Investing is not Gambling
Since there is a long-term positive expectancy in equity investments, buying stocks is not a gamble in the normal sense — a lottery ticket, a trip to the track, or a basketball pool. Why do so many investment authors use gambling terminology and analysis?
There are two very good reasons.
- Gambling activities often permit an exact calculation of odds and edge (positive or negative). This means that the action can be simulated, modeled, and analyzed. The study of risk and reward has drawn many serious economists, mathemeticians, and other scholars into the realm of gambling.
- The examples may be easier to understand than those from the investment world. In explaining to clients why certain ideas are silly, a sports or racing analogy often makes it clear.
William Poundstone’s book, Fortune’s Formula, provides an interesting trip into this world. I cannot really remember a book featuring both gangsters and academics, both separately and face-to-face. Poundstone describes the efforts of brilliant scientists exploring information theory, the travels between blackjack and investment management of Edward O. Thorp, and some insight into why certain strategies work and others do not.
Much of the book is a debate over the Kelly Criterion, a method of money management that optimizes the size of individual investments. Some economists dispute this idea, so there is a lively and informative discussion between the information theorists and the economists.
A mistake made by many investors (and even more gamblers) is a failure to understand risk, even when they have significant edge on a specific trade. Poor money management cannot turn a losing system into a winner, but it can turn a winning system into a big loser.