Investing Is Not “Gambling”


During the day, I pretty much do nothing but obsess about my stock portfolio.  Over the years, I’ve had difficulty convincing my friends, including my colleagues who do this kind of work, that investing in the stock market is not akin to gambling.  Perhaps the image of my beaming face when I talk about a trip to Foxwoods clouds their judgment (to say nothing about their opinion of me), so I’ve decided to articulate the reason here, where I can remain faceless.

Let’s start with what gambling is.  The dictionary defines it as:

1.  to play at any game of chance for money or other stakes.

2.  to stake or risk money, or anything of value, on the outcome of something involving chance

The key word in the definition is “chance,” because successful investing has very little to do with that word.

Investing takes advantage of inefficiencies in the market.  At least in theory, there is a correct value of every stock, the amount each shareholder would receive if the company was ever liquidated.  In reality, the market never reflects this value because, for one, the value is impossible to determine.  The balance sheet, cash flow and income from operations only give investors glances from different perspectives of a very complex picture.  But the problem isn’t just insufficent information in the marketplace.  No one, not even the head of the company, has all the information to determine how much, in reality, shareholders would receive if the company were to ever liquidate.  A structure of a public corporation (even a small one) is far too complex for such an exercise.

But just because you can’t determine the value, it doesn’t mean there is no value to determine.  Quite the opposite.  The company can and do go into liquidation and the priority in which the shareholders receive a cut–that is, dead last–is determined by law.  It’s just that liquidation rarely happens.  So the stock market is an exercise of trying to determine a value assuming an event that is very unlikely to occur.  Add in the fact that investors are intrinsically forward-looking (after all, they’re interested in profiting from increased future value, not in correctly guessing the present value), and people begin to have vastly different views on what each company is, should be or will be worth.  In this variance of opinion, investors who put money behind their conviction make and lose money.

The stock market is thus not a game of chance but an interplay of competing rationale.   That is not to say that chance doesn’t play a part in the process.  No financial model accounts for a freak accidental fire that destroys the only factory the company runs.  Nothing can be done if the company’s founder and a visionary has a heart attack.    But if you look to get lucky in a game where everyone is trying to get smart, you’re going to get burned because picking one stock out of the three you narrowed down to through reason has a better shot of succeeding than picking ten stocks out of the fifty you know nothing about.

This is why I emphasize valuation in stock picking.  It is the most rational investment strategy.  If the stock has fallen below what you believe is the value of the company, you must conclude that the stock must increase in value.  The worst case scenario is that the company goes into liquidation and you recover more money than you put in.  You could of course be overvaluing the company, but that’s not the same as saying you got unlucky.  You simply got it wrong.

This is not the way casinos work.  No amount of “right” decisions can make a difference in a casino because you’re ultimately playing with or against chance.  In roulette, the odds of you hitting red is slightly less than half each time.  Since the house only pays two-to-one if you win, the law of probability says you’re going to lose in the long run (assuming the casino has a cap on maximum bet at the table, but that is a discussion for another time).  In poker, the odds of you hitting an inside straight on the river is 9%.  The only question is how much that 9% is worth.  In the casino, numbers are always there and it’s never 100%.

In the stock market, though, there are times that you can reach near 100% certainty.  Apple at one time was trading at $15 a share with $12 a share of cash on the books.  The stock is almost certain to rise–and a man in Saudi Arabia who knew this became very rich(er).  During the tech bubble, internet companies were being valued at $100 while bleeding cash and no profit in sight.  These stocks were in for a crash and lo and behold, it did when common sense returned.

I think people confuse investment with gambling because they think of investment as speculation.  But investors who engage in speculation have merely a different form of investment strategy than I.  They are seeking high reward with high risk and they place an appropriate value on such risk.   The strategy is an aggressive one–one in which I haven’t succeeded–but that doesn’t make it a game of chance.  Taking a calculated–and monetized–risk is no more of a game of chance than starting your own business.  If your definition of gambling includes starting your own company, then you’re right–stock market is gambling.

But as a gambler and an investor, that is a far too broad of a definition of gambling.

After all, I’ve made money in my ten years of investing while I’ve lost a plenty in my eight years in a casino.

Advertisements

0 Responses to “Investing Is Not “Gambling””



  1. Leave a Comment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s




Enter your email address to follow this blog and receive notifications of new posts by email.

Top Rated

Categories

Archives

August 2010
M T W T F S S
« Jul   Sep »
 1
2345678
9101112131415
16171819202122
23242526272829
3031  

%d bloggers like this: