Is Investing Like Gambling? How to Tell the Difference
Saying that investing is like gambling may seem sacrilegious to some; however, the two forms of risking money for a perceived “profit” are similar in multiple ways. If your not careful, the “investing” you think you’re doing may be more like gambling than you think it is, especially when it comes to bringing home a profit (or lack there of) at the end of the day.
How is investing like gambling?
It’s 9:45pm on a Tuesday and your having your weekly night out at Stanky’s Card Shack and Resort, your local casino. You drive up to the front door, toss your car keys to the valet, and you’re greeted by a rush of stale warm smoke as you open the large brass lined front doors. You take a deep breath in, and after coughing a few times you take a moment to revel in the sight of shouting gamblers at the craps table. “this is my night,” you whisper under your breath as you walk towards the blackjack table.
Three losing hands in a row and $200 later you are about to throw in the minimum bet on the next hand, but then you get a familiar tingle in your left pinky toe. “This is it” you think to yourself as your mouth rotates into a crooked smile, “god is giving me a sign, this is my hand!”. You chuckle to yourself as you push in all of your money, knowing that this is the big win you’ve been waiting for. Does this sound familiar? Now read this next story and see if you agree that investing can be like gambling:
It’s Wednesday morning at Sunny Acres Retirement Villa. You wake up at six thirty in the morning to a throbbing ache in your hip. “My darn hip replacement won’t let me get any sleep” you mumble to yourself as you roll out of bed and hobble over to your high backed easy chair. Knowing your schedule, the nurse had snuck in minutes earlier to drop off your coffee and a copy of the Wall Street Journal. You pick up the Journal and you notice a colorful jumble on the front page that looks interesting. You grab your reading glasses off of the coffee table to get a better look and you notice it’s an article about Wal-Mart.
As you read the article you feel your heart start to thump harder in your chest, thinking “My friend Marjorie works at Wal-Mart and she said there have been more customers coming into the store recently”. Not only is the Wall Street Journal recommending the purchase of Wal-Mart because it’s cheap compared to competitors, but you have undeniable proof from Marjorie that there are more customers coming into the store! It’s now 8:20am and you start to formulate a plan: “When the market opens, I will buy $50,000 of Wal-Mart, and then sell it in a few days when people realize that it was previously undervalued and raise the price by buying it”.
While this is an extreme and longwinded example, it makes it easy to see how investing can be like gambling.
Behavioral finance is an emerging field of study that addresses the behavioral issues that investors face when making and analyzing investment decisions. The specific behavioral bias we are examining here is called Gamblers fallacy.
Gamblers fallacy results from the belief that the occurrence of one or multiple random events will have influence on future random events, such as a coin flip. In our example above, the card player believes that the tingle in his toe is signaling a good hand; however, the toe tingle is random event that has no effect on the cards the dealer will deal. Investing becomes gambling if you fail to understand the risks you are taking.
When applied to investing, gamblers fallacy can result in holding a stock that has performed poorly multiple quarters in a row thinking that it is “due for a rebound” or that “it can’t possible fall any further”. Gamblers fallacy can also lead to making investment decisions based on hunches instead of utilizing probabilities and thorough analysis. In the case of the Wal-Mart story, the investor is looking at the investment as a “sure thing” because her friend saw an increase in customers, instead of taking the time to understand the risks involved.
Investing can be very exciting, but that excitement, like the excitement from gambling, can be addicting and cause you to make poor decisions
It’s impossible not to get a bit excited when you see the Microsoft stock you bought at $20 soar to $36; however, letting that excitement guide your decision making can be disastrous! Trading based on excitement can cause you to take positions that are too large and carry too much risk, all for the sake of “making more money off of a sure thing”.
If you think you might be gambling instead of investing, spend some time learning about financial and portfolio theory. Make sure you have a diversified portfolio of stocks if you must invest in individual companies, and don’t overtrade. If you really want to ensure that one of your reasons for investing is not gambling then stick with index mutual funds or ETFs in an appropriately balanced portfolio for your investment goals and age.