versus investing. With a long enough time horizon, you will eventually lose all your money gambling. Gamble for long enough and your expected return is not only negative, it’s -100%. Always2.
But if you invest for long enough, your expected return isn’t just positive, it’s extremely positive. The chart below is taken from another post on the benefits of compounding, and shows the historic probabilities of returns at different time horizons:
Spending 20 years in the market is clearly more profitable than spending 20 years in a casino.
I think why some people distrust markets (and I’m guessing here) is because they don’t understand why stocks go up. To some, investing in stocks is just as risky as investing in something like Bitcoin, fine art, or stamp collections. What makes stocks different?
‘Why stocks go up’ is a question which deserves an article in its own right. It’s a really interesting fundamental question, and so I’m going to make it the topic of my next post. For now, we can summarise by firstly confirming that stocks have indeed gone up most of the time throughout history:
Source: Stocks for the Long Run by Jeremy Siegel
I’m not sure I trust stock market data from of 1802, but general point is true. Stocks, over time, go up.
As for the reasons stocks are likely to continue to go up over time, there are a few factors at play, but the main thing to remember is that stocks represent ownership of the underlying companies. Over time, the market is highly likely to continue to rise thanks to a combination of productivity increases due to technological advancements, capitalism, human ambition and ingenuity, inflation, and the positive skew of stock returns. But more on that in my next article.
With gambling, you don’t own anything. There’s no underlying reason for your expected return to be anything other than the negative.
So expected return is the first difference between gambling and investing. It’s positive for investing, negative for gambling.
Time horizon
Closely related to expected return, and a second difference between investing and gambling, is time horizon. When you go into a casino, your time horizon is very short. Nobody expects to gamble for months or years at a time – they’re expecting to get lucky more often than not, and get a quick win.
This is the opposite of investing. Investing (in equities) is a long-term activity. Most investment professionals recommend a minimum of 5 years as a time horizon for an equity investment, but I think that may even be on the conservative end – my own investments are at least 10 year commitments.
As we saw in the previous section, the longer you’re in the market for (i.e. the more you increase your time diversification), the more your returns will approximate returns from investing, and the less they’ll look like returns from gambling.
Improving your odds
You can’t sit down at a roulette table and say to the croupier, “Excuse me sir, I don’t like these odds. Can you improve them please?”
But with investing, you can.
Using the sliding scale example, where gambling sits at the chance end and investing sits somewhere closer to the certainty end, we’re able to choose where we place ourselves between those two points, and improve the odds of investing successfully.
By diversifying your holdings, lengthening your time horizon, paying less in fees for your investments, improving your investing behaviour, and ensuring your portfolio’s risk is appropriate for your own circ*mstances, you can drastically improve the odds of a successful investing outcome (whatever your own investing goals are).
You can’t do that with a slot machine.
So the probabilities of losing money are also different between investing and gambling. Now let’s have a look at the amount you’re likely to lose.
Worst case scenario
To figure out the most you could lose in each situation, we should probably start by taking the two worst scenarios for each. We’ve seen that gambling is worst over long time periods and investing is worst over short time periods. In the worst case scenario for a gambler, the gambler enters a casino and is chained to the roulette table for an indefinite period of time. Eventually, they’ll lose all their money – their maximum loss is 100%. It’s a mathematical certainty.
The worst case scenario for the investor is to be forced to invest at a market peak, then be forced to pull their money out of the market at the bottom after a subsequent market crash. But how bad could that damage potentially be?
In theory, there’s no law against all markets crashing to zero and never recovering – it’s just incredibly unlikely. That’s not to say that it could never happen (Black Swans, and all that), but in the event that all markets collapse, I think you’d have bigger problems than your investment portfolio. If all markets crashed to zero, you’d need to figure out where you can find weapons, bullets, food, and a fortifiable position. Your Vanguard tracker fund portfolio won’t hold off the hordes of Zombies.
Short of the zombocalypse, the best we can do to get a feeling for the sorts of losses we can expect from the stock market is to use history as a guide.
There are always horror stories about people losing money in the market, but most of them involve un-diversified portfolios (if we’re ignoring losses resulting from outright scams). The most recent high-profile example in the UK is those investors who lost huge sums of money by investing in Neil Woodford’s Equity Income fund, which went into liquidation. These portfolios were un-diversified by holdings (you should never hold only one actively managed fund).
Taking some examples from the regional level, the Greek stock market is down 96% since the 2008 financial crisis. The US market fell over 85% in the Great Depression, and the Japanese market still hasn’t reached its previous high from 1989. Any portfolio which was invested solely in any of those countries would’ve seen huge losses, but those portfolios weren’t diversified.
It’s the same story with stocks – losing the majority of your investment in a single stock isn’t outside the realms of possibility.
But anyone whose portfolio suffers as the result of one stock isn’t diversified. Their returns are the result of speculation.
To get an idea of the losses we can expect from a globally invested and well-diversified portfolio (even using 100% equities for maximum risk), we can look use a global equity index as our guide. The largest drawdown since the data started for the MSCI World in 1971 was a loss of 52%, during the dotcom crash. We’ve seen 3 other drawdowns of over 30% since 1971 (in 1974, 1990, and 2008). So even if you’d had the worst timing imaginable, you wouldn’t have lost all your money. I don’t think anyone would consider losing half your investing to be a good outcome, but it’s definitely better than the worst-case outcome from gambling.
It’s important to note here that we can’t use this as a high-water mark for worst possible losses going forwards. The future could definitely hold larger drawdowns. We don’t want to fall victim to the ‘Lucretius Problem’ as Nassim Nicholas Taleb calls it: predicting the future worst-case scenario based on historical worst-case scenarios. That’s what the builders of the f*ckushima nuclear reactor did, constructing the reactor to withstand the worst past historical earthquake, before watching an earthquake of unprecedented size strike in 2011 and causing the worst nuclear accident since Chernobyl.
Back in the investing world, the 52% MSCI World drawdown is a cherry-picked example to show that in the incredibly unlikely event that you invested at the exact worst possible time in history, and were forced to sell again at the exact worst possible time (so having maximum bad luck twice in a row – both at buying and selling), you still wouldn’t have lost all your money.
And as we’ve discussed, the chances of recovering from those losses can be increased through diversifying your holdings, lengthening your time horizon, paying less in fees, improving your investing behaviour, and ensuring your portfolio’s risk is appropriate for your own circ*mstances. That’s a luxury you don’t have in gambling, where once you’ve lost your money, it’s gone, and further gambling only increases the chances of further losses.
With investing, it’s possible to reduce the magnitude and frequency of large drawdowns, as well as improving the ability of a portfolio to recover from losses – none of which is possible with gambling.
Before we conclude, one final difference between gambling and investing has to do with zero sum games.
Is investing a zero sum game?
This is another one of those topics which requires its own post, so I’ll take the notes I’ve made on this section and turn them in to a separate article. This article’s getting long enough, so I’ll summarise the point here.
When you play at a casino, if you win, you take someone else’s money. If you lose, you give someone else your money. There is no wealth created, it’s just the same cash being redistributed between the players. That’s a zero-sum game – more for me means less for you.
Investing, on the other hand, is not a zero-sum game.
Just as we derive extra value above the price we pay for something in a shop (otherwise we wouldn’t buy it), stocks have extra value above the price we pay for them. We buy stocks in the belief that the value they generate for us in long run exceeds the price we’ve paid for them. I invest £100 because the chances are that given a long enough time horizon, I will have more than £100 in the future. Each investment we make generates extra value for us.
It’s not risk-free extra value, though. Some stocks will turn out to be worthless. But on average the gains are likely to outweigh the losses, because markets go up over time (for why markets go up, see more in my next post). Markets going up means wealth is being created, which is the opposite of a zero sum game.
Because investing in ‘the market’ (as approximated by a global tracker) doesn’t require someone taking the opposite position, it’s the ultimate positive-sum game in investing. Just because I make money through investing doesn’t mean you lose money. More for me does not mean less for you. We can both invest in the market and we can both make money.
Where investing is a zero sum game, however, is in trying to outperform the market. For every 1% of outperformance against an index, there must be 1% of underperformance. That’s the logic behind William Sharpe’s Arithmetic of Active Management, and one of the reasons why, on average, passives have outperformed actives in the past.
Using the FTSE 100 as an example, for every 1% of outperformance vs the FTSE, there must be 1% of underperformance somewhere. That’s how we end up with ‘market performance’ – it’s the combined performance of all active and passive strategies in the market. So 1% of outperformance for me means 1% of underperformance for someone else. That’s zero sum.
While trying to outperform the market is zero sum in terms of relative performance (but not necessarily in absolute terms – you can still generate value despite underperforming and index), investing in the global market is not zero sum for investors. But more on that in a future post.
Gambling is clearly a zero-sum game. There’s no wealth creation, just wealth redistribution. Investing, on the other hand, creates wealth. As long as the global market continues to rise over time, investing will continue to be positive sum for investors.
Summary
Similarities
- According to the dictionary definition, investing is gambling. Both investing and gambling carry the risk of losing money in the hopes of a future prize for a specified stake.
- While the dictionary definition doesn’t tell the whole story, speculating (not investing) should be viewed as gambling.
- However, sensible, long-term investing is hugely different to gambling because…
- Investors own shares in the underlying companies they’re investing in. Gamblers don’t own anything.
- The expected return of investing is therefore positive (and increases with time), compared to gambling’s negative expected return (which decreases with time).
- The time horizons for gambling/speculating and investing are at opposite ends of the spectrum – investing is a long-term activity, gambling is short-term.
- It’s possible to improve the odds of success with investing, but not with gambling.
- The worst-case scenario is more favourable when investing sensibly than with gambling.
- Gambling is a zero-sum game, where one person’s gain is another’s loss. Investing is a positive-sum game where all participants can gain value.
Conclusion
It’s common for new or inexperienced investors to equate investing with gambling. And it’s understandable for those with no investing knowledge to approach the unfamiliar with a sense of unease and scepticism. The confusion is especially understandable given news outlets are eager to jump on investing stories which feature the lottery-type outcomes. Making a 10,000% return on your Tesla shares is a great story – compounding gradually for 30 years is not.
So, is investing gambling? No, it’s not. Investing differs in its ownership of cashflows, expected returns, time horizons, its ability to alter the odds, likely worst-case outcomes, and payoff structure.
In fact, thinking of investing as nothing more than a spin of the roulette wheel is not only flawed, it can be harmful. If you consider investing to be a gamble, then the chances of you investing early, often, and into a diversified portfolio are slim. But by avoiding investing, you’d be missing out on one of the most powerful forces it has to offer – compounded returns. The likely outcome of which is either not meeting your investment goals, or having to save much more than you’d otherwise have needed to in the future to compensate.
Differentiating between what’s considered speculation and what’s considered investing goes a long way towards understanding why investing and gambling aren’t the same thing. Speculation should rightfully be thought of as gambling. And while it’s understandable to confuse gambling and investing at first glance, it’s hopefully clear by now that they’re not the same thing.
Having said all that, I’m still partial to an occasional punt.
I personally allocate around 10% of my otherwise boringly sensible global index tracking portfolio to stock picking gambles. It’s fun, cheaper than going to the casino, and most importantly, it stops me from tampering with the main portfolio, which I know has by far the best chances of long-term wealth-building.
And as long as I know my gambles aren’t investments and my investments aren’t gambles, I think that’s OK.
Footnotes
1. This is obviously applicable to stock/sector/regional diversification, but it’s also useful to think about increasing the length of time you’re investing for as diversifying by time.
Investing for longer increases the number of discrete time periods you’re investing for, just like buying lots of stocks increases the number of stocks in your portfolio. By investing for a longer length of time, you reduce the effect that any single bad time period can have on your portfolio, and maximise the chances of being invested during the time periods where the market takes off. And that’s the definition of diversification.
2. The reason the long-term returns are -100% for gambling isn’t only because the house has an edge. Even if the house had no edge and there was an even 50/50 probability of winning or losing on every spin of the roulette wheel, you would still eventually lose all your money. The basic idea is that losses have a disproportionate impact on returns. Losses matter more because they require a larger percentage gain to break-even – the larger the loss, the larger the gain to break-even. A 10% loss requires an 11% gain to break even, and a 50% loss requires a 100% gain to break even.
Imagine starting with £100, and winning 50% if you flip heads, but losing 50% if you flip tails. After one flip, you either end up with either £150 or £50. If you flip again and get the opposite result to your first flip, you end up with £75 either way. You’ve had one win and one loss, but still lost money.
In this example, and also with gambling, each loss requires more than one win to get back to square. So the even chances of winning or losing combined with the disproportionate effect of losses means that eventually the maths catches up to you, and the expected return converges to -100%.
