#2 - Investing vs. Gambling: How to Tell the Difference
The topic of the difference between investing and gambling, as well as the morality of each, was recently discussed in episode 2 of the Peacock Investment Partners Podcast. I think we have all been guilty of confusing the two before, often with undesirable results. I believe that understanding the difference between investing and gambling is immensely important and integral to achieving long-term success in investing, so below is my opinion of what the difference is and how to know when you are investing and when you are gambling.
Various Definitions of Investing:
Oxford Languages - expend money with the expectation of achieving a profit or material result by putting it into financial plans, shares, or property, or by using it to develop a commercial venture.
Merriam-Webster – (i) to commit (money) in order to earn a financial return, (ii) to make use of for future benefits or advantages, (iii) to involve or engage especially emotionally.
Investopedia – Investing differs from trading in that investing is for the long-term, usually years or decades. Investing is one of the key strategies to building long-term wealth and financial security.
Forbes - Investing is the process of buying assets that increase in value over time and provide returns in the form of income payments or capital gains. In a larger sense, investing can also be about spending time or money to improve your own life or the lives of others. But in the world of finance, investing is the purchase of securities, real estate and other items of value in the pursuit of capital gains or income.
Various Definitions of Gambling:
Oxford Languages – (i) play games of chance for money, (ii) take risky action in the hope of a desired result.
Merriam-Webster – the practice or activity of betting, the practice of risking money or other stakes in a game or bet.
Britannica – the betting or staking of something of value, with consciousness of risk and hope of gain, on the outcome of a game, a contest, or an uncertain event whose result may be determined by chance or accident or have an unexpected result by reason of the bettor’s miscalculation.
Investopedia – Staking something on a contingency. Also known as betting or wagering, it means risking money on an event that has an uncertain outcome and heavily involves chance.
Differences Between Investing and Gambling:
The differences are easy to identify when looking at the definitions of Investing and Gambling side by side.
Time Period. Investing is a long-term activity and gambling is short-lived. An important aspect of investing is that positive returns are earned over time and are dependent on consistent, predictable performance and positive developments that happen with the underlying asset. In theory, investors are even rewarded in proportion to the time an asset is held, meaning the longer they tie their precious capital up in a venture, the more they should expect to receive upon their eventual exit. Of course, this is an ideal based on the financial concepts of the time value of money and required rate of return, and it can all be thrown out the window if the underlying venture fails. However, this concept does not seem to exist at all when gambling. Gambling offers returns that are uncorrelated to holding period and are ultimately determined by the outcome of some event or short series of events. This is easy to understand when thinking of a casino, where outcomes of roulette, slot machines, etc. are determined almost instantly, but gambling also exists in the stock market in the form of trading. While these activities can offer very high returns in a short amount of time, those returns are ultimately short-lived because long-term participation in gambling will almost always lead to loss because the odds are always stacked in favor of the house rather than the gambler on average.
Commitment vs. Risk. Investing is based on the commitment of capital in order to earn a return, while gambling involves the risk of stakes in hopes of a desired outcome. On the surface, these may seem like the same thing, but they are not. A commitment of capital means that it will be used for some underlying purpose, such as growing a business or acquiring productive assets, and it is the underlying purpose that will drive a return on investment. On the other hand, capital risked in gambling is not typically used productively by the recipient and may even serve as dead money until some event happens. Even if that event goes well for the gambler and they win money, that money did not come from production, but directly from someone else’s pocket.
Role of Chance. Gambling outcomes are mostly dependent on chance and investing outcomes are not. Usually, the primary consideration when gambling is odds and probabilities while investing relies more on knowledge, research, and tangible economics to assess the merits of an opportunity. This is not to say that the odds can’t sometimes be in favor of the gambler, but even when they are, the outcome is still based on chance and favorable odds likely won’t persist. For example, the Powerball jackpot was once $2.04 billion with a probability of winning of 1 in 292.2 million. Ignoring taxes, payout structures, and positive outcomes besides the jackpot, this would mean that the expected value of each lottery ticket would be $6.98 (= 1/292.2 million * 2.04 billion). This is much higher than the cost of $2.00 per ticket, so a gambler might conclude that you should buy lottery tickets and expect to win an average of $6.98 per ticket. However, they would almost certainly be wasting the money and never see a long-term return despite the odds being in their favor.
Although the differences between investing and gambling are easy to identify in definition, I have found they are often hard to distinguish in practice. There are definitely activities that fall entirely in the gambling category: roulette, sports betting, slot machines, etc. These types of activities will clearly never provide long-term returns because the odds are in favor of the house rather than the gambler, even though they have the potential to provide enormous short-term gains. However, there is also a large gray area in which falls activities that some would consider “investing” and more conservatively-minded people would consider “gambling.” In the investing world, we call participating in activities within this gray area “Speculating.” Speculation is defined as (i) the forming of a theory or conjecture without firm evidence, and (ii) investment in stocks, property, and other ventures in the hope of gain but with the risk of loss.
The Role of Speculation:
Speculation has been rampant throughout the history of the U.S. stock market, often leading to market crashes. While it is true that investing can involve speculation, there is a limit to the amount of speculation a good investment should require to make sense. Levels of speculation have been amplified in recent years with cryptocurrency and high-growth, low-profit companies capturing the minds and wallets of even reputable “investors” with grand, ethereal visions of the future. In the late stages of the recent bull market throughout 2020 and 2021, it even seemed like most were blatantly denying the realities of gravity and believed we live in a world where trees can grow to the sky (to paraphrase a letter in The Buffett Bible). In my opinion, this is the point where speculating becomes gambling, even though the participant may believe the activity ticks all the boxes of investing laid out above. This is because it either requires the participant to be delusional to think the outcome is related to anything more than pure chance or there are a significant amount of contingent events preceding a hypothetical positive outcome.
When investing, it is okay and often necessary to speculate to some degree. It could even be argued that every investment, outside of a risk-free U.S. Treasury, involves speculation because every investment comes with some risk. It is also okay to gamble if your moral compass allows it, but the two activities should never be confused. However, I would speculate that the confusion of these two activities is far more common than anyone realizes or will ever be willing to admit. It is easy to understand how people could get the two confused if they take the academic view of the risk/return relationship to heart, which says that high returns are associated with taking more risk and speculating to a higher degree. However, in my view, the key to successful investing is figuring out how to break this theoretical risk/return relationship and minimize risk/speculation while maintaining the ability to achieve a high return. If you are not able to achieve this in a potential investment opportunity or your desired investment outcome has many contingencies, then you are probably too close to gambling for comfort and should just walk away.
So how do we achieve high returns with low risk? This is essentially what Warren Buffett and Charlie Munger have been doing for the past 60+ years, which is why I study their methods by reading The Buffett Bible. I will discuss this more in future memos.
New Years Resolution:
There is some disagreement among the Partners on the merits of New Year’s resolutions. However, I (The Value) tend to believe they are good, so since it is a new year, I will suggest one for all of us who like to participate in the stock market: Invest More, Gamble Less.
Featured Readings:
Security Analysis by Benjamin Graham and David Dodd
This is one of the foundation books on Investing by the father of value investing, Benjamin Graham. It is literally a textbook about everything related to investing. A free copy can be found in the link below, but this can also be purchased on Amazon, if you want a physical version.
You Bet! by Howard Marks
This was a memo by Howard Marks, the co-founder of Oaktree Capital Management, sent to clients on January 13, 2020 discussing his decision-making processes and the differences between investing and gambling. The link to this pdf is below.
https://www.oaktreecapital.com/docs/default-source/memos/you-bet.pdf
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