Investing vs Gambling: Do you know the difference?

By Mark Story | More Articles by Mark Story

Given the great flexibility and liquidity they offer, along with the added bonus of dividends and their history of repeatedly outperforming all other assets classes (including property), it’s hardly surprising that 74% (6.6 million) of Australia’s 9 million investors hold stocks (shares) or other on-exchange investments. However, while Australians have a growing love affair with stocks, the reasons why they’re boarding the ‘equities train’ with growing alacrity are diametrically different.

The beauty of investing in the stock market is that you can still be a successful investor, regardless of whether you’re defensive, balanced or aggressively chasing growth. But if you don’t know what type of investor you are, or what your strategy is, you risk buying (and selling) stocks for all the wrong reasons.

It’s true, the advent of Covid has made it trickier to work out what camp you belong to, but given the heightened market risks it’s time to find out.

The tale of two investor cohorts

Nowhere in Australia’s past have the core drivers of stock ownership been as polarised as they have been since the Covid outbreak early in 2020. The Coronavirus era has widened the gulf between those buying stocks based on a company’s fundamentals – notably on financial performance based on core underlying earnings – and those buying stocks purely on the expectation that positive momentum will continue to drive the price higher.

Admittedly, the stock market has always attracted people taking a punt on prices continuing to go up. But the emergence of the Robinhood trading brigade last year in the US effectively turbocharged the speed at which seemingly intelligent people were crossing the Rubicon between investing and gambling.

In the pre-Covid world, those buying and selling stock typically fell into one of two camps.

Firstly, there was the old-school: value investors painstakingly attempting to buy stocks at a discount to their true value (intrinsic value) using key fundamentals indicators like price-to-earnings ratio, net-debt to equity, and price/earnings-to-growth (PEG) ratio, to name just a few; and typically adopted a ‘buy and hold’ strategy.

The rationale underscoring value investing (or investing based on fundamental indicators) is the expectation that stock price and value will eventually converge. Trouble is, within the Covid world value investing had been seriously eclipsed by momentum trading into the direct beneficiaries of Covid, namely retail, healthcare and technology.

Then there were the chartists. This cohort typically comprised day traders who used signals and trend lines from charts to determine when to buy and sell.

While a lot of traders will buy and sell a stock within a few hours or days using candlesticks charts or similar, others are willing to let their profits run.

Amateur investors juiced up on Robinhood Kool Aid

Just like the Pied Piper, Robinhood traders have mesmerised a cadre of predominantly millennials (or younger) and highly inexperienced amateurs into believing it’s ok to take what little money they have and take a “let’s put it all on red” approach to buying stock.

With the fortunes of fundamental (value-based) stocks seriously out of favour due to Covid, Robinhood hacks were only too happy to throw a fist full of dollars at Covid’s darling stocks that were rising in price right before their eyes. Ultra-low (or sometimes none at all) fees charged by Robinhood trading platforms, plus the ability to trade fractions of stocks (like Apple), was an extra enticement to pile on in.

To make matters worse, Robinhood traders began to aggressively spruik the fortunes of preferred stocks, and their army of gullible disciples were only too happy to drink the free Kool Aid on offer. Without putting too fine a point on it, Robinhood trading is gambling by any other name, and the old axiom “The house never loses” applies as much to Robinhood trading platforms as it does to Sportsbet, Crown Casino or the Melbourne Cup.

From sideshow to disrupter

The not so funny corollary to the rise of the Robinhood platform is its meteoric assent from sideshow to the point where it started having a material impact on markets. For example, Credit Suisse estimates that at times this year amateur traders have accounted for a whopping one-third of all US stock market trading.

As we found out earlier this year, the “Robinhood factor” on markets can be immense. For example, the impact became highly evident when failing US-based bricks and mortar games business, GameStop (NYSE: GME) got embroiled in a crusade by Robinhood investors on social media site Reddit to teach institutions shorting the stock a lesson they’ll never forget.

So much so that asset managers – who now realise the impact low-value, high-volume traders can have on the market – will think twice in future before opening shorts.

Another nasty fallout from Robinhood trading is the damage being inflicted on young amateur investors, many of whom got their fingers badly burnt. Clearly, when amateur investors share a wealth of ideas on social media, based on hearsay, fear, greed and media hype, no good can come of it. The other point to note here is that the objective for getting Robinhood cohorts to buy GameStop had little to with acting in the best interests of their members.

But if that wasn’t enough to rattle Robinhood investors, more recently they’ve encountered the rotation out of “reopening” stocks – including the tech stocks they blindly threw their money at – back into deep-value stocks that were overlooked during the worst of the pandemic.

Unsurprisingly, the three-fold jump in retail broking accounts and trading volumes over the pandemic period triggered both ASIC and the Reserve Bank to warn retail investors about the potential pitfalls of stock market investing.

Tell-tale signs: Investing versus speculating

While all investors want to grow their capital, it’s important to remember that investing and speculating are two totally different beats. Unsure of why you’re buying stocks and for how long? Chances are you’re default gambling.

Here are some pointers to help you determine which camp – investor or gambler/speculator – you fall into.

For starters, investors will typically hold stocks over a pre-determined time horizon. That’s because stocks are by nature risk assets which typically deliver better returns over longer timeframes. Sure, many investors like to have a speculative investment bucket, but this typically would account for only around 5% of a total portfolio.

The benefit of holding a diversified basket of both defensive and growth stocks is that those going up in value will offset those that aren’t, thereby smoothing out your returns over time. Then there are the added benefits of owning stocks for over 12 months, which in Australia reduces your capital gains tax (CGT) to 50% when you sell for profit. Would the Robinhood crowd even know this?

By comparison, those who “buy the stock price” and not the underlying company are, whether they realise it or not, gambling. This means the stakes – potential for loss – are a lot higher. For amateur Robinhood investors, the risks of paying over the odds for one or two highly overvalued stocks are even greater.

Bottom line is, if you approach the stock market like it’s a casino, placing your bets on red or black, then your chances of a successful investing career are greatly diminished. However, if you view the stock market as a place to pick top stocks, acquiring businesses that are run by honest and high performing managers and implementing a sensible portfolio risk management strategy, the opportunity to build your wealth over the longer term is vastly improved.

Understand why you’re investing

Remember, investing blind is a dangerous game: sooner or later it’s going to catch up with you. Admittedly, having a flutter at Randwick can be fun. But taking the same approach to buying stocks is not an investment plan, and everybody, regardless of how much (or little) they have to invest, should have one.

Before devising an investment plan, it’s important to have an accurate picture of your cash flow, including income, regular outgoings – especially any discretionary spending – and your capacity to save/invest surplus money. Sage advice from US investing guru Warren Buffett suggests spending what is left after saving, as opposed to saving what is left after spending.

Remember, all good investment plans will have one aim in common: wealth accumulation over time. The right investment plan for you will depend on a myriad of factors – most importantly your age, earnings and existing assets – which have a direct bearing on both your investment time-horizon, and risk/reward profile.

There’s no shortage of data to prove convincingly that investing in stocks over time returns in spades. For example, based on Vanguard data, $10,000 invested in US or Australian stocks in 1990, would by 2020 have returned 10.3% ($189,350) and 8.9% ($129,073) respectively. The next best returning asset classes were listed property (7.8%), Australian Bonds (7.7%), international stocks (7.3%) and cash (5.1%).

Do your homework before dipping your toes in the stock market, and never buy stocks on tip-offs or unsubstantiated rumours. And while it’s important to stay “in the market”, that doesn’t mean buying stocks and parking them in the bottom drawer indefinitely.

The wakeup call for value investors is that in an environment where volatility is the “new norm”, a buy and hold approach may need to give way to a strategy for actively managing stocks. So stay alert to what the market is telling you.

Hallmarks of a gambler versus investor
Gambler Investor
Buys stocks purely on momentum. Research stocks before buying, and often seek professional advice.
Tend to rely on hearsay and media commentary. Tend to view stock ownership as a long-term commitment.
Are over optimistic and driven purely by sentiment. Will own a diversified basket of stocks.
Have no investment plan and a cavalier approach to losing money. Try to buy stocks trading at discounts and/or with significant upside yet to be factored into the current price.
Run from one hot theme to the next, and are typically over-exposed to the fortunes of one or two stocks. Buy stocks on fundamental indicators, like underlying earnings on core business activities.
Have the mindset of racetrack betters. Try not to buy falling daggers.
Typically buy stocks when they’re seriously overpriced. Understand the value of diversification, and time in the market.
Have a limited understanding of the share market, and tend to be more financially illiterate. Will know when to lock-in gains.
Typically don’t know when to exit. Recognise that total returns come from both income and capital gains.
Tend to have much shorter time horizons. See stocks as part of an overall long-term wealth accumulation plan.

 

Mark Story

About Mark Story

A former editor, columnist, and chief reporter on business and financial publications across NZ, Australia, Hong Kong and the US, Mark operates Prime Strategy Media. He divides his time between share market commentary and analysis, B2B, financial, mainstream media, and high level content and strategy for financial institutions.

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