When Investing becomes Gambling

Investing becomes gambling when your rationale for an investment relies on your ability to see into the future. Purchasing a low-priced, non-dividend paying stock is gambling since there is no rational reason to assume the stock will increase in value. If you think you know what product will be the next big fad or which technology will succeed, you are thinking like a gambler who fancies himself able to predict the outcome of a roll of the die or a spin of the roulette wheel.

Investors and traders do not rely on their ability to guess future events. Instead, they base decisions solely on the data in front of them. The company’s book value, current price, volatility, and price/earnings ratio are all valid pieces of data for assessing whether a stock is overbought or oversold. Studying the historical behavior of a stock by looking at its chart and applying some common sense and/or technical analysis is also a good way to obtain real information upon which to obtain decisions.

Stock traders use the criteria above to decide when to buy and sell. Some of them are successful, but they still take a great risk. On overvalued stock can always climb higher (Google, I’m thinking of you), and an undervalued stock can always plunge lower (have you seen Ambac lately?). Bond traders, on the other hand, rely on interest to make a steady stream of low-risk income (assuming they are long the bonds).

Options traders use a variety of strategies to take advantage of panic and chaos in the stock market. The most lucrative type of options trading is selling short, naked options, although with technically unlimited risk, you have to know what you’re getting into before opening positions. Like bond traders, those who sell short options rely on simple, time-based reasoning rather than any illusions about being able to predict the market.

A put option can be thought of as “stock insurance”. Stock traders purchase such insurance not because they think it’s a good investment, but because they want to hedge against disaster. Sell enough insurance on enough different stocks, and the law of large numbers says you’ll walk away with most of the premiums. While this strategy is not riskless, it is grounded in basic financial principles and assumes to special insight into the behavior of the market or a particular stock.

In reality, even the most successful traders do gamble to some extent. While my options positions are bi-directional, they are generally skewed based on my prediction of the stock’s behavior. If the stock does what I think it will, I make a lot of money. If it doesn’t, I may still make a fair amount, or I may lose on that position. The majority of my potential profit on a given trade, however, has nothing to do with my ability to predict behavior and everything to do with the passage of time.

Those who lose a lot of money trading stocks are usually people who confused investing with gambling. It is interesting to speculate upon the direction of a price change, and those who trade for a living devote a lot of energy to discussing such things. However, it is not the basis of a trader’s income. Those who don’t understand the difference between investing and gambling should do neither.