Updated: Aug 3
Retail investors cannot be adequately protected until the fundamental similarity between investing and gambling is recognised
I was drawn to the article in yesterday’s in yesterday’s Financial Times, Save for retirement or just put it all on red? The article noted that the gambling and investing industries were increasingly encroaching on each other’s territory and suggested this was blurring the lines between the two.
First, let’s be clear what is meant by gambling, as this is where lines and terminology have always been blurred. There is a fundamental difference between luck gambling like Roulette and skill gambling like horse betting. Both involve precise outcomes, a red in Roulette or a first-place finish by horse A, for example. The difference is whether the probabilities of the outcomes are driven by maths or humans. At no stage with Roulette are the probabilities of the outcomes driven by anything other than precise mathematics. Your own probability of a red cannot vary from the mathematical probability of it. Unless you're a fantasist. Or you cheat. But both of those are for another time.
With horses, or politics, or The Oscars, the probabilities - the odds - are determined by market forces, which themselves are driven by humans, not mathematics. It is therefore possible for you to have an edge, some knowledge that allows you to think that the probability of an outcome is different to those implied by the market odds. Again, you can cheat – your knowledge can be inside knowledge – but that’s also for another time.
If it isn’t obvious, Roulette and other casino games are luck gambling while if you can have an edge, it’s skill gambling. The gambling referred to in the FT article is the latter form and henceforth in this post too.
There has always been a widespread belief that investing is fundamentally different to gambling. The image of the professional fund manager is very different to that of the professional sports bettor, and the investment industry is keen to perpetuate this image. It was certainly drummed into me early in my career as a fund manager that I should never suggest there were similarities. Unless I wanted to be quickly shown the exit, that is.
Now, if you can, forget for a moment whether the underlying contender is a horse or a slice of a company, a share – the latter can be thought of as a contender in that companies are in competition – a race – with each other. Instead, think only about their prices and how they move over time: the market odds on a horse or a share price. Appraisal of the underlying race contender – a horse or a company - is called fundamental analysis. Looking at their market prices only is called technical analysis.
The two charts below are of market prices of contenders in two races, one is Donald Trump in the 2016 US presidential election, the other is Amazon Inc in 2019/20.
I have removed the vertical price scale as that would be a giveaway. With gambling, the scale is always zero to one – either the outcome happens - a price/probability of 100% - or it doesn’t - 0%. Share prices on the other hand are not binary – they either go to zero or more commonly stay above zero. A simple log transformation could convert a share price to a zero to one scale to bring it in line with the gamble, but this is not necessary; a log transformation just transforms the scale, it does not alter the prices.
As for the horizontal scale, the timeframes for both are around two years. Of course, with gambling there is always an end to the bet – either a horse wins or it doesn’t. This is not the case with a share price which, if company management is any good, carries on and on above zero, and on an upward path. Again, this difference is not fundamental – I could have used an Amazon option, which would have a finite end.
Unless you happen to know, you will not be able to tell which is which. Why? Because they are mathematically identical, a combination of randomness and pattern known as a Markov Chain. In other words, investing and gambling are fundamentally identical. Again, forget about whether the underlying is Amazon or Trump.
Protecting retail investors from themselves or rogue fund managers I believe, to a degree, is essential. However, as long as we pretend that investing is not gambling, we will never do this effectively.
By the way, below are the two charts that include their price scales.
How did you get on?
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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