Investing vs Speculating vs Gambling

 

Investing and gambling are sometimes discussed in the same context as they both involves putting money at risk with the goal of making a profit.

To distinguish between the two, we first need to understand what is gambling. There are two main elements of gambling:

1. Gambling involves randomness and it is therefore risky

2. The expected return of gambling is negative (note, I'm excluding games like poker where the skill of the player can increase their chances of winner against other players). For example, the roulette at casinos has an expected return of -5.3%, which means for every $10 you bet, you are expected to get back only $9.47. The slot machine expected return is between -15% and -2% depending how the machine is configured. And Toto, our national favourite form of gambling, has an expected return of an abysmal -58%!!

Like gambling, investing also carry risks. Changing market conditions, shifting demand and supply, new innovation etc. could influence the value of your investment. But it is the expected return aspect that makes investing different from gambling. In particular, investors are rewarded with positive expected return when they take compensated risk.

In investment, compensated risk is a risk that will increase the expected return of your portfolio. For instance, investing in the overall stock/bond market is a compensated risk where investors are rewarded for providing funds that allow capital to flow efficiently to where it is needed most.

This is oppose to uncompensated risk which is a risk that doesn't increase, or may even decrease expected return. This include betting a large part of your portfolio in a single stock/bond or buying a single investment property, because doing so introduces idiosyncratic risk (i.e. company-specific risk). For example, if the one firm you invested in is sanctioned or faced other disruptions that significantly affect its operation, then the impact on your portfolio will be disastrous. Investors are not paid for taking on such risk because it can be diversified away. That's why uncompensated risk is also known as diversifiable risk. This type of "investment" approach is typically considered as speculation, where a person makes a big bet on the success of a company or property.

In conclusion, gambling and investing are two very different activities, and the approach one takes to investing reflects whether they have an investor or gambler mindset.






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