is investing gambling

Is investing gambling, what is the difference?

It’s a tough question, investing can be gambling but at the same time it isn’t. They are two different things which are brought closer by probability. What are the odds that tennis player A will win or that the new IPO stock will keep going up?

If there is no further information available I’d say 1:1. Both are binary outcome events so I have about 50% chance of winning. Nevertheless, in sports there would be set odds which can give me a clue which player is better.

When it comes to stock I can dig a bit to form an opinion. I’ll get the odds from the market. Is it pricing the risk to the upside or to the downside and where exactly.

But first thing’s first. Let’s think about the games we play.

Is it a game of chance or a game of strategy?

A coin toss

How about a coin toss, a game of chance. If you throw with friends you’d expect a 50% chance of heads or tails. I believe you’ll get there if you throw the coin 10,000 times.

But what about when there’s something at stake. No one throws a coin for fun. There’s always a reason, whether money or a task of some kind. So how can you shift the odds in your favour?

Do you extend the game? If you toss a coin one time the chance of losing is 50%. Settle for 3 out of 5 and the chance remains unchanged at 50%, because the game is symmetrical, or it drops down to 31.25% depending on the calculation method (P=(0.5^3)x(0.5^2)x5C3=0.3125). The probability to win or lose all 5 is 31.25%.

But 31.25% can’t be true as your opponent will have the same chance of winning. Where did the other 37.5% go? I think that the calculation is more suitable for a slot machine at a casino.

Nevertheless, if you think about the math in stock market terms it does work. If you invest in 500 randomly picked stocks the chance of losing all of your money is pretty slim. Simultaneously, the chance of outperforming the market will be very low too.

How about chess, it’s a game of strategy

Chess is simple, whoever’s better wins, but that’s true if you know your opponent. What if you never played against that person? It will be difficult to use math. I could say 50% as I’ll either win or not.

Or I could use the formula above and I’ll get a discouraging result like ~16.45% assuming a draw and a loss carry the same weight.

Let the game begin and if my opponent is thinking too much the first 5-6 moves I’d change my prior belief and I’d raise the stake. There are only a few ways you can start a game of chess and any good player would know them.

This is the kind of situation that you may find yourself in when investing or gambling. You just don’t know what is about to happen so you have to start and then adapt to the changing market conditions.

What about backgammon

Superficially it may seem like a game of chance but it is not. It is actually a game of strategy. You need to position your chips in a way which can withstand a long streak of bad luck.

Every gambler knows that you can throw bad combinations all day long so you need to set yourself for success.

Therefore, it is similar to the job of a stock picker. He or she aims to choose the stocks which deliver maximum return with a minimum risk of losing all the money. Not so different from the job of a poker player.

Is it a game of probability & statistics?

Poker

Poker is mixed, sure there is chance but there are statistics and strategy too. I’ve got a 9 of hearts and a 10 of spades, you’ve got two Aces, one of clubs and one of diamonds, in a Texas Hold’em game.

Others have folded and there are a 2, 5, 8 and a Jack on the table. I have an 18% chance, considering that no one knows what cards the others had. Do I fold?

If my total bet is 10% of the pot I’m in, if it’s 18% or over I’m out. It’s just statistics as the 10% bet will be an overall winner if I repeat it enough times.

At some point the probabilities will work themselves out because of the law of large numbers. It is present in investing and gambling and may or may not work in your favour. When it does, you are the house!

Roulette

I was still a kid when my dad told me Son, never gamble in a casino, while passing by a newly built one. I remember asking him But why Dad, I could win, it’s still a game. He just looked at me and said That fancy thing over there was built with money that came from people who thought that way.

If you bet red or black the pay-out is 1:1 but the probability of profit is not 50%. You’re looking at 48.6% on a European table (because of the 0), 47.35% on an American (they have 0 and 00) and 46% on the new 0, 00 & 000 tables.

If you are going for an individual number you win 35x and your original bet. But the chance is not 2.777% (1/36). Depending on the amount of zeros the actual probability is 2.703%, 2.6316% or 2.564%.

Some of you may think is this guy crazy, what difference does 0.07% make? A really big one.

If you bet 100 you’d get 3,600 in total. In the absence of any edge (0,00 & 000) this will be a zero-game. The net profit and loss after 1 million repetitions will be zero as the losses and the wins will offset each other perfectly. The easiest, but not the most accurate, way to think about it in terms of math is 100/0.027778~3500.

The casino edge for single numbers is 2.7% on a European table, the American one yields 5.26% and the 000 delivers 7.69%.

They optimise the edge

Go to a casino and tell them you want to bet £1 million on number 5. They’ll decline and introduce you to the manager as the chance of winning is small but if you do the casino is toast. That’s why they have betting limits.

The casino wants you to play small because a large number of transactions will average out winners and losers realising the theoretical edge. This is how the law of large numbers works in practice.

A small number of transactions may result in a random sequence of losses, therefore, they aim for high volume. There is a minimum bet too as the casino doesn’t want to risk you making 35x for a few pennies.

The most important similarity between investing and gambling in a casino is risk management and an awareness of return on risk.

When trading you could sell $0.10 S&P 500 index options, amounting to $10 per contract before commissions. The win rate should be >99.5% but if you lose you’d be out of pocket between a few hundred and a few thousand.

Another resemblance between investing and gambling is that a small bet will result in a small win. For example, if you buy 1 share for £20 and make 100% in a year, you’re looking at £20 gain so it’s not like you got rich. You could also lose money so you may not want to buy 1,000 shares to chase a big win.

Similarities between investing and gambling

Probabilities are real, you buy a stock and you have a 50% chance of making money in the absence of any additional information. A stock is never a sure win in the same way as a pair of Aces.

Whether you have a pair of Aces or you own a stock you play with the hand you are dealt. If the stock goes down you have to consider your options. You can approach this like a casino and manage your risk by selling options against the stock. This way you can reduce your losses by capping the upside.

New information may flow into the market and change your prior belief about any stock. The market works in a similar way as a Texas Hold’em game, each new card on the table changes the probability of winning. The only difference is that you are dealing with information which is more ambiguous.

Diversification reduces the chances of losing on all of your stocks but it also brings your profit down to the market average. That’s not so bad as it is really difficult to beat the market.

When it comes to strategy we can borrow from chess and backgammon. Picking stocks is the same as positioning pieces or chips. You have to choose wisely to improve your odds. As the game goes on you acquire new information and adapt to it.

How are investing and gambling different

You may never make any money gambling while you have a good chance of making some money when you invest. Sure, you may not become a billionaire (I hope you do!) but at least you’ll shield your cash from inflation.

Advantages of investing

The market has an overall positive drift, meaning that it goes up more than it goes down. A few years go by and chances are you’d end up with some profit unless you are unfortunate and get caught in a market crash. But don’t worry crashes are followed by recoveries so all you have to do is wait.

There are tax efficient methods to invest like SIPPs and ISAs so you make some money from the tax man. You’ll get dividends too so it’s not just about the share price.

The game is different

When you gamble you always know what game you’re playing. There’s no chance that your opponent will come up with a new card called 73 while playing poker. So poker, chess, backgammon are all games with set rules and set outcomes.

There’s no such thing in the stock market. You can only make a decision based on the best available information at the time of the trade.

Share prices can move for obscure reasons, for example market makers hedging options positions. Furthermore, an industry can be transformed out of thin air.

Think about what happened to the advertising industry when the internet companies (Google, Facebook, etc.) showed up. The same is true for video rental, Netflix adapted and remained successful while Blockbuster LLC went into administration.

The stock market has millions of participants and everyone is playing a different game. Making money is the only factor which unites everyone. Consequently, the amount of information and analysis is obscene. You can never keep up. In my opinion this is one of the biggest differences between investing and gambling.

A note on probability and statistics

Some of the math used for financial analysis is not a perfect fit when it comes to stock. Standard deviation for example doesn’t give us all the answers as it seems to understate the frequency of outlier events.

This section is concerned with basic math that you can use as a retail trader. Institutions have very complicated models and algorithms which are likely more accurate. Don’t worry they can’t predict the future either, you can find examples here.

Frequentist statistics

This method is suitable for things like calculating the average foot size in the UK by gender, the median height of year 3 schoolchildren, or the anticipated profit of a casino. This is again because of the set parameters, it is not possible for a quadruple zero to pop up on the roulette table out of nowhere and then disappear along with the double zero 2 days later.

Don’t get me wrong, I use statistics all the time, I’m just trying to say that Frequentist statistics have limitations when it comes to tail risk. Outlier events and tail risk are the kind of things that render hedge funds bankrupt so we all have to be careful.

Probability

The same goes for probability. A certain trade can have some kind of probability of profit, like 70% chance for an options trade, but it is valid at the time of opening. If the circumstances change, and they do by the hour, the probability will change too.

It’s always a good idea to research on a few levels. For example, macro economic situation, industry analysis, company data, Frequentist statistics, Bayesian statistics, qualitative analysis.

Some say that Bayesian statistics are better than the Frequentist approach but I think what’s stopping us from using both. We’re all in the market to make money not to argue over math.

Financial modelling

Financial models suffer from handicaps too. It is common knowledge that they are only as good as the assumptions which are plugged in.

Otherwise, the math behind a discounted cashflow model for example is pretty simple. Consequently, 10 models yield 10 different outputs, add a sensitivity range of 20% and you’d be scratching your head wondering what am I looking at.

Once I came up with a company valuation within the range of 400 million and 1.2 billion matched by 2 different methods. That wasn’t very helpful.

Conclusion

I’d be surprised if there is someone who is trading and has never played a game of chance. Maybe not necessarily for money but it seems obvious that both improve our knowledge of probability and statistics. So if you’re good with stocks you may try a poker tournament too, why not.

It turned out that there are a lot of similarities between investing and gambling but there are a lot of differences too. The main one is that the stock market game changes very frequently. You may be playing something completely different in a few years.

If you gamble I think it may be worth to try dipping your toes in investing. There is a thrill but at the same time the positive market drift works in your favour in the long term. You can also save some money on tax too, even better! Always make sure to invest in a responsible way though. Remember, the purpose of this is to make money not lose them.

One of the things I have not addressed is trading psychology. I believe that it is a major issue which deserves a piece of its own. Watch this space, I should come up with something in the future.