Tips, insights and information on general finance topics for better financial plans.
A lot of people’s first reaction to this question will be “what’s the difference?” It’s a fair question. Both involve putting money on some metaphorical or literal “table”, awaiting an uncertain outcome completely beyond one’s control, and taking back either more or less money than initially placed at risk. Some might counter that with investing the money is put to productive use and that in gambling it is simply put at risk using some randomizing mechanism (cards, a wheel, dice), but I really don’t think that’s the most important distinction to the risk taker as both instances involve uncertain outcomes regardless of the mechanism.
To a would be investor trying to execute a financial plan, there is a very important distinction to be made because you absolutely can use the stock market or other investment vehicles exactly like a gambler uses a casino. This runs you into the hard reality that like anyone that gambles against a casino long enough, if you do this you will lose money over time. Not probably, but with the near certainty of a statistical law. It is also easy to accidentally go from being an investor to being a gambler if you are not conscious of the difference, and this is something every investor needs to guard against.
I believe the difference comes down to expected return. If you have a negative expected return, you’re gambling. If you have a known positive expected return, you will make money, the odds are in your favor, with enough trials (time) you can predict your profits with reasonable accuracy and precision, and you are investing. Investing can reliably be part of a plan for achieving goals like retirement savings, gambling cannot.
The expected return of an investment or a bet is the risk adjusted return. So for example, if you bet $1 on the flip of a coin and you will lose your dollar if you get it wrong (50%) or win a dollar if you get it right (50%) your expected return is zero or (.5*($1))+(.5*(-$1)). If you make this bet a few times, you may come out ahead or lose. If you make this bet 1000 times it is staggeringly likely that you will be very very close to even when all is said and done.
Now change the above scenario slightly. Say you have a magic coin that has a 10% chance of landing on it’s side, and when this happens you lose. Now you have an expected return per flip of -10 cents. Again, if you make this bet a few times, you may come out ahead or lose. If you make this bet 1000 times it is staggeringly likely that you will be very very close to having lost a total of $100.
Every single bet in a Casino where you bet against the house (a game like Poker which is against other players and has an element of skill can have a positive expected return, which is why some people can consistently make money at it) has a negative expected return. If you put money down with a negative expected return, by my definition I’d say you are gambling not investing. This is also why casino are NOT gambling when they allow you to play against them.
Like a casino, some investing behaviors have a negative expected return. Over time “playing” futures, options, shorting the market and frequent stock trading all have negative expected returns. This is due to bid/ask spreads, expenses and fees and tax implications, the same things that cause actively traded mutual funds to typically under-perform the market. For a more detailed discussion of this reality there is an excellent book by Burton Malkiel called A Random Walk Down Wall Street that is an essential read for anyone interested in investing vs. gambling.
The problem is that the return on investments with a positive expected return tends to be modest. For example the real return on the stock market overall after inflation and over long periods of time has run in the 3% to 5% per year range (compounded and with much higher volatility in the short term) before taxes pretty much since the start of it. The investor that becomes a gambler usually does so trying to exceed these return rates substantially by capitalizing on short term volatility…looking to multiply their money quickly rather than grow it consistently over time. And often they do! At least for a while.
There is also a completely indefensible assumption in our society that brains and savvy can overcome the odds and that people* can be investing geniuses, lending a prestige and ego boost to the successful “stock market gambler” that the craps winner lacks.
So what does this tell us? If you select a diversified portfolio (equities, bonds and real estate and a diverse mix of each balanced to achieve the degree of volatility you can tolerate and the corresponding expected returns) of investments in such a manner as to minimize expenses and hold it over time looking for real returns (after inflation) in the 4% per year range (we suggest using this assumption in our financial planning and retirement planning software), you are probably investing and are likely to achieve your goals. If you think you can dramatically improve on these results by trading more frequently or engaging in more exotic strategies (much like a gambler with “a system”), you have probably and perhaps inadvertently becomes a gambler and gamblers are almost certain to lose if they play long enough.
*These geniuses perhaps do exist. They have PHds in Math and Physics, access to extremely powerful computers and they excel at writing sophisticated programs on these computers to execute trades automatically, work in buildings directly adjacent to major exchanges and pay to have their transactions executed faster than yours or mine. They also have privileged access to people with in depth expertise in various pertinent industries and specific companies. If this describes you, please disregard everything I wrote.