Human beings are naturally terrible at gauging risk.
Here’s one example: Many people are scared of flying, but not many are scared of driving. Both are relatively safe, but flying comes with fewer fatalities per million miles traveled. When you consider the fact that you drive more miles than you fly, you’re much more likely to die in a car crash than a plane crash.
Our difficulty gauging risk carries over to the realm of investing. Investing carries risk, and many people associate any risk with gambling. But that perspective isn’t nearly nuanced enough.
Investing is a spectrum and it looks something like this:
Although I’m presenting it as one dimension, there are actually a few different factors that affect whether a venture is gambling or investing. Here are a few that I consider important:
- Worst case scenario: How likely are you to lose all your money?
- Control: How much can you influence whether you get a positive return?
- Intrinsic value: Is your investment actually worth something? Does it produce income?
Let’s break down the three categories of investing with examples and see how they do against these tests.
The best examples of gambling come from…well, gambling. It’s roulette and blackjack and slot machines. It’s the grim reality that the house always wins.
Probably the most common form of gambling is the lottery.
Worst Case Scenario
With gambling, there is always a very high likelihood that you’ll lose all your money. You bet red but it comes up black and everything you “invested” that round is lost.
With the lottery, every dollar “invested” is essentially a dollar lost.
Depending on what kind of gambling you’re doing, there’s a decent range of how much control you have, but there’s always a strong element of chance.
With the slot machines, the only choice you have is whether to foolishly keep playing.
In blackjack you can at least make the choice of whether to hit again, and there’s some ability to use statistics to play the odds. But you can’t control what card comes up. For you or the dealer. And unfortunately that’s the whole game.
With the lottery, you can “control” what numbers you pick, but this is chance disguised as choice. You can also control how much you lose—I mean, “invest.”
There’s no intrinsic value in playing games of chance. No one is going to pay you to play (although the casino might put you up in a nice suite if you’re put enough of your money at risk).
The only value a gamble has is the off-chance that you win. But in the long run, the house always wins.
What is speculation? Different people have different definitions. I define is as investing in an asset that doesn’t produce income.
A good example right now would be cryptocurrency. Many people are investing in Bitcoin or Ethereum hoping that the price will go up. But if the price does go up, it won’t be because any fundamental attribute of these currencies changed, it will be solely because their perceived value changed.
Worst Case Scenario
There’s still a decent chance that you could lose everything when you’re speculating in general and buying crypto in particular.
With Bitcoin, I think it’s a little less likely that you’d lose everything. There are a lot of true believers with laser eyes on Twitter who would be happy to buy your BTC even if everyone else concludes it’s worthless.
Unless you’re Elon Musk and can send the whole market soaring or crashing with a single Tweet, you have very little control.
You do have some control. You can control whether you buy or sell. With gambling, the dice is rolled and you win or lose. With speculation, the dice is rolled and you can pass and wait for another roll. Of course, it’s possible that the price might never rebound, but if it does, you can still get out ahead.
Speculation is based around investing in things like gold of Bitcoin whose value consists entirely of perceived value. If people think Bitcoin is worth a lot, it is. If they think it’s worthless, it is.
There’s no aspect of these assets we can measure that gives us a clue as to what they are worth.
For investing, let’s use the example of commercial real estate; buying a property to rent out.
Worst Case Scenario
If you don’t know what you’re doing, it’s definitely possible to lose money in real estate. Could you lose everything? I guess anything is possible, but it’s hard to imagine a situation where this would happen.
At the very least, the property and the land it’s on can be sold. Maybe it’s possible to run your rental at a loss for so long that it more than offsets the gains of the sale. But I think we can say that the odds are stronly against you literally losing everything.
You have a lot of control in real estate. You control where you buy and what you buy. You even have some control of the price through negotiation. You control how much you charge for rent. You control what sort of renovations and changes you make to the property. You control how you market it to renters.
The amount of control in real estate is extremely high, even compared to many other legitimate investments.
The property has real value in the sense that it produces rental income. Yes, you can hope the price of the house goes up so you can sell it at a profit, but even if it doesn’t you’ll be happy sitting back and collecting rent.
The Stock Market
So is investing in the stock market investing, speculating, or gambling?
Well, there are actually two ways of investing in the stock market. Long term investing is real investing. Short term investing (i.e. day trading) is speculating at best, and gambling at worst.
The Stock Market As Investing
Long term investing is how I invest. It’s how Warren Buffet invests. It is definitely investing, not speculating or gambling.
Let’s look at how it stacks up:
Worst Case Scenario
I invest in the stock market by buying low cost, total stock market index funds. This means I invest in a fund that buys shares of every publicly traded company in America, with more money going toward the bigger ones.
Could I lose everything? In the sense that anything is possible, yes, I could. But what would have to happen in order for me to lose all my money? Every publicly traded company in America would have to go under at the same time.
I guess that’s not impossible, but even if that zombie apocalypse future plays out, you’re screwed too, regardless of how you invested your money.
The stock market has less control that real estate, but certainly more control than gambling.
In all honesty, it’s similar to speculating in crypto in the sense that you have the decision of whether to sell at a loss or hold.
But I think it’s better that crypto in this respect, because there’s reason to believe the market will continue to go up in the long term. Which leads us to:
Stocks pay you dividends just for owning them. They don’t pay as much as they used to, but when it comes to investing in the stock market, you get paid just to play.
This is a form of direct income that goes right into your pocket or gets reinvested back into the fund.
There’s also an indirect income component in the sense that the companies that you are investing in produce income. This is crucial, because it’s a way of measuring their intrinsic value.
Let me ask you a question: Which company is more valuable, Amazon today, or the Amazon that was a bookstore run out of Jeff Bezos’s garage?
Or how about Apple today vs. Apple in the 90’s when it nearly went under and was getting dominated by Microsoft?
Their increased stock prices are reflections of the increase in value over the decades.
Many businesses fail, but a failed business can only lose 100% of it’s value. There’s virtually no limit to how much a business can gain. A 100% gain is possible, but so is 200% or 300%. Businesses can, and do, experience 10,000% gains. This imbalance is what causes the market to keep rising.
The Stock Market As Speculating
This is the short term flipping of stocks hoping to earn a profit. In addition to the disadvantages I’ll describe below, there are also high transaction costs and taxes associated with this approach.
Worst Case Scenario
How likely are you to lose everything? It depends on how diversified you are. If you invest in one company, you lose everything if that company does. If you’re invested in 10 companies, you only lose everything if all 10 go under.
With index funds, diversity comes built in. Every dollar you invest in a total stock index fund is spread out across more than 3,000 companies. With speculating, you need a lot of money to diversify properly.
This is actually one area where short-term trading comes out ahead.
But despite having lots of choices, it’s not immediately clear which are good and which are bad. We know that investing in the market over the long term is a good choice. But which hot stock pick will hit and which will bust is anyone’s guess.
Even though the companies you are investing in have intrinsic value, your investment style doesn’t take advantage of it when you are buying and selling.
You aren’t going to get paid dividends on a stock you bought Monday and sold Tuesday.
Also, even though the companies you are investing in are producing income, you aren’t holding the stock long enough for it to track the growth in earnings. You’re just hoping someone else values it more than you tomorrow.
In The Little Book of Common Sense Investing, Jack Bogle shares his research that shows that of the 9.5% annual return the stock market has produced since 1900, 9% is explained by dividends and earnings growth. The other 0.5% is explained by speculation.
In the short term, all the daily changes in price have nothing to do with the intrinsic value of the investments. The daily price is driven entirely by speculators operating irrationally out of fear and greed. Over the long term, this cacophony is drowned out completely and the market is valued almost entirely on it’s actual merits.
As Warren Buffet’s mentor Benjamin Graham once said:
“In the short run the stock market is a voting machine . . . in the long run it is a weighing machine.”Benjamin Graham
Investing in the stock market isn’t gambling, but it can be close if you are trying to get rich quick.
If you have a sensible long term strategy, the stock market is definitely and investment, not a gamble.
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