Gambling, Investing And Benjamin Franklin

by: Bram de Haas


Meb Faber's list of best investment articles about 2016 includes: are you a gambler or investor?

Framing questions about money in terms of gambling and investing is counterproductive.

Feeling good about yourself, being the cool investor, isn't going to help you do well.

Be mindful of transactions that matter for you, no matter how it is framed.

The only sure thing: Things will change. Knowledge and learning have tremendous optionality.

Co-founder and CEO of Cambria Invest Meb Faber put together a list of best investment reads of 2016 and surprisingly it included an article titled, Are You Gambling Or Investing? It happens I spent six years playing poker professionally which got me interested in investing. Subsequently, I pursued and attained a Dutch investment advisory diploma. So, I've done both and this emotionally laden terminology is a pet peeve of mine. The author of the piece states:

most of what passes for investment advice is really gambling.

What's so shocking is it implies there is some investment advice that's somehow way different from gambling. Obviously, he means his kind of advice. It is framing designed to look favorably upon his brand of investing. (I actually have no idea what that is. It might be good.) Now, let's look at what we mean when we talk about investing and gambling. It starts with the definitions (per Google):

Immediately you sense how imprecise language can be. "To invest" seems to mean "putting money into something with the expectation of achieving a profit."

I'll compare it with the definition of speculation - which appears to imply, because of the "in the hope of gain but with the risk of loss", that there is no risk of loss in investing. Alternatively, there is no difference between the two, which explains why gambling and investment are considered synonyms.

The definition of gambling is "to play games of chance for money" which I find the most accurate of the three definitions. Whereas investing is defined as "putting money into something", gambling is "to stake money on something". I won't make this any harder to read but you can Google the definition of stake here yourself. All these definitions are quite fuzzy. I suspect because the words and their meanings developed before any widespread understanding of probability. Perhaps the words are supposed to differentiate between the odds of "whatever they describe" resulting in a positive payoff, but there is no consensus about that. It is also quite useless information without differentiating between the magnitudes of the payoffs at the same time. To me "investing" has a connotation of a long term tie-up. The definitions don't have any element of time to them though which also explains why the phrase "long term investing" continues to be in vogue.

An article that only adds to our confused understanding of investing doesn't deserve to be in a top 2016 list on the topic.

The article which asks the reader whether he or she is gambling or investing is littered with examples the author does not understand the differences himself. At the heart of the confusing article lies his misconception of what investing and gambling are:

Investors should only risk money on positive mathematical expectancy situations; whereas gamblers risk money on negative mathematical expectations and unknown probabilities. That's the crucial difference between a gambler and an investor.

What I think the author gets at is the expectation of investing in the market has a history of showing positive results for those maintaining continuous exposure while putting $100 on every game since the first sportsbetting boards went up has a history of negative returns.

It's certainly fair to say sports betting indiscriminately has a negative expected value due to the overround. It is not coherent.

Image: Econ Library

But there are some arguments against his definition:

1) The positive expected value of investing in the market isn't god-given. It depends on you collecting something of an anomaly (the risk premium of stocks over bonds) or the markets actually being much riskier than statistical methods show us.

It works like this. The stock market is either so risky, or perceived to be so risky, that people want a sweet deal for them to trade cash for stocks. Over time, they demanded a steep premium to trade a sure thing for an uncertain thing. In other words, people have been unwilling to keep bidding up stock prices up high enough for the risk adjusted premium over government bonds or savings to disappear.

You could rely on behavioral psychology to conclude that will be true for the future as well. That would be the forming of a theory without firm evidence. Which by definition (see above) is speculation and not investing.

2) The comparison between buying stocks and bonds and sports betting is flawed in another way. Let's take Nassim Taleb's four quadrants model:

Source: Business Agility workshop

We find coin flips, sports matches and casino games in the simple/normal quadrant. Meaning the outcomes are simple and their frequencies are distributed normally. Markets are put in the complex/power quadrant. These couldn't be further away from each other. What it means is relying on historical statistics to make a conjecture about the expected value of future sports betting is reasonable. It is much less reasonable to rely on historical evidence to predict future returns of the stock market.

3) The comparison of returns of the stock market with the returns of games of chance like roulette, sports betting or blackjack has more flaws. Let's say you buy into the conjecture the stock market shows positive expected value. You buy some stock and you feel pretty good about how smart you are. You just set yourself up for something like a sweet +6% expected annualized return. However, you bought those stocks from someone else. Do the people on the other side of a buy decision have a negative expected return on their decisions? Are you making a negative expected value decision every time you are a net seller of stock?

Does that mean you are gambling if you aren't investing or quit investing?

The Dutch state levies a curious tax on wealth. In 2017, it will hike taxes on its citizens' net worth. If you are above a certain (fairly low) threshold, you'll pay 30% of taxes on a virtual return. A virtual return means an assumed return of around 5%.

Example (the details are slightly different but I streamlined it to avoid complexity): If you are a Dutch citizen and have a net worth of one million USD, the Dutch IRS will assume you'll return 5% on your net worth and charge you 30% of that $50K or $15K in taxes.

The policy assumes a blended return of 5% across your asset base.

If you are a Dutch saver and decide investing isn't for you, are you a gambler?

You are certainly making a decision with a negative expected value as interest rates don't cover the 30% tax on your virtual return.

4) The yield of a 10-year is 2.54%. Meanwhile, there's the Fed with a long-term inflation target of around 2% and trading securities you'll incur some costs as well. If you hold them through a bond fund, you'll pay a management fee of up to 1%. Depending on the specifics, you'll get into negative expected value territory pretty quickly.

Germany is considered one of the most solid countries in the Eurozone. The country has an industrious economy and a solid balance sheet compared to other large countries in the Eurozone. It is exporting more than its importing. You can hardly find a bond that's more certain to be paid back in full which drove the yield down to -0.8%.

If you buy German bonds are you gambling?

5) In pratice, gambling's negative expected value is a function of a few things: 1) taxes, 2) inherent services, and 3) cost of the service itself.

Engaging in a game of chance for money doesn't intrinsically have a negative expected value. I'm uncertain whether the harm it can do to a person is an intrinsic quality.

Let's say you play poker at a friend's house. There's no rake being charged. The expected value for the player group as a whole is neutral. Is this a group of gamblers? Are the weaker players gamblers? Are the stronger players investors?

What if you and your friend both own the latest model Tesla (NASDAQ:TSLA) and you flip for it because you'd like one for your life partner as well? Are you a gambler?

What I'm getting at

These terms like investing, gambling and speculation are toxic. It isn't clear what they mean and we throw them around while we may understand them to mean different things. We also (ab)use them to charge articles or decisions emotionally:

"I'm an investor not a gambler."

"I don't gamble."

"Buying biotech stocks is like buying lottery tickets."

None of that helps you or I to make better decisions. Let's stop labeling activities like this and debate them on their individual merits.

Sometimes you can make a good case for playing the Powerball or why you can do better at real estate by buying local.

The author of the original piece says he only cares about making money, but he puts a lot of emphasis on how others perceive what he is doing:

He is investing.

If you want to read the writing of someone who truly cares about making money, and not how it is perceived in the eyes of others, read Seeking Alpha contributor Chris DeMuth.

Making great decisions under limited information constraints within a complex adaptive systems like the real estate or stock market, if that's what they are, is not something that has a set solution. The answers to the questions raised are forever in flux and there are no durable certainties. Except maybe one:

An investment in knowledge pays the best interest.

- Benjamin Franklin

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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