I often meet people who conflate investing and gambling. Their confusion is understandable. There are many similarities between gambling and investing, but also important differences. As with most complex topics the devil is in the details.
How Investing And Gambling Are Similar
Both investing and gambling are exercises in decision-making under uncertainty. In both activities one places bets (takes positions) based on one’s appraisal of future expected value. Critically, both gambling and investing outcomes are subject to randomness. These are probabilistic activities. And therefore in both investing and gambling, it is difficult to disentangle luck and skill.
Professionals: let’s not kid ourselves. It is better to be lucky than skilled.
Another reason investing resembles gambling is that many people exhibit a preference for lottery ticket-like “investments.” Penny stocks and cryptocurrencies are excellent examples. People like to buy lottery tickets because the downside is small and well-defined, while the theoretical upside is very large. They say: “I’m just going to put $100 in BTC or this marijuana penny stock and maybe it goes up 100x.”
However, these individuals do not realize that many lottery ticket-like investments are, like lotteries themselves, negative expectation propositions. For example, some penny stocks and cryptocurrency ICOs are in fact fraud schemes with zero probability of success over the long run. Which brings us to…
How Investing And Gambling Are Different
Almost all casino games and lotteries are negative expectation games. That is, the odds are rigged against the players (in mathematical terms: the probability-weighted value of the payouts is less than zero). Were this not the case, neither lotteries nor casinos would last very long!
A casino underwrites risk in a similar way to an insurance company. Broadly speaking, the goal is to price risk in such a way that the insurance losses (gambler wins) will be more than offset by the insurance premium income (gambler losses) over long time periods.
In casino games, risk is priced such that if you play for an arbitrarily long period of time (let’s call it 1,000 years) you are all but certain to lose everything you bet. In other words, casino payouts are set so they do not adequately compensate gamblers for the riskiness of their bets. This is “the house edge.” In the United States, we actually use these negative expectation games as a regressive tax on the poor and uneducated, in order to fund certain social programs. You read a lot about social justice these days but one idea you don’t hear much is to outlaw lotteries!
Below is a table showing the house edge for various craps bets from the Wizard of Odds. As you can see, the best advice you can give to any craps player is to limit her bets to pass/don’t pass, taking the odds when the point is set (one of the best bets in the casino!), and maybe a place bet on the 6 or 8 to keep things interesting.
Investing, on the other hand, may or may not be a negative expectation game. Historical data leads us to believe investing is a positive expectation game (at least in the aggregate). If you have ever worked with a financial advisor, you have probably been told something to the effect that “in the long run the market always goes up” before being shown a chart like this one as “proof:”
However, by naively extrapolating from historical data we are subject to the problem of induction. To make the issue more concrete, consider Nassim Taleb’s graph of a Thanksgiving turkey’s happiness:
The turkey doesn’t realize it until it’s too late, but she is playing a negative expectation game. So are volatility shorts…
…and certain hedge fund managers…
Small wonder so many people believe investing, like gambling, is a negative expectation game. Indeed, it is entirely possible the long-run expected value of all our 401(k)s is $0.00. Try arguing to a Russian government bond holder circa 1917 that markets always go up over the long run!
So like the turkey, we will have to wait and see.