Is Investing The Same As Gambling?
Investing can take many forms, but it typically involves buying an asset for less than it is worth. Regardless of the form the investment takes, when determining the value of any asset it is important to think probabilistically – that is, acknowledging that there are many possible outcomes that can eventuate in the future.
Furthermore, each of these outcomes most likely has a different probability of occurring. So if investing involves making decisions about future outcomes, supported by an assessment of the likelihood of these outcomes transpiring, one might naturally start to draw parallels to gambling. Doesn’t gambling similarly involve making decisions based on a range of possible outcomes?
The truth is that there are numerous similarities between investing and gambling. For example, both pursuits involve putting capital at risk with the aim of generating a profit. Furthermore, both require decisions to be made under uncertain conditions where there is a spectrum of possible outcomes. No one knows for sure which outcome will occur, but it is possible to conclude that some outcomes are more likely than others. However, despite these similarities, there are a number of major differences between investing and gambling which give your author comfort that he did not make a career mistake when choosing investing as a profession.
Hard works pays off
A key difference between gambling and investing is the degree to which diligence and effort can give the decision-maker an advantage. Although there are many forms of gambling – whether it be casino table games, slot machines, sports betting, or otherwise – the gambler typically starts at a disadvantage due to the “House Edge”. For example, a casino will establish the House Rules such that over multiple rounds, the laws of probability will ensure that the casino always wins. This is a mathematical-advantage built into each play such that by playing more rounds, a gambler increases the likelihood that they will lose against the House. Slot machines are a key example of this, with some machines rigged for players to lose an estimated $25+ for every $100 they gamble over a long enough period.
In contrast, investors are able to judiciously research companies, generate insights that other market participants may have missed, and make investments only when the odds are stacked in their favour. Despite the risks being fluid in investing, whereby they are constantly changing, investors have a greater opportunity to take well-calculated risks, and can selectively invest in companies where the upside materially outweighs the potential downside.
Investing also features the absence of a requirement to correctly pick the precise future outcome. Unlike gambling, where you only get paid if you correctly call the outcome (e.g., picking the winning sports team or rolling a six), investments can be made at prices that provide a margin of safety to safeguard against errors in the analysis. The future is uncertain in investing, but by buying stocks at low prices, investors can afford themselves leeway to still profit even if future outcomes turn out to be less sanguine than initially expected.
Skill and effort can give investors an advantage in investing, and this is something that cannot be replicated in the majority of gambling activities. It should be noted, however, that in investing the role that skill plays diminishes when the time period over which returns are measured is shortened. As such, a sufficient time period must be adopted by an investor so that their insights can be recognised by the market and ultimately reflected in the share price.
Loss-mitigation possible in investing
Investors, in addition to being able to benefit from hard work and robust analysis, also have more loss-mitigation options at their disposal than gamblers. Consider a gamble that pays off if your favourite sports team wins the game. The outcome is binary; the team either wins or loses. If the team loses there is no way to salvage the capital you wagered in that bet and you lose the entire sum that was gambled.
In contrast, investing your capital in a stock gives the investor significantly more flexibility and choice in mitigating losses. For example, if new information comes to hand which undermines the investment thesis underpinning the stock, the investor can choose to trim or completely exit the position, avoiding a complete loss of capital. It is clear that the ability of an investor to reassess the risk profile of an investment in light of new information, and use their discretion to make any necessary changes to the portfolio, is an important facet of investing and not a luxury afforded to the gambler. The stocks in the Montgomery Global portfolio are liquid securities, such that we can exit a position with relative ease if the investment case changes.
Time is on the side of the investor
Gambling is a time-bound activity, given that a final outcome is determined at the end of each play. Once the game is over, the outcome of either winning or losing money is decided and cannot be reversed. Investors, in contrast, are able to weather short term share price volatility, and are likely to be rewarded over the long-run if the underlying businesses grows. This is particularly true for businesses that are referred to as “compounders” – that is, companies that are able to reinvest their earnings at high returns on invested capital. Time is the friend of these businesses, and they are capable of producing immense wealth for investors when held for the long-run.
It is worth remembering that investing involves buying a slice of a business. Stocks are not just pieces of paper with quoted prices that fluctuate on a daily basis. Rather, they are claims over the earnings and assets of a business. This is not the case for gambling. In gambling, you are risking capital but you don’t end up owning anything enduring as a result, just a promise to profit if an outcome eventuates. In addition, the gamble involves unpalatable downside risk, given that if the desired outcome fails to emerge you lose all of the money you put forward.
Despite the superficial similarities between investing and gambling, there are marked differences that remind us that a sensible investment approach, carried out with discipline, is likely to yield superior results over the long-term. Failing to adhere to a tried-and-tested investment approach amounts to mere speculation, and the less diligence with which investment research is conducted, the more the purchase of that stock begins to look like gambling. The Montgomery Global team seeks to apply a proven investment process to uncover stock candidates with risks that are significantly skewed in our favour. In doing so, we aim to maximise the chances of both preserving and growing the capital we have been entrusted with by investors.
Roger's step-by-step guide to valuing the best stocks and buying them for less than they're worth, Value.able, is available exclusively at rogermontgomery.com. Skaffold is an online stock-picking application that rates ASX-listed stocks from A1 to C5. Watch a demo of Skaffold at www.skaffold.com.