Gambling and Investing are two very different games, though sometimes the lines get blurred.
Of course, if you say you are a gambler you will be stigmatized while the investor will be looked upon as a genius with people begging him for “tips”. Gambling may be a vice, but it is amazing how much it reveals about our true selves.
Retirement expert and author Don Ezra is known for his casino analogy when it comes to investing. He presents individuals with these games and questions that need to be answered. I use them below to make my point.
GAME A
The casino official will toss a coin. If it comes down heads, every player will win $1,000. If it comes down tails, every player will win $500. Either way you look at it, you win. Easy money!
But before you play, you have to answer three questions.
- Would you pay $400 for the right to play this game?
- Would you pay more than $400?
- What’s the most you would pay?
Here’s how most would probably answer.
Yes to Q1. You would pay $400 for the right to play this game because at this price you are certain to win.
Hesitation to Q2 because you have not been asked what your limit is. You will pay more than $400, but any price up to $499 still results in a win.
Difficult to answer Q3. Some would pay $401, others would pay $450, and so on. If you settle for $749, it is just enough to keep the game in your favour, though it’s far from a certain win. You could win $251 or lose $249, with equal probability. Some may back out because they want a better margin in their favour; others may pay much higher.
GAME B
The casino official will draw a card from a standard deck of 52 cards. If it’s an ace, every player loses $100. If it’s any other card, every player wins $100. The odds are heavily in your favour: twelve chances to win, for every one chance to lose.
Before you play, you have to answer two questions.
What’s your reaction if you win? Your answers would be:
- It was bound to happen.
- This is too easy.
- Luck favours me.
- Let’s play again!
What’s your reaction if you lose? Your answers would be:
- It’s a fix.
- The game is rigged.
- It’s a scam.
- Let’s play again.
From this, you will decipher that there is no mystery to investment principles. Human behaviour being the constant. Naturally, investment outcomes aren’t as predictable as tossing a coin or drawing a card, where the odds are known. Nonetheless, similarities exist. And the odds help us to decide whether an investment is oriented more towards safety or highly risky.
#1. We hope for good outcomes when we invest. But we must consider the possibility that outcomes can be bad. Even a good strategy or a good investment can have a bad outcome. Playing Game B for no entry fee is clearly a good strategy, because it’s tilted so strongly in your favour, and even if you lose, the loss is bearable. But there’s still a chance that you’ll lose. That’s just bad luck, but bad luck does happen sometimes. Not all your investments will play out as expected.
#2. No one wants to lose. No one. But you should have an idea of how much you are capable of losing. This is when asset allocation comes into play to balance the risk in your favour.
#3. How much of risk you are willing to take is a very personal issue. Everyone has a different attitude towards risk and a different tolerance level. Don’t borrow someone’s idea of risk, understand your own.
#4. The stock price gets bid up to the point where there’s no easy money, just a risk-versus-reward calculation. Have a margin of safety when you buy a stock. Just because a stock price is rising rapidly doesn't mean that trend will be sustained.
#5. Individuals will play the investment game (many times) if they think they’re likely to win. You can reduce the possibility of a bad outcome if you follow certain principles. If investing in an equity fund, invest consistently and systematically. Stay the course through all markets. If buying stocks, have a margin of safety so you don’t buy at exuberant levels.
#6. With a good strategy, the more often you can play the game, the more likely you are to win over the long term. That’s why you said, “Let’s play again!” even if you lost Game B the first time it was played. The chances are so much in your favour that you’re highly likely to come out ahead if you play, let’s say, 10 times, and even more likely if you play 100 times. In investment parlance it would mean giving equity a long runway. It’s the passage of time that constitutes a play. Over time the likelihood increases that you’ll come out ahead when you invest in equities.
#7. When it comes to investing, have a long-term perspective. Gamblers have a much shorter perspective and are betting that they are smarter than other gamblers in predicting the course of short-term movements. The chances of losing money are higher when you gamble.
Gamblers take risks that are not likely to pay off. Prudent investing is to employ certain strategies that will help you come out the winner over the long term.