Is Trading or Investing Gambling?


Q.: Is trading/investing gambling?

A: The very word, gamble, means (one of its definitions) to take a chance on; venture; risk. Therein lies the similarity between gambling and investing or trading; all come with an element of risk. For one thing, if you have a sum of money available to invest, you have risk whatever you do with it. Even if you leave it idle and don't put it into anything, you will still experience inflation risk.

Thus, it would be better to describe the financial industry as a form of risk management. The entire world of business and financial services is based on risk versus reward. Could (the enterprise) make more money freeing up resources to inject into another activity versus the current risk/reward associated with the current investment? Point is no one gives anything away for free! The risk/reward relationship means that in order to compensate for higher risk, for instance with a smaller company, you can expect a higher return.

 

While some would say there is very little difference between CFDs and gambling the ATO did beg to differ. According to the Australian Tax Office: 'CFD trading requires a high degree of skill than mere luck or chance and therefore is not comparable to gambling'. The ruling does not anticipate a 'gambling' outcome in most CFD trading.

What is gambling?

Staking money on the flip of a 'true' coin is definitely gambling. With pure gambling you put up a stake with no certainty of return: and generally the odds in the long term are biased towards the house, otherwise casinos would be out of business.

Staking money on a horse racing competition after doing some background checks is also gambling (although may improve your odds if you do your background research well).

Putting a copy of the sporting pink (FT), The Wall Street Journal or another financial investment paper on the floor and throwing darts at it and investing in the securities you 'hit' is also gambling. A point worth noting here is that investments don't generally become worthless (as opposed to a lost wager); they are simply continously re-adjusting in value according to the information available at the time. Thus if you are randomly selecting companies to invest without doing any real research, logic follows that you are effectively gambling.

Doing lots of background and putting money into companies you feel have good potential may be also gambling to some extent, but I like to call it investing. In this context the professional punter who makes a living betting on horses at a betting exchange is much more an 'investor' than the average Joe who punts on the price of Microsoft stock because he 'has a hunch'. Thus, the real distinction between a gamble and investing is not dependent on the asset or outcome but on the degree of analysis, skill and intent.

If you want to know that investment/trading is the game of expectancy, it will be good to read Dr. Tharp's 'Trade your way for financial freedom.' And Dr. Elder's book 'Come into my trading room' mentions of an 'intellectual gambler' who can compute the expectancy of the gambling game, very-very coolly... But in the business of trading the most important thing is not calculating expectancy, but money management, which for example Dr. Tharp calls 'position-sizing'.

All in all I would say that the stock market definitely has traits that are similar to gambling, but there are other dimensions as well. For one managing risk in gambling is not so easy; for instance a person playing roulette could 'guarantee' picking a winner by playing all numbers on the wheel. The problem is that there are 38 numbers and the payoff is only 36 to 1, so while a payout is guaranteed, he still loses each time a spin is made. But with trading you can position size and you can invest in diverse asset classes to lower your risk and still end up ahead. Moreover, when you gamble at the a casino, the odds are against you or at best close to breakeven with the house in a slight advantage. In contrast when you day trade you are using tools in an attempt to put the odds in favor. To get this into perspective imagine playing blackjack, and you only had to bet after checking what cards you got. Plus, before betting, you got to take the cards that have already been played and analyse and graph them. You would probably do pretty good that way huh. Isn't daytrading somewhat the same thing?

Also, shares is not like buying lottery tickets meants to be scratched and dumped away. A shareholding represents fractional ownership of a real enterprise. Thus, it is best to focus on strong stocks that are selling for less than their intrinsic value...as these shares are more likely to outperform in future.

Even investing and speculation are different with investing tending to focus on fundamentals and sustainable growth (i.e. Hussman, Shiller, Buffet...etc.); if you buy into an enterprise you really expect it to increase in value depending on various events, that might take place. On the other hand speculation is more about momentum trading without necessarily understanding the fundamentals; and unfortunately there are plenty of speculators who don't really have an idea what they're doing, but then the market needs donors... However, all those diverse market participants with very different agendas make up the market; from investors who have a 20-year time horizon to short term day traders who are only looking at a couple of days holding; they all are in to make money, but the way they go about it is very different, and thus the market is thus very dynamic.

For me it's gambling if you are:

Risking more than you can lose.
Taking time away from other things you should be doing (work, family, etc.)
You are impulsive about decisions and compulsive about the behavior.
You are hiding your trading activities from your employers, or spouse, etc.
You lie to yourself or others about how much you lose, etc.

It also depends on how you approach it - if you approach stock trading as a gambler, then obviously for you it is gambling. Being a trader myself I can honestly say that some of the greatest windfalls have come from what others might perceive is just plain luck, giving support to the intelligent gambling hypothesis. The trick is to be exposed to luck which is not as easy as it sounds. For a good read regarding this subject can recommend 'Fooled by randomness' and 'The Black Swan', both by Nassim Nicholas Taleb. In a nutshell on can say that chance favors the prepared mind.

'Anyone who trades in a share, bond or a commodity for profit is speculating if he employs intelligent foresight. If he does not, he is gambling'. I have no problem in accepting that I am trading an uncertain outcome on each trade but I manage this with my view of the market and a "system" that has a positive EV - that is a difficult thing to accept because our brains are not wired for 75% this and 25% that outcomes, we like certainties.

Little quote from Nassim Nicholas Taleb:

Consider a bet you make with a colleague for the amount of $1,000, which, in your opinion, is exactly fair. Tomorrow night you will have zero or $2,000 in your pocket, each with a 50% probability. In purely mathematical terms, the fair value of a bet is the linear combination of the states, mathematical expectation, ie the probabilities of each payoff multiplied by the dollar value at stake (50% x 0 and 50% x 2000 = $1,000). Can you imagine (visualize) the value being $1,000? We can conjure up only one state at a given time, ie either 0 or $2,000. Left to our own devices we are likely to bet in an irrational way, as one of the states would dominate the picture.

Is crossing the road gambling? Yes, you can apply some probability to it somewhere but you manage the process with a form of risk management that you were probably taught as a kid.

Is buying a house gambling? Yes, but many don't manage the risk so well. They may manage things like their payslips, the payments, the bills, but they are open to the market fluctuations. They have other concerns like a roof over their heads.

Is cooking chicken gambling? Probably. I could go on. I'm not sure I want to apply a mathematical EV calculation to my next Chicken Korma dish.


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