How Playing the Stock Market Is Like Gambling

Stock Market Data, Casino Roulette Wheel
There are two differences between the stock market and gambling games. First, the stock market represents the equity in business operations. That equity includes the value of assets and potential future income. Buying stock, mutual shares, or options is treated as an exchange of value.

When you gamble, you’re not buying into anything.

Second, when you gamble, there’s a middleman (typically a casino or bookmaker) who is carving some of the money out of the exchange for themselves.

Gamblers pay each others’ winnings. In theory, established casinos stake their bets against players from players’ money. Only a new game or casino requires business owners to risk wealth on early wagers.

Where playing the stock market begins to resemble real money gambling is in the uncertainty of what happens next. The investor must decide whether to “keep playing” or to bail out of a declining investment.

Even so, there are several ways investors can turn their investments into high-stakes gambles. All the equity they believed they were buying vanishes.

Equity Is No Longer the Most Important Value in Stocks

Anyone who has taken an accounting course or two should be familiar with the following formula:

Owners Equity = Assets – Liabilities

The shareholders’ equity in a publicly traded company is whatever its net assets are worth, including intangible assets like intellectual property rights.

Future potential income isn’t included in basic accounting equity formula, but investors looking for potential gains or returns are interested in some kind of future income. So-called income investors want to be paid dividends. The best dividends are paid from profits. The worst dividends are paid from loans.

Since the 1980s, equity investing has gained more popularity than income investing. The equity investor doesn’t care if the stock pays dividends or even if the company makes a profit.

All the equity investor wants is to buy low and sell high. That’s similar to how gamblers want to put money into a game and receive a high payout.

While you may not be buying equity in the craps table, you’re risking your money on a potential outcome. Equity investors could lose everything if the stocks they buy drop to zero.

Every year, the major markets delist stocks whose market prices per share have dropped below required minimums. These companies may own valuable assets, but their stock prices reflect a lack of investor confidence in their futures.

True net asset value isn’t as important as market price in the stock market.

Equity Investors Bet on Uncertain Outcomes

During the good times, the stock market tends to carry most stock prices up with it. There will always be losing stocks, but as the major indexes grow in value, most stocks follow.

But even good, strong companies may experience sudden loss in share price. The market may panic if a corporation’s CEO is charged with a crime or otherwise loses investors’ trust.

You might be thinking investors should just use a buy and hold strategy. That’s a great theory, but it creates an unrealistic expectation.

One of the mechanisms at work in the stock market is automatic trading. There’s more than one kind of automated trading. The officers of publicly held corporations must exercise their options (to buy stock at discounted prices then sell it at market price) in a careful, transparent way.

Using Laptop Computer Looking Over Stock Market

If you track insider trading, you’ll often see reports about programmed sales that go through when stock prices are volatile. The executives have no choice but to let some sales happen and take a loss.

For all intents and purposes, because you don’t know when the next natural disaster or scandal affects your equity investments, you’re gambling that your stocks won’t lose share price value when you’re ready to sell.

It’s similar to betting on a slot machine or any game of roulette. No matter how skilled the investor, the future is still a big unknown for all of us.

Some Investments and Gambling Games Are Extremely Volatile

One of the saddest investment stories I remember following was for a company whose stock fell from about $50 a share to less than $10 a share.

The stock eventually stabilized, and new investors were able to get a great deal. But I saw a few people complaining on investor forums about how they were never going to recover their lost equity.

One guy bought 1000 shares at $50. By the time he sold, he lost more than $40,000 on that investment. This is why equity investors should set loss limits on their purchases. Income investors should protect their capital, too, but they tend to buy companies whose stocks are less volatile.

Most gambling games offer volatility.

A simple rule of thumb for determining the volatility of a gambling game or wagering strategy is to compare the frequency of wins to the payouts.

High volatility slot machine games pay less often but are more likely to pay higher prizes. By comparison, an outside bet in roulette is a low volatility wager, but a single number bet is a high volatility wager.

Gamblers and Investors Fall Prey to Sunk Cost Fallacy

The sunk cost fallacy assumes that if you’ve already sunk a lot of money into a project, then you can’t afford to abandon the project. The fallacy leads you to continue dumping money, time, and energy into the project even though all signs indicate it’s failing.

Investors do this when they “average down” on stock prices. They believe they’re reducing the cost of their shares and improving future equity gains. It’s true that many stock prices are cyclical in nature. They regularly move up and down within a “trading window.” The principle of buy low, sell high is important for investors who buy stable stocks.

Inexperienced investors often fail to realize when stocks they’ve chosen have fallen through the floor of their previous trading range. These stocks are bad investments because more people are trying to get out than are trying to get in.

Dollar Bills, Casino Chips, Casino Dice

By comparison, many gamblers will lose their entire casino bankroll on a single game. Their thinking is based more on the randomness of the games they’re playing. This is especially true in slots and roulette.

Appearances are always deceiving in these games. Whereas some players conclude, “If I just keep playing I’ll win it all back,” other players assume that any hot or cold streak will run for a while.

In reality, a hot streak of wins occurs just as randomly as an individual win. By statistical measures, these variances are perfectly normal in the estimated probabilities. Gambling game probabilities are calculated on the assumption that the games are played continually without end.

Good gambling budget guides recommend setting loss limits. Even if you’re playing a game you know well and you have full confidence in future wins, it’s a good idea to take a break when you’re losing.

Savvy Investors Study Companies and Markets

Just as many gamblers study probability tables and strategy guides for games like blackjack, keno, and poker, many investors study companies and their market sectors.

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Knowing the history of a company and its industry makes you better informed. It doesn’t guarantee you’ll always make good investment decisions.

By the same token, knowing the odds and probabilities for your favorite games doesn’t guarantee you’ll always make good wagers. Experienced players sometimes make bad decisions.

Warren Buffett is the greatest investor in history. On several occasions, his company, Berkshire Hathaway, has lost hundreds of millions or even billions of dollars on investments. The losses only count if they must be charged off on corporate income statements, but even Berkshire Hathaway occasionally does that.

The stock market isn’t necessarily a safe place to put your money. It’s a better investment channel than gambling by far, but there is one way big investors are piling into gambling.

Some Gamblers Attract Sponsors With Deep Pockets

Although the casino industry is big business and some casinos are owned by publicly traded companies, world-class poker players may be backed by sponsors.

If you don’t trust your own gambling skills and instincts, then bet on someone with a winning track record. Professional poker has attracted a lot of money.

Lottery Numbered Balls

Even state lottery games sometimes attract syndicates of investors who hope to buy jackpots. Although there is no skill involved in playing a lottery game, large jackpots make it mathematically profitable to buy a lot of tickets.

Conclusion

Gambling is like attending a music concert. You’re paying for an evening’s entertainment. But whereas the concert audience may go home with a ticket stub and t-shirt, gamblers may go home with more money than they took into the game.

Given the possibility of making money from gambling, it does work like the stock market in some ways. Gambling is a more volatile channel for investment. At least with the stock market, you can invest in index funds that are stable and have good long-term prospects.