Investing Is Not Gambling But It Sure Can Look Like It

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.

Source: Wizard of Odds; Second column is House Edge; Third column is standard deviation or “bankroll volatility”; Note that expected value and standard deviation (volatility) are also building blocks of Modern Portfolio Theory!

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:”

Source: J.P. Morgan Asset Management

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:

Source: Attain Capital via ValueWalk

The turkey doesn’t realize it until it’s too late, but she is playing a negative expectation game. So are volatility shorts…

Source: Google

…and certain hedge fund managers…

Source: Wikipedia

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.

The Notion Of The US Total Market Portfolio Is Redundant And Really Kind Of Silly

Today I am going to channel my inner Cliff Asness and demonstrate why it is more or less irrelevant whether you own a Total US Market index fund or an S&P 500 index fund. Intuitively, the reason for this is straightforward:

Since a Total US Market index fund is market capitalization weighted, it is dominated by the largest companies. The largest US companies are all included in the S&P 500. Hence, S&P 500 stocks drive the overwhelming majority of the return of the total market portfolio.

If you trust me, you can stop reading here. If you would prefer to see some supporting data, read on. Fair warning: it gets wonkish rather quickly.

Statistical Evidence

I used Portfolio Visualizer to run regressions on two widely held index funds using the Fama-French Three Factor Model. The model fits the index funds extremely well as evidenced by the respective R^2 values of 99.7% and 99.99% (this means the model explains over 99% of the variation in returns over the time time period analyzed). One regression was for VTSMX and the other for VFIAX. Below is the output:

Source: Portfolio Visualizer
Source: Portfolio Visualizer

The key numbers are in the Loading column. Do a quick visual compare/contrast. See how they are almost identical? That is because at the end of the day, when you own the market portfolio, most of your money is invested in S&P 500 stocks (you can verify this using the actual portfolio holdings if you want).

This is further underscored by Portfolio Visualizer’s performance attribution analysis:

Source: Portfolio Visualizer

In the attribution table, SMB means “the return you got from investing in smaller companies” and HML means “the return you got from investing in “cheap” (value) stocks versus “expensive” (growth) stocks. The total market fund earned basically no return from exposure to small companies over this time period, while the value/growth stock exposures are so similar as to be irrelevant.


The market cap weighted total US market portfolio does not provide a meaningful exposure to small company stock returns (or a meaningful tilt to value or growth stocks–a non-issue for the purposes of this post).

Put another way, in statistical terms, the total US market index behaves nearly identically to an S&P 500 index fund.

For people who are knowingly overweight US large cap stocks in the form of the S&P 500, I’ve got nothing to argue with you over. This bet has worked out pretty well over the last couple of decades. Maybe it will keep working (there are a lot of great businesses in the S&P 500). Maybe it won’t keep working (a lot of those companies are richly valued). Anyone who claims he can handicap future market returns with any degree of accuracy is an idiot or a liar (possibly both).

For people who are naively overweight US large cap stocks in the form of the S&P 500, I have this to say: like it or not you have made a bet on a particular market segment. Admittedly, these are high quality companies and the underlying revenue sources are globally diversified. However, the valuation risk is not necessarily very well diversified. Something like 20% of the portfolio is invested in FANG stocks (that’s an off-the-cuff number).

My point here is not to say definitively that the S&P 500 is a bad place to be invested. No one knows what the next 30 years will look like.

Rather, I am making a philosophical point about asset allocation. Namely, when you “passively” allocate assets predominantly to a market cap weighted US total market portfolio, you have implicitly made an active decision to concentrate your risk exposure in US large cap stocks. Only about 50% of global equity market capitalization is located in the US. If you truly believed in the logic behind a capitalization weighted total market portfolio, you would obtain all your equity exposure via something like ACWI.

However, I have yet to meet anyone who does this. Or any financial advisor who recommends it.


(a good subject for another post)

“The Last, Best Order”

There is a neat post on Redfin’s blog. It is the CEO’s “IPO diary.” Read the whole thing for a fascinating look at the process from the inside. A couple of sections really resonated with me:

Masters of the Universe
In other ways too, the roadshow had the feel of a bygone era. For example, almost everyone on the buy-side we met that week was a man: in one group lunch, all 24 of the portfolio managers in attendance were male. We may have met more portfolio managers who were Israeli special forces veterans than women. I asked our bankers how long it would take the first one to kill me with his bare hands.

Almost all of them took notes on tablets. Some of them tried to look up as you spoke, but with their eyes focused on nothing except the numbers in their head. They weren’t just capturing the highlights of a meeting; it was a nearly verbatim transcription of what we’d said, so we could be held accountable for it later. Information in every form is the currency of Wall Street, and drops of it never seem to fall on the floor.

Chess with Bobby Fischer
Most of the fund managers were exotically, obviously smart. Except for one person who fell asleep in a meeting, none of the fund managers we met was anyone I’d want to be on the other side of a trade with, buying what he sold, or selling what he bought. This is what I realized I had been doing my whole life as an E-Trade stock-picker; it had been like challenging Bobby Fischer to a game of chess. I spent a long time that first week trying to judge whether it made sense to have so many brilliant people decide where our society allocates capital, as opposed to making cars or software or hospitals.

The Last Ideology-Free Realm
What impressed me most about these people was their willingness to change their minds. No one in our society seems to change her mind about Donald Trump or Hillary Clinton based on a new fact, but a fund manager on the wrong side of a bad trade has to change her mind in a moment or lose her job. This is why investing is the world’s last ideology-free realm. It would be easier to accept the premise that our society can’t agree on one version of the truth anymore, about whether temperatures are rising or the economy is growing, except that’s exactly what happens when every public company reports its earnings every quarter. You can believe what you want to believe, but not with a million dollars on the line.

And, perhaps most interesting to me:

The Last, Best Order
One of my favorite meetings was with a Scottish fund manager in San Francisco. His firm was known for buying only a few stocks, and holding each for as long as a decade. In a hotel meeting room with enough prospectuses, pitchbooks, cookies, fruit, cheeses, crackers and popcorn for 30 people, he came in alone. And rather than rattling through twenty or thirty questions about our metrics, he just asked me why I ran the company.

I found myself talking about my older brother, who had died just before I became Redfin’s CEO, and the feeling I had then that my life so far hadn’t made the world a much better place. He asked me about whether Redfin’s sense of mission would survive our public offering. He didn’t write much down. His order was one of the last, and the best, to come in.

My aspiration as an investor is to be that “last, best order.” There’s a reason I classified this post under Finance, Investing, Learning and Values. There is some real insight here.

I Would Like To Be Reincarnated As An Italian Mutual Fund Manager

I met with a UK-based portfolio manager yesterday and our conversation eventually led to a fascinating discussion of the differences in distribution and compensation structures in the US versus Europe.

In the US, for example, we have well-developed retail distribution channels for financial products (wirehouses, RIAs, broker-dealers, banks).

In continental Europe, distribution is dominated by the banks. For many reasons, there is simply not much of a retail investing culture in Europe. The end users of UCITS (European mutual funds) tend to be very wealthy families with multi-generational wealth management needs.

While here in the US we are preoccupied with what a fiduciary standard for investment advisor conduct and compensation should look like, the discussion in Europe is much different (to the extent there is any discussion at all).

Which leads me back to the title of this post, and why I want to be reincarnated as an Italian mutual fund manager…

In Italy, the standard compensation structure for an equity manager is apparently a 2% management fee with a performance fee assessed monthly, but with no high watermark or preferred return hurdle (!!!)

That is to say, if you are an Italian fund manager operating under this scheme, you get a cut of the profits every month you post a positive return. Even if your clients are underwater on their original investments. It is a hedge fund manager’s dream!

(I know, I know, #notallhedgefundmanagers…)

I will close with this chart from Deloitte:

Source: Morningstar via Deloitte

Trolling Warren Buffett

So the annual Berkshire letter is out and Buffett could not resist taking another swipe at Wall Street over his bet with Protégé Partners. I am not going to re-hash the letter or the bet here. (Incidentally, I highly recommend giving this annotated version a read) Rather, I want to draw your attention to one particular bit no one ever seems to talk about:

Sources: Berkshire Hathaway; Safal Niveshak (highlight)

Am I the only person on the internet who believe this was a completely insane way to build a portfolio? Obviously, in the aggregate, the best investors can hope to do is match the market return, less fees (they can of course do considerably worse). It cannot be otherwise. There is nothing especially profound about the observation that it makes no sense to try and replicate the broad market with scores of active managers.

Fama and French demonstrated long ago that the aggregate portfolio of all investment managers more or less resembles the market cap weighted portfolio (read: an index fund, but with higher fees). Behold:

The high management fees and expenses of active funds lower their returns. If we measure fund returns before fees and expenses – in other words, if we add back each fund’s expense ratio – the α estimate for the aggregate fund portfolio rises to 0.13% per year, which is only 0.40 standard errors from zero. Thus, even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns. After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.

Adding insult to injury, the aggregate portfolio of active mutual funds looks a lot like the cap-weighted stock market portfolio. When we use the three-factor model to explain the monthly percent returns of the aggregate fund portfolio for 1984-2006, we get,

RPt – Rft = -0.07 + 0.96(RMt – Rft) + 0.07SMBt – 0.03HMLt + eit,where RPt is the return (net of costs) on the aggregate mutual fund portfolio for month t, Rft is the riskfree rate of interest (the one-month T-bill return for month t), RMt is the cap-weighted NYSE-Amex-Nasdaq market return, and SMBt and HMLtare the size and value/growth returns of the three-factor model.

The regression says that the aggregate mutual fund portfolio has almost full exposure to the market portfolio (a 0.96 dose, which is close to 1.0), but almost no exposure to the size and value/growth returns (0.07 and -0.03, which are close to zero). Moreover, the market alone captures 99% of the variance of month-by-month aggregate fund returns.

In short, the combined portfolio of all active mutual funds is close to the cap-weighted market portfolio, but with a return weighed down by the high fees and expenses of actively managed funds.

Therefore, in my view, Protégé’s failure was first and foremost a failure of portfolio construction. It’s totally fair to fault Protégé for this, just as it’s fair to fault many investors for buying into a collective delusion around hedge funds as magical assets* in the mid-2000s. To the extent Warren is underscoring that point, I wholeheartedly agree with him.

Beyond that, I don’t know the outcome of this best offers much insight into investment manager selection or the merits of investing actively. (See my Truth About Investing post for more on that subject) Warren Buffett did not get to be a billionaire buying index funds. Neither did Jim Simons. Or David Tepper. Or Seth Klarman.

Someone please sit down with Jim Simons or David Tepper or Seth Klarman or Howard Marks or any of the dozens of hedge fund managers who have trounced the S&P 500 over the past couple of decades and lecture them about the aggregate performance of active management. I would love to hear how it goes.

*  When I write about magical asset classes I am referring to any asset class or strategy people believe is inherently superior to others. In the mid-2000s investors clearly believed they could generate outperformance just by “being in” hedge funds. There are lots of reasons why aggregate performance has declined since then. First and foremost, hedge funds became victims of their own success as the space attracted large amounts of investor capital and many hundreds of talented money managers. Now that hedge funds are out of favor, the magical asset classes of today are private equity and venture capital. Also, hedge funds are not an asset class. They are a type of fund structure, just like closed end funds and mutual funds are types of fund structures. Similarly, you can argue that private equity isn’t a unique asset class so much as a levered investment in illiquid small caps and micro caps.

The Truth About Investing, Part II

(See Part I for the background on this post. As usual, none of this should be treated as financial advice as it does not take your personal circumstances into account. If you want advice, talk to a professional advisor. Trust me, there are plenty  of highly competent, ethical professionals out there who are excited to help you achieve your goals.)

After sharing the original post with some savvy friends, subsequent discussion stirred up some additional ideas for questions and answers. So here are some additions to our little Socratic dialogue.

So back to this active versus passive investing thing. It sounds like you are pro passive?

If I absolutely have to take a position, I would say most people are probably better off investing passively. Unless they happen to be really good at investing actively, of course.

Ugh. There you go again. But how can I figure out if I’m good at investing actively?

We can look at your returns 20 or better yet 30 years from now. That will give us a pretty good idea.

Double ugh. How can I know BEFORE I start making active bets? If I start down this path and it turns out I suck I may lose a lot of money.

You can’t know ahead of time. Don’t waste your time trying to “know” things that are fundamentally unknowable.

There are certain skills and psychological traits that may make you a better active investor than someone else. For example, skilled poker players typically make for good active investors. They intuitively understand expected value, probabilistic thinking and mental models for decision making under uncertainty. They understand the interplay between luck and skill in determining outcomes. Psychologically, they know how to handle a “bad beat” (or several) without blowing up. They are used to making calculated bets, and therefore also have an intuitive understanding of risk management.

If you are a good portfolio manager (you’ve got “poker skills”), you don’t have to be a great financial analyst to do well. The reason for that is that randomness plays a huge role in the markets (as it does in life). Thus it is more important in the markets to optimize decisions under uncertainty than it is to be “right” analytically. You still need to have an above average understanding of accounting, capital markets and basic principles of economic value creation to avoid making stupid, otherwise obvious mistakes. These things are easier to learn than “poker skills,” if you are willing to put in the time and effort.

Ultimately, if making decisions under uncertainty makes you queasy, I suspect you will have a difficult time investing actively.

That seems complicated and unhelpful.

Then invest passively. Or find someone you trust and respect to develop an active investing program suited to your goals (whether that is picking managers or individual stocks).

Okay. Let me try this another way. What I have really been asking this whole time is this: what is The Best Thing To Do?

There is no Best Thing To Do. There is only The Best Thing For You To Do.

So what does YOUR portfolio look like, big shot?

Approximately 70% of my investable net worth (ex-cash) is invested in actively managed strategies that should earn something like broad market returns over time. If I am lucky maybe a little extra. If I am unlucky maybe a little less. The remaining 30% is invested in a concentrated portfolio of individual securities with the goal of generating extraordinary capital appreciation over a multi-decade time horizon.

How do you know these managers will perform well over time?

I don’t. Honestly,  just try to put money with folks doing sensible things who I think will be good stewards of my capital over a multi-decade time horizon, and who I believe charge reasonable fees for managing my money. That frees me up to do the work I want to do on individual securities, which will potentially compound value at a much higher rate over time.

Why this 70/30 split? Why not just go all in on the stuff that you think will go up the most?

Because if 30 years from now it turns out I really sucked at this I will not have laid waste to my net worth or my family’s financial security.

Risk management, remember?

The Truth About Investing

I was inspired to write this post by a conversation I had this afternoon at a lunch event. I sat next to a gentleman who has been working in the capital markets for about 40 years. We were discussing active, passive and smart beta strategies. Our conversation revolved around the idea that much of what passes for investment strategy is an incoherent jumble of half-truths and gross oversimplifications. The reason for this is that investors are always looking for THE ANSWER. You can move a lot of product pretending to have it.


It is the magic asset, or strategy, or star manager that beats the market like clockwork. It is the alluring promise of “equity returns with less risk” (whatever that’s supposed to mean). It is the siren song that drew investors to hedge funds in the mid-2000s and draws them to private equity and venture capital today.

In reality of course there is no magical asset class, strategy, or manager. There is only the ever-shifting landscape of the capital markets. In capital markets, the only constant is change. Fortune ebbs and flows. Just when you think you have the game figured, the game will change. Count on it. George Soros calls this “reflexivity.” The game changes in response to how we play it. Don’t like it? Too bad. That’s America.

People do not like change. They especially do not like change of the reflexive kind. And don’t get me started on cognitive dissonance. Nothing wrecks Average Joe’s head quite like trying to hold two contradictory ideas in his head at the same time. Because people prefer order, stability, predictability and logical coherence, we as financial professionals tend to coddle them. We show them charts of historical capital market data and pretend it is meaningful. We make neat little graphs showing historical drawdowns and recoveries and emphasize that things always turn out okay in the long run. What we don’t give them is THE TRUTH. Most of them can’t handle the truth.

Because THE TRUTH is that there is no single ANSWER. There is only a long list of general principles in constant conflict with one another. And the reality is that sometimes things don’t turn out okay in the long run.

In that spirit, I will endeavor to answer some common questions as truthfully as I can. Note that as always, this is not financial advice. I have no idea what your personal situation may be. I am not in a position to be advising you to do anything. And anyway when you are through reading you will probably be more confused than when you started. Silver lining: you will be incrementally closer to understanding the truth about investing.

So here we go.

Is it better to invest actively or passively?

It depends on what you want to achieve.

If you are comfortable earning broad market returns, and you want to maximize tax efficiency and minimize costs, passive strategies are probably the tools you are looking for.

If your goal is to generate extraordinary capital appreciation, you must concentrate capital in equities with extraordinary compounding potential, and you must hold these positions for a very long time. Perhaps that means starting your own business. Perhaps it means owning a concentrated portfolio of individual stocks. Perhaps it means investing a significant portion of your investable net worth with a single asset manager. Warren Buffett didn’t get to be a billionaire buying index funds, no matter what he writes in his shareholder letters.

What if the broad market doesn’t return what it has historically and it ruins my financial plan?

Too bad. There is no law saying you are entitled to a particular return over time. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.

What if I can’t pick the right stocks/managers/business opportunity and I lose all my money?

Too bad. There is no law saying you are entitled to a particular return over time. However, if you are unwilling to devote a significant amount of time learning about business, accounting, capital markets and psychology, it is unlikely you will do well investing. Don’t be ashamed of that. It just means you will need to seek out professional advice, the way I sought out a coach when I wanted to change careers from writing to finance. You will be better for it in the long run, and contrary to what you read in the news there are many highly competent advisors out there who want to help you achieve your goals.

What if I can’t pick the right stocks/managers/business opportunity and I significantly underperform the broad market averages?

Too bad. There is no law saying you are entitled to a particular return over time. If you are that concerned about underperforming the broad market averages you should invest passively. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.

How do I know I am picking the best investment manager?

You don’t and you can’t. Don’t waste your time and energy thinking about this. If you go this route, focus more on avoiding the worst managers, and developing an investment discipline you can stick to over time, through thick and thin.

Isn’t it true that no one can beat the market?

The average investment manager will not beat the market over time, especially net of fees and taxes. However, that is the “average” and there are many talented managers who do outperform over the long run on a net basis. Unfortunately, most of the managers who outperform over the long run will suffer extended periods of underperformance, and most investors will not be sufficiently disciplined to stick around for the good times. In my opinion, picking managers is every bit as difficult as picking stocks. Perhaps even more so.

So if I am invested with a poorly performing manager I should just hold on longer until the good times come?

No. Poor performers often continue to perform poorly, and this poor performance is exacerbated by outflows of investor capital. If this persists for an extended period, it will render the asset manager’s business non-viable and the fund will liquidate, crystallizing your losses.

So how do I know if performance will turn around?

You don’t know. And you can’t.

Grrr… this is getting annoying. Fine. How can I try and figure it out?

Better, grasshopper. You are slowly learning to ask the right questions!

You need to understand the manager’s investment philosophy. You need to understand the way she looks at the world, the way she thinks about value creation and what she perceives as her “edge.” Is she focused on long run intrinsic value creation or the shorter term re-rating of market expectations? (Hint: when she models companies, does she use a discounted cash flow or earnings methodology, or does she compare price multiples such as EV/EBITDA to peer companies?)

You need to assess whether her portfolio is in sync with how the capital markets are trending, or whether she is a contrarian. If she is a contrarian, you need to assess whether and when the market will turn in her favor, and whether you can hold out for that long psychologically.

You also need to understand her investor base, the health of her business, the loyalty of her team and her personal goals. If she is losing assets and is motivated primarily by business success (versus “winning” at the game of investing) she will be more likely to liquidate (a.k.a return investor capital to spend more time and energy with family).

This sounds hard.

Why should it be any easier than mastering any other technical or artistic skill?

Well, I can trade commission free on Robinhood.

You can cook elaborate meals in your home kitchen, too. Yet you don’t expect your butternut squash risotto to earn three Michelin stars.

Thinking back on the first part of this conversation, I notice you repeat yourself a lot.

Is that so? Gee. Maybe there’s something to that…