Is investing in stocks gambling, like in Las Vegas? When we buy stocks, is it the same as putting our dollars on red or black and hoping the gods of chance will reward us? The short answer is No. However, it doesn’t mean that chance, luck, good timing, whatever you want to call it, doesn’t have an impact. In this post, I want to explore why investing is not like gambling but also talk about the role of probabilities and chance in investing.
Gambling has a negative Expected Value
I hate talking about Expected Value because when investors look into purchasing stock of a company, they don’t look at a thousand other stocks and pick the one with the expectations of the highest return. That happens on its own if you find a company that you expect will outperform the competition, and you end up being correct. You can achieve that by looking at the company itself and not some statistical model. Fund managers perform scenario analysis on their portfolios, but that is not what makes them great. It is their ability to pick the best businesses to invest money in, not a superior statistical model.
What is Expected Value?
Simply put, expected value is the the value of the money in the future if you put it somewhere, given the probability of that money going up in value and the probability of it going down in value.
The simplest example is a coin flip. If we play a game where I give you $100 for every time you win in a coin flip, that means you have a 50% chance of getting $100 and a 50% chance of getting $0. Expected Value is = 50%*100 + 50% * 0$ = $50. That is an example of a positive expected value. It makes sense for you to play that game because, on average, you expect to win.
Gambling in a casino has a negative expected value. That is where the saying comes from, “The house always wins”, meaning that you can expect to lose money in a casino over a long period of time.
Okay, but what about stocks? Can I realistically expect to make money from stocks over time?
The short answer is, Yes.
The stock market generates positive returns but not equally
Take a look at a hypothetical $10,000 investment made into the S&P500 ETF – SPY in 1993. Over almost 30 years the S&P returned 16x the initially invested capital. If we take into account inflation, that is still a CAGR of 8.09%.
During that 28 year period there were definitely ups and downs. Look at 1999, 2007, 2017. However, the trend line is clear.
That doesn’t mean, however, that we can always expect to make money. Although in general the stock market has shown positive upward trend throughout its history, not all companies did the same.
Let’s take Oil & Gas as an example. Here is the return profile of some of the popular Oil & Gas ETFs since 2007.
If you were bullish on Oil & Gas and were heavily exposed to the industry, in the worst case you could have had an 80%+ loss.
Then to contrast that, let’s take a look at the technology sector, represented below by the NASDAQ 100 Index ETF – QQQ.
That is almost a 700% return or 8x your money since 2007.
Wait, so is investing in stocks like gambling? Put money on oil & gas and lose, put it on growth stocks and win? Isn’t it the same as putting money on Red vs. Black? Not exactly.
In investing, we don’t have to choose Red vs. Black
Thankfully in real life, I can invest some of my money in Oil & Gas and some of my money in Technology, Financial Services, and so on. I am not bound by the rules of the game. My decisions, unlike gambling, are not binary.
Of course, you can put your money on both Red & Black but they will always cancel each other out. That is not the case when you invest in the stock market. There will be periods when most types of industries will all go up together and there will be times when most will go down.
In the industry, we call this diversification.
What is diversification?
Diversification, means I invest my money in a few things that are not related to each other. So if one were to go down and I had to sell it, the other did not or perhaps even went up in price.
What do I mean by not related?
What I mean is two different assets that have negative correlation. If you are not familiar with the term, it just means when one moves in one direction, the other moves in the opposite direction.
The most popular example that investors and pundits talk about is safe haven assets like gold. The reason they are called “safe havens” is because they perform very well during most crises. Here is an example to illustrate.
S&P 500 ETF SPY vs. Gold ETF GLD
Here is the return of the popular S&P 500 ETF SPY compared to gold ETF GLD from Jan 01, 2007 to Jan 01, 2010, capturing the years of 2008 financial crisis.
While S&P was falling like a knife, gold kept on going up. For the 3 year period, GLD returned 69% while SPY lost 21%.
Here is more examples of how different assets correlate to each other, not just during crises.
Coming back to Oil & Gas example, if you only put your money into one thing, then yes, it may very much feel like gambling.
Investing is a long term endeavour
Is investing in stocks like gambling? Not if the investment lasts for just a few seconds. When you gamble, the process that will tell you whether you made money or lost money can literally last a few seconds.
Investing is a long-term endeavour. However, there are people that trade some stocks for split seconds at a time, called high-frequency traders. I do not consider them investors, and they should never be confused with investors.
When you invest, you purchase assets that are designed to deliver you sustainable results if you plan everything right.
Over time there are two things at play here that work tirelessly for us:
- Compound interest
The ability to earn interest on the interest we already earned.
- Business growth in one of the best economies in the world
The simple fact is that over time businesses grow and create Value. Not all, of course, but many do. Markets continue to innovate and create new businesses. The good thing is that we don’t even have to handpick them. We have the ability to invest in the market as a whole, and as long as the economies keep producing and growing, we can expect to see positive returns over the long term.
Read related: Why do stocks increase in value? – Alterna Invest
Investing is buying businesses, not stock tickers
What do we buy when we purchase the most popular ETF in the world, SPY? Are we buying some magic three-letter digital asset, called S.P.Y? No, we are buying a fund (Exchange Traded Fund) in this case that invests in actual businesses.
Here are the sectors we invest in when we buy SPY.
And these are the top companies:
That means, that when these businesses grow, innovate, create new products, benefit society in some way, we get to be part of that action. As the earnings of these businesses go up, the prices will follow.
Expected price increases will also not be linear. Price to Earnings multiples tend to fluctuate. When earnings go up, price to earnings multiple can go up at a quicker pace because on top of fundamentally good results, investor emotions kick in and they push the price further.
Investment loss is only a loss when we sell
When we gamble in a casino, the money we put up goes out right away. Once you lose, there is no way for you to get the money back without picking a fight with the dealer or a casino, which is a sure way to end up in jail 😃.
That is not the case with your investments, however. Just because the investment went down, that doesn’t mean you lost money, it only went down on paper. To solidify a loss, you have to then sell it at a loss.
After we make the investment, it is unlikely it will be smooth sailing. Stock prices fluctuate every day the markets are open. Those fluctuations don’t mean anything to us.
Read related: Best way to deal with volatility? – Alterna Invest
The best way to handle volatility in investing is by ignoring it or taking advantage of it.
- Ignore Volatility
If your investment is with a Robo-advisor or a DIY portfolio that is designed to be invest and forget then the best thing you can do is to just ignore volatility. Stop checking prices every day. Do not bookmark your broker or Robo-advisor’s site. Try to visit them less frequently. That’s why it is crucial to understand what to expect from a portfolio, so you don’t worry about it every day.
- Take advantage of volatility
If you invest in individual stocks and the price goes down due to volatile swings, it can be a great opportunity to buy the stock you want to own at a lower price. Unless the fundamental position of the business changes negatively, I always welcome price declines. The lower the price I pay, the less risky the investment becomes and the higher the return expectations.
There are no gambling billionaires
Gambling is a loser’s game. Math is clear on this, you can win from time to time but over the long period of time, it is certain that you will lose. Stock market, on the other hand, produced numerous billionaires. Luck definitely played some role, but if you look at somebody like Warren Buffett or Seth Klarman or Michael Burry, their extraordinary results can’t all be attributed to luck.
You simply cannot attribute annual returns of 19% for 50+ years to luck.
It is possible to gamble with stocks
So gambling and investing actually have almost nothing in common if you actually invest. However, it is quite possible to gamble with stocks. In 2021, it has been a big problem with Reddit creating a group of institutional gamblers. They gamble on stocks by taking out risky positions that are binary in their nature. Because Redditors tend to use option contracts, they gamble with things that either make them money or produce a 100% loss—basically a roulette table. Although the community presents itself as gamblers, they admit it, I still see the tremendous damage that it does for beginner investors.
Younger people who discover investing through these forums don’t know how to set realistic expectations. They expect quick wins and little losses. Worst of all, these communities almost encourage borrowing to execute trades which financially is the dumbest thing a new investor can do. Will some of them make a lot of money in record-breaking times? Absolutely. But we have to remember the vast majority who will lose everything they invest.
The good thing is, investing doesn’t have to be this way. If you are careful enough, if you diversify and do good due diligence, you have to expect positive results.
Happy Investing & not gambling!