SECTIONS
Introduction | Gambling & Probabilities | Shaping the Risk/Reward ProfileSo should we play Black Jack instead? | Insurance | Investing | Conclusions
This is the final part of a 4-part article that begins here, with the previous part being here.
Investing
Investing, like gambling, implies an uncertain reward but, in this case, the ones providing the service are the investors
Where does investing stand here? Like gambling and insurance, it implies an uncertain reward, but in this case, the big difference is that the ones providing the service are the investors, who are financing companies and governments. Therefore, we can expect the average outcome, when all investors are considered, to be positive for them, in return for the service they provide.
So it is not a zero-sum situation among market players, but a positive-sum one, as there is an increasing flow of money being received by them from companies and governments. Nevertheless, we may think it is like a poker table where new chips are being added to the table for free, which doesn't guarantee that all players will win something. This idea is particularly worrisome for the askers of our fundamental question Is investing the same as gambling?, because that skepticism of financial markets can be a consequence of them feeling like sheep among wolves, afraid that the experts will take all the profits and more, like a much-superior player would at a poker table, be there a flow of new chips or not.
Lets analyze the poker analogy more carefully. Why may we lose at poker? We can distinguish two causes. One is low skill, which would reduce the result to be expected from us. The other is bad luck. Inexperienced investors may think that their low skill will leave them without their reasonable share of company and government profits, or that they might be unlucky and lose their savings.
Societies, through their governments, work on making investing accessible for everyone, to have more money in the system
Regarding the skill factor, the main difference with the poker analogy has to do with investing not being a game. In poker, we purposely have fierce competition with skill coming into play, because it is fun and games are supposed to be like that. But financing is a serious thing, people's jobs and futures depend on it being plentiful and inexpensive. Hence societies, through their governments, work on making investing accessible for everyone, to have more money in the system. They have agencies, like the U.S. Securities and Exchange Commission, to protect investors who may otherwise evade the markets to avoid being swindled. Imagine a "bluffing-prevention" agency for poker players...
Moreover, financial markets have collaborative mechanisms. All the time there are lots of knowledgeable people deciding what values are adequate for each security. When you buy stock, you do it at a price that was agreed upon by other people who studied the company carefully, so, in a sense, they are helping you pay no more than a fair price. This is related to the important Efficient Market Hypothesis. Investing is not cut-throat competition, like poker.
You do need some skill to invest appropriately and avoid wise-guys, but that knowledge is accessible to almost everyone. So lack of skill is not a reason to evade the markets, just educate yourself on the basics of investing, and seek good advice.
The remaining worrisome factor is bad luck. To provide an answer lets go back to what was explained in "Shaping the Risk/Reward Profile". It is not possible to build exact graphs like we did there, because investing is not an exact science like probability, but the same notions apply. There are risk/benefit profiles, which we cannot calculate but we can estimate based on past performances. These profiles can be described by means of expected values and standard deviations. Therefore, to minimize the impact of "bad luck", we can also perform shaping on the risk/reward profiles. For example, we can apply diversification to concentrate the probabilities at expected values, or returns, reducing the risk. In this case it does make sense, because the expected returns are positive: they are the charge that companies and governments pay in exchange for being financed (remember that the service provider is the investor).
Financial markets have collaborative mechanisms. When you buy stock, you do it at a price that was agreed upon by other people who studied the company carefully. They are helping you pay no more than a fair price
How much are those expected returns? It depends on how much risk the corporation or government is transferring to the investor. For example, stock should return more than bonds from the same company. Why is that? Because stock returns are closely related to the performance of the corporation, which is uncertain. Companies need to transfer some of that unpredictability to others, or they wouldn't be able to secure enough loans and bond purchases. As investors, we demand a premium in exchange for that risk-absorption. So markets self-regulate to the point of making stock returns greater than bond returns, in average. This fact suggests another way of shaping risk/reward profiles: asset selection. Selecting less-risky assets diminishes the risk, and selecting more increases it.
If you think it sounds too risky to receive that risk from corporations and governments, don't worry. You may shape the risk/benefit profile, through diversification and appropriate asset selection, to reduce your total risk to something bearable. Unfortunately, applying diversification with investing is not as easy as with Roulette, because in that case the spins were independent, but there can be high correlations between the performances of different corporations. Those high correlations makes diversification less effective, and its effectiveness diminishes as we add more and more corporations into our portfolios, until we reach a limit called systematic risk that is un-diversifiable. Remember: if the resulting uncertainty is still too much for us, we can reduce it even further, by allocating more of our capital on the lower-risk assets.
Therefore, shaping the risk/reward of our investments is beneficial, which wasn't the case with gambling, where uncertainty rules and it is pointless to pretend to get rid of it. That shaping basically means getting rid of unnecessary risk through diversification, and absorbing the right amount of risk for our case, by choosing an asset allocation that is good for us. If we are going to need the money in the short term, then we should buy more of the predictable instruments. If we can hold our investments for long, we may buy more of the riskier ones, and enjoy higher rewards.
Conclusions
Gambling, insurance and investing have something in common: there is a reward tied to an uncertain outcome. But there are huge differences when we analyze more thoroughly, answering some fundamental questions such as: What do they really offer us? Where are the potential profits coming from? How much risk are we receiving? Can we decide how much? Is the reward enough considering that risk?
Gambling can be divided in playing against the house or against peers. If it is against the house, we (should) do it just for the thrills. We won't win money unless we are lucky, and a winning streak won't last for long, because playing many times is the same as diversifying, which in gambling only takes us to a certain loss. Therefore, much diversifying in gambling makes no sense, and uncertainty is king. If we are referring to peer-to-peer games, we need a lot of skill to be better than the rest, and still need to resort to luck. Moreover, who guarantees that we are really the best player at the table? One way or the other, high risk rules the gambling world. Whatever money we put there, we may lose it all.
Insurance, like gambling, is a service that we pay a provider for. But what we buy is quite the opposite. Instead of the thrills of uncertainty, we buy stability and assurance. We gamble to win, we insure not to lose. Hence insurance is done to bring more predictability into our lives.
The risk-tolerance we give can be less valuable, for us, than the benefit we get in exchange
Investing is another practice with uncertain elements. It is done to earn money, so some people associate it with gambling, and refrain from putting their capital there. But the reasons not to bet our savings on a game of chance are that high uncertainty dominates gambling and a lot of skill is necessary for playing peer-to-peer games like poker competitively. That is not the case with investing. It is a service that we are providing, thus the expected returns are positive, and risk/benefit shaping results advantageous. That way, the risk-tolerance we give can be less valuable, for us, than the benefit we get in exchange.
Those monetary benefits give us certainty, so investing can bring predictability into our lives, just like insurance. Or not, depending on the risk in our portfolio. The point is that, if insurance and gambling are extremes in regards to the certainty or uncertainty they produce on us, then investing stands in between, at a point that depends on the way we allocate our capital. If we want more predictability in our lives, we can invest conservatively. If we can stand a bit of risk, then we may do it more aggressively to pursue better potential benefits. And if we like to gamble with our savings, we can put all our capital in a focused, 5x leveraged investment, to put an example, although I wouldn't call that investing at all...
Moreover, investing is not cut-throat competition like playing poker. Society protects us, through governmental agencies, and the whole market is, in some aspects, collaborative. Therefore, the skills necessary to obtain benefits from investing our savings can be learned without hassle.
The bottom line is that investing is not the same as gambling, because uncertainty is the rule and the produce of gambling, while, in investing, it is an element that we can manage, in the pursue of our own objective, which can even be the opposite of what gambling really offers us. Besides, compared to poker tables, investing can be a much less competitive environment.
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