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12:12 am - Monday September 26, 2016

Understanding the difference between investing and gambling

| Investing | Rating: 4.5
by Numan

While this title sounds intuitive many so called investors are in fact gamblers. In order to substantiate the difference between the two we need to a closer look in to the basics of investing.

When we invest money in a financial asset we are basically risking a sum of money for potential future return. Financial assets vary by risk and return. The latter two are tightly bound in a reverse relationship the higher the risk the higher the potential return. For example, some of the least risky financial assets (or risks free) are cash deposits and government bonds where the chances of losing your investment are slim and returns are known at the time of investment. At the other hand we have options and derivatives which offer high risks with high potential returns.

Now, what exactly is risk of a financial asset? Think about any raffle or draw. A financial asset is very like one. A coin toss for example has a 50% chance to land on tails or heads. Buying a specific financial asset holds the same sort of risk due to the uncertainty of financial outcomes. A stock, for example, might be priced at 10$ while it’s actual worth is 5$ or 15$ depending on certain assumptions. These might turn to be true or false in certain scenarios. This certain scenarios have creation probabilities of success.

When buying a specific financial asset, like a stock, we are basically gambling on the financial results of that stock. The odds might be in our favour as we have analysed the firms finance and business but we are still talking about odds or risks.
So, whether we like it or not, buying a specific financial asset is gambling.

What is investing then?

Investing is making use of statistics by participating in many small draws with favourable chances over a long time – Diversification and Long term investment.

Think about betting 10,000$ on one coin toss with the possibility of winning 25,000$ and loosing everything. Now think about betting 1$ on each of 10,000 coin tosses with the possibility of wining 2.5$ and loosing 1$ each time. That is diversification in a nutshell. While participating in both bets yield, on average, the same gain (7,500$) the second bet seems much more inviting. The appeal of the second bet is due to the fact each one of the 10,000 bets is a small version of the large one thus reducing risk of losing everything in one big bet.
Simply put, a diversified portfolio is a portfolio which has many “bets”, each with a relatively low investment when compared to the sum of the portfolio. The risk level of the entire portfolio can still be high (all stock for example) but a diversified risky portfolio is, of course, better then having just a risky portfolio.

Diversification is one of the most basic tools of investors. Diversification will enable your portfolio to minimize specific risk (Not to be confused with market risk of the portfolio), lower the portfolio’s variability and change over time and help generate better return on investment.
The other side of investing is holding on for the long term. Buying a financial asset for 1 minute, for example, is much like placing a bet on a roulette table as specific risks are the highest possible (it might go up or down with even chances for example). Buying financial assets for the long term smooths over those specific risks and leaves us with the stock’s business risk.
By combining diversification and long term investment we reduce specific risks to a minimum this becoming investors and not gamblers.

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