Investing and Gambling

by | May 25, 2003

Earlier this month, William Bennett — the high-profile Republican “morality” advocate — was outed in the media as a big-time gambler, a high-roller who made and lost millions in the casinos. There was the usual tempest in the public teapot, with Democrats attacking him for hypocrisy and Republicans defending him for having a right to […]

Earlier this month, William Bennett — the high-profile Republican “morality” advocate — was outed in the media as a big-time gambler, a high-roller who made and lost millions in the casinos. There was the usual tempest in the public teapot, with Democrats attacking him for hypocrisy and Republicans defending him for having a right to his own private and entirely legal vices. Now Bennett has foresworn gambling, believing that to continue now would be to set a bad example for the nation.

Why, exactly, is gambling — although now widely legalized in various forms around the country — seen as a “vice,” or sometimes even a “sin”? Is it any different from investing or trading? Aren’t they all just different ways of putting money at risk in the hope of making more money — and don’t gamblers, investors and traders all get some entertainment for themselves out of it, too?

Moral issues aside, I think these are important practical questions for investors and traders. There are plenty of people out there who probably now feel that a lot of the “investments” and “trades” they made in 1999 and 2000 were sheer gambling (and, in the end, not all that entertaining). How can serious investors and traders understand the difference — and protect themselves from indulging in mere gambling?

The central idea that separates gambling from serious investing or trading can be discovered in the old saying, “I’d rather be lucky than smart.” The essential distinction is that gambling isn’t smart, and depends entirely on being lucky — while investing depends on being smart (but being lucky never hurts).

More formally: Investing is putting your money at risk in the rational expectation that you will earn a return.

It doesn’t matter whether the money is at risk for a Warren Buffett-like eternity or for just five minutes in a quick day trade. What counts is that you weren’t just trusting to luck — you had a reason to think you were right, and to expect a payoff from being right.

A digression: Should short-term trading be called “speculation” instead of “investing”? No — “speculation” is a just a put-down that has no real meaning. The length of time doesn’t turn investing into something more like gambling, so long as you’re acting rationally. If the only difference between long-term and short-term investing is the length of the holding period, then let’s just call short-term investing “short-term investing,” because that’s what it is.

And just as holding period doesn’t matter, whether you win or lose doesn’t matter, either. A rational investment isn’t gambling just because you lost money on it. And a stupid gamble isn’t a smart investment just because you ended up winning.

What does matter is that you put your money at risk rationally — that you have a reason to believe that you’ll earn a positive return. And it doesn’t have to be old-fashioned Graham and Dodd-style rationality. You could invest in an index fund having done no research at all, or for that matter you could pick stocks by throwing darts at The Wall Street Journal — neither of those would be gambling if you did them because you had a rational belief behind them — that all stocks, at least on average, will go up over time.

Gambling is putting your money at risk in the hopes of earning a return, but with no rational basis.

State lotteries are a perfect example of pure gambling. You know that the odds are stacked against you, because only about half of the money contributed is paid out to the winners (the rest is the “house take”). And there’s no possible way you can apply any knowledge or skill to make your odds any better. But you buy a ticket anyway because you just hope you’ll win — and perhaps you tell yourself that the worst thing that can happen is you’ll lose a dollar, while you might win millions.

Poker, on the other hand, isn’t gambling. If you’re a skilled player, poker is investing because you put money at risk with the rational expectation of earning a return. Even if you’re an unskilled player, the possibility of becoming skilled through study or experience is always an option for you. If you choose to remain unskilled and play anyway, then you treat poker as gambling — but that doesn’t make the game itself into a gambling game.

Investing and trading are like poker. Even pure guts-driven day trading can be a form of investing. Buying a hot mo-mo stock just because you feel it’s going to go up in the next five minutes can be considered investing if you have a good reason to think that your feelings are valid, such as a track record of success for following your feelings. If you find that following your feelings consistently loses you money, then persisting in it isn’t investing; that would indeed be gambling for you, even though day trading itself could be a form of investment for someone more skilled at it.

There’s one factor that can transform investment to gambling: costs. Suppose a poker game were sponsored by a casino that collected a large fee from every player for every hand that was played. If this fee were large enough in relation to the amount of money being wagered, then even though any player might still hope to win by luck, even the most skilled player would not rationally expect to win. The costs will eventually kill you.

The impact of costs on investing and trading aren’t trivial, as advocates of index funds have pointed out so effectively over the years. Today’s online trading commissions are indeed low, but every time you trade you rack up another commission cost. If the cumulative commission costs are greater than what you can rationally expect to earn from your investment or trading skill, then you’re gambling — you’re just hoping to get lucky beyond your skills and overcome the costs. That means that part of the skill of a good investor or trader is to control costs, to execute only the trades that really need to be made and avoid the ones that don’t really matter.

So here’s my advice to Bill Bennett: Take up investing. Online brokers can’t afford to pick you up in a jet and buy you front-row seats for Celine Dion. But it’s a great game, and a rational one. If you get good at it you could win. And for the moralist in you, you could have the satisfaction of knowing that your invested capital is helping America to grow.

Shall we deal you in?

First published on SmartMoney.com.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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