Over the years, I have heard people compare investing to gambling. It normally occurs during periods when the stock market is experiencing negative returns. People will make comments comparing investing in stocks to casino gaming. Those who market alternative investment products will use heavy rhetoric and refer to conventional investments as the Wall Street Casino.
There are a few similarities between investing and gambling. Investing and gambling both require money. Both can be profitable. Both can cause you to lose money. Both require consideration. Gamblers and speculators who trade frequently will look for favorable odds and try to come up with their own strategy to capitalize on what they think is a sure thing. That is basically where the similarities end.
Gambling is a game of chance. Gambling is based on greed. It involves a wager on an uncertain outcome. Gambling comes in many different forms. A gambler can bet on a sporting event like a football game or horse race. Gamblers can play cards, roll dice, spin a roulette wheel, or play other casino games. Buying lottery tickets is also a form of gambling.
Some forms of gambling are legal and others are not. Betting on a horse race at a track like Churchill Downs is legal. Calling up a bookie to place a bet on the big game is illegal. The major difference between illegal and legal gambling is based on regulation and taxation.
One of the main differences between gambling and investing is that gambling is quite often based on immediate results. For example, the results from a scratch-off lottery ticket are known as soon it is scratched off. Some forms of gambling have longer waiting periods to know the outcome based on the results of a future sporting contest. With all gambling, once the results are in, the outcome is known.
Investing is not a game of chance. It is not a game of probability. Investing is based on being prudent. When you buy a mutual fund, it is not similar to hoping your number will come up when you roll dice. By the way, you have a 2.778% chance of winning at rolling two dice and the casino has a 97% chance of taking your money. Those are not favorable odds.
To invest in the stock of a company is to buy ownership in that company. That company produces a product or service. It is an entity that has financial statements and records. Those records generally reflect why the stock price is worth its current value.
A mutual fund or ETF is a basket of different stocks. By owning more than one stock in a fund, it helps to reduce risk and increase the likelihood of better returns. That is known as diversification and is based on the efficient frontier.
Diversification does not improve the odds when it comes to gambling. It does not matter how many times you roll the dice. The odds of rolling a pair of 6 sided dice will always be 2.778%. The best you can do to improve your odds with games of chance is a switch from rolling dice to flipping a coin. That would improve your odds to a 50% chance of winning.
Bonds can also be used to improve investment returns. When stocks go down in price, bonds tend to go in the opposite direction. Bonds are a loan to the government or corporation. Some are guaranteed by the government. They have a quality grade and risk associated with the term length. Generally speaking, the shorter the term, the less risk. Bonds are used for offsetting the risks of stocks or for income.
Stocks and bonds are also different from gambling when it comes to time. Gambling is bound to time. When the game is over, it is over. There is just one opportunity to win or lose with gambling.
When an investment such as a stock is purchased, the amount of time that an investor has to earn a profit is based on how long they own the stock. It can be a profitable investment for many years. It can also lose money, but recover and become profitable again. It is a time rewarding activity. That is why many financial experts suggest a buy and hold approach.
Another key factor that separates investing and gambling are dividends. Ben Carlson writes about this in his book A Wealth of Common Sense. By investing in investments that pay a dividend, investors are rewarded for putting their dollars at risk based on market performance. By holding on to a stock, a company will continue to pay a dividend. Dividends are a key factor for making money in stocks over long periods of time. There are not any dividends with gambling.
Investing also uses the power of compound interest. This is another time rewarding aspect of investing that does not apply to a one-time wager. For example, if you invest $100 and it has a 10% annual return, the following year the investment is worth $110. If the investment is held for 25 years and continues to have a 10% annual return, the final amount of money will be $1,205.
Not only are gambling and investing different, they are totally different. Every form of gambling is a game. It is a game of probability. The probability is always in favor of the house because of the vigorish. It is a one-time chance to place a wager that might have a payout.
Investing in stocks is a business transaction. It does not matter if you buy stock in a single company or buy hundreds of different stocks in a mutual fund. It is a business transaction because the investor is buying ownership in a company or group of companies. It is only a small fraction of ownership, but it is ownership never the less.
With investing, there are ways to improve performance and reduce risk. An investor can buy stocks that pay dividends. An investor can hold on to their investments and let compound interest work its mathematical magic. The short-term market risks of owning stocks can be offset by also owning bonds. By owning both stocks and bonds, an investor can rebalance their holding and always be buying low and selling high.
With gambling, the odds do not change. As I explained with the dice example, there will always just be a less than 3% chance of winning. The odds will always be in favor of the house.
During the next major market correction, you are likely to hear people say that you are better off taking your money to the nearest horse track or gaming parlor than to put it at risk in the stock market. Yes, in the short-term, investing in stocks can be volatile. Over the long-term, however, stocks are the greatest wealth building investment for the individual investor. When they decline in value, look at it as a buying opportunity. Gambling is based on a one-time event and the odds favor the house. As long as you invest wisely and have patience, the odds are far greater in your favor than by playing games of chance.
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