Is Investing Like Gambling? (November 2011)

By Professor Ricardo Ulivi, Ph.D.

In light of the incredible volatility we have experienced in the past few weeks, months and years in the stock, real estate and other markets, many investors are wondering if investing has become a chance game, like playing roulette or black jack in Las Vegas. In other words, has investing become analogous to gambling?

It would certainly seem so.  However, as much as both activities share similar traits, they are also fundamentally different. Let's review the similarities first.  Wikipedia defines gambling as  "the wagering of money or something of material value (referred to as "the stakes") on an event with an uncertain outcome with the primary intent of winning additional money and/or material goods." That definition could also be applied to investing.  Therefore, I can say that both activities are similar in that winning requires the correct prediction of a future outcome.  That is, if I know that the next number to be called while playing roulette is going to be 24, all I need to do is bet on that number and my profit will be the 32 times greater than my bet. Investing is no different; if I can correctly predict what will happen to the price of a share of stock, say Bank of America, all I have to do is buy that stock and see my investment or bet grow in value.

So, winning in gambling and in investing require that you correctly predict the future.  That's their similitude.  Where do these two activities differ fundamentally?  In the value of information. In gambling, having access to information, and the ability to interpret that information, will not give you an advantage. That's because outcomes in gambling are, to a great extent, random.  Whereas, in investing, having access to information, and correctly evaluating it, has a great impact on the correct prediction of an outcome.  Let me illustrate this with an example.

Suppose I have a chicken in my garage that lays one golden egg per year.  This egg weighs exactly one ounce, so I can sell that egg today for $1,755.  Furthermore, suppose that I have decided to take my wife on a trip to Mexico for one week, all first class, and so I need cash.  To finance my trip, I have decided to sell my chicken.  I advertise it on Craigslist.  One question arises: how much should others offer to pay for it?  For the buyer, is this a gamble or an investment?

Let's look at it from one buyer's perspective.  Let's call him Sam.  Sam wants to make a 10% annual rate of return on his investments.  He will use information about the chicken to determine the price to pay for it.  For example, he assumes that the chicken will live for 10 years, and that gold will stay at today's prices.  How much would he be willing to pay for it?  He would calculate the present value of receiving $1,755 for the next ten years, at 10%.  This is $10,783 and that's how much he would offer to pay for the chicken.  If he buys it, and the chicken lays one golden egg as expected each year for the next ten years, Sam has made an investment that has given him a 10% compounded annual rate of return. Certainly, a great investment for him.

So, why do the prices of investments fluctuate so much?  Because people's opinions of true value fluctuate wildly too, often from day to day, or minute to minute.  Let me illustrate this by going back to my chicken example.  Suppose Sam had offered me $10,783 for the chicken.  But as I am thinking about it, a veterinarian also saw my ad on Craigslist and he happens to know about a hormone injection he can give the chicken that will make it yield not one egg, but two golden eggs per year.  What would he be willing to pay for it?  Certainly a lot more than the $10,783-perhaps twice as much.  Access to information, and different viewpoints, are what make prices fluctuate. Suppose now that the veterinarian bought my chicken for $18,000.  He's happy and I am happy.  Further assume that on his way home, with the chicken in the back seat of his car, he is listening to the radio and he hears about a new epidemic that is killing all chickens.  In other words, all of a sudden he fears that his chicken might die before it lays a golden egg.  What should the vet do?

Most likely, he would stop at the first 7 Eleven on his way home, and let’s assume he meets a guy I will call Jack.  The vet tells Jack that he has this chicken that lays golden eggs.  He says he bought it for $18,000, but his wife just telephoned him to say he'd better not bring it home, because she is allergic to feathers.  So, for the love of his wife he tells Jack he is willing to sell it to him for $5,000.  Jack knows a great deal when he sees one, and so he counter-offers $3,000 and the vet accepts.  Jack feels he got the deal of a lifetime, and the vet is relieved that he, at least, got back $3,000.

As you can see, as new information enters the marketplace, prices change and they can become quite volatile. The price of this particular chicken went from $10,783 to $18,000 to $3,000 all because information entered the marketplace and was evaluated differently by people.  The same thing happens to stocks, real estate and other investments.  In sum, the greatest difference between gambling and investing is that gambling is a chance game, whereas investment performance can be improved by correctly evaluating information.

To end this educational story, I took my wife to a five-star vacation in Mexico with the $18,000 I got for selling my chicken.  I laughed hysterically during the entire trip thinking about the stupidity of investors: how can anyone buy a chicken believing it will lay a golden egg?  Just because you are given information does not mean that it is correct.  Numbers lie, statistics lie, financial information lies, and numbers can also misrepresent reality.  In sum, be very careful when investing or you too will end up paying top price for what really is a worthless chicken.