Six lessons investors can learn from gamblers

Is investing a form of gambling?

One of the common misconceptions amongst the general public is that investing is simply a form of gambling. It can sometimes feel like it is even to investors. Especially in current markets where small caps can move up or down over 10% daily on no news. This year, investing in the FTSE All Share has been little better, with rapid moves up and down in a largely range-bound market:

Despite this, two key distinctions mean investing is not gambling:

1. The first is that investors own an asset. That is part ownership of a company that makes sales and profits, which it reinvests into growth or returns to shareholders (or it intends to do these things in the future). In contrast, a gambler is wagering on an uncertain outcome via a contract with an external party, without owning an asset. Bets are not usually transferrable either, whereas the point of investing in a listed stock is that it can be sold at any time (within market hours).
2. Secondly, an investment has a positive expected return. On average and over the long term, stocks generate a return above the rate that can be earned in short-term government bonds, the so-called risk-free rate. This difference is known as the equity risk premium and is the excess return the average stock market investor receives. In contrast, a gambler bets against a “House” who sets up the wager or prices the odds so that the expected return is always negative. A sensible gambler only bets when they believe an individual bet has a positive expected return. I.e. they think that the odds offered do not reflect the odds in reality. However, in aggregate, the system is set up such that gamblers have a negative expected return. The house always wins.
   

It is possible to think of many cases which meet one but not both of these criteria. For example, mathematician Ed Thorp famously devised a system of card counting at Blackjack. He bet minimally when the deck was unfavourable and aggressively when the cards were stacked in his favour. He calculated that this gave him a positive expected return. Which it did do, and for many others, too, when he wrote a book about it called Beat the Dealer. However, casinos quickly adapted the game to introduce multiple decks of cards or mandatory shuffles that removed this edge and started looking out for betting patterns that indicate card counting.

Likewise, a series of “rollovers” in a lottery may make the winning pot so large that buying a ticket has a positive expected return. (Normally, buying a lottery ticket is a very poor bet on a purely mathematical basis.) The “rollover” may make the lottery worth playing, but I don’t think anyone would describe the lottery ticket (prior to the draw taking place) as an asset and, therefore, an investment.

What about trading or spread betting?

A trader who purchases stocks is clearly owning an asset. And stocks have a positive expected return over the long term. However, a trader rarely holds a stock for many years, expecting internal compounding to deliver above-market returns. Instead, they are hoping to take advantage of short-term price moves. Over these periods, the outcomes are much more likely to be a zero-sum game. The trader is looking to use chart patterns or other technical indicators to find situations where other traders or investors are likely to become exuberant about a company and bid up their share price. They then want to get in ahead of the crowd and exit before exuberance turns to gloom.

A trader friend once told me they would purchase shares in a known fraud if the technicals told them that the share price would likely go up. This is clearly not investing since the underlying asset here is worthless. However, the truth is that trading blurs the lines. In practice, trading can look very similar to investing, and many successful investors use criteria to time their entry into stocks they believe to be undervalued or have superior quality characteristics. There is undoubtedly some truth in the saying that a long-term investment is a short-term one that has gone wrong!

Likewise, spread bets. While clearly set up to encourage gambling, they can be used for investment. The investor may not technically own the underlying asset but may use spread bets to invest long-term and take advantage of the favourable tax treatment. Hedging risks can also be a crucial aspect of more sophisticated investment strategies, where spread bets may form an integral part. Again, the substance of the transaction rather than the technical detail determines the difference between investing and gambling.

The power of dopamine

Although it is right to draw a distinction between investing and gambling, that doesn’t mean it is always clear-cut. As well as being a world-famous economist, John Maynard Keynes was an active investor. He recognised the link between gambling and investing in 1936 when he wrote:

The game of investing is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.

The thing that makes gambling a popular pastime is the power that positive, unexpected outcomes have over us. A predictable positive outcome may give us a warm feeling, yet it rarely generates the sheer elation of an unanticipated victory. Back then, Keynes knew this simply from experience, but we now know that this is because an unexpected win releases the hormone dopamine.

Dopamine is a vital part of the reward system in the brain. It is partly because of dopamine that we can think ahead and plan, are motivated, seek novel experiences and procreate! Everyone has a different level of need for dopamine, including those who don’t get much of a hit from positive, uncertain outcomes. These people are unlikely to be active investors; as Keynes says, they find investing “intolerably boring”. The reality is that, despite being different in substance, investment gains generate the same dopamine release in the brain as gambling wins. Keynes recognised that this is one of the main reasons investing is a fascinating pursuit.

Keynes also recognised that the dopamine-seeking behaviour, which he called the gambling instinct, has the power to make us behave irrationally. In the pursuit of the dopamine spike from repeated but unexpected wins, we may end up making suboptimal decisions. We have to pay the toll. For some gamblers, this is the compulsion to repeatedly make negative expectation bets. While gambling addiction has complex causes, it seems brain chemistry, and in particular, the desire for dopamine, plays a significant part. Investing has the same power, and investors should be on guard against similar compulsive behaviour.

While most investors will never face such severe problems, the gambling instinct can still exact its toll on us. Thankfully, much study has gone into the suboptimal behaviour of gamblers and the biases they suffer from are well known. Indeed, as investors, we can suffer from the same biases. It is, therefore, worth studying these to make sure they don’t also fall for them.

What common gambling mistakes can teach us about investing

The Gambler’s Fallacy

The Gambler’s Fallacy is the belief that past events define future ones even when there is no causal link. For example, if a coin toss comes up heads five times in a row, we may believe that tails is “due”. Of course, if it is a fair coin, the outcome is equally likely to be heads or tails.

We see this effect when investors think a persistently losing stock is due for a bounce. In reality, academic evidence detailing the Momentum effect shows that losers over the last year will likely keep being losers. This Gambler’s Fallacy is most prevalent with profits warnings. It feels like a company that has lost 60% of its value in a day must be due for a rebound. It may occasionally pay to be a liquidity provider when a stock sells off significantly on a minor issue. However, the effect is usually short-lived. Ed looked in detail at what happens to stocks that warn here.

The House Money Effect

The house money effect sees gamblers risk more with their winnings than their original stake. This is a form of mental accounting whereby people sort their money into the money they have earned and the money they have won and behave differently with each pot.

We see this in investing when investors say things like, “The price has dropped 50%, but I’m still up 30%, so I haven’t lost money”. A more subtle form is when investors quote “dividend yield on purchase price” rather than current yield. The reality is that liquid stocks can be sold today and that money can be invested into any asset, so any gain or drop in value is real.

The easiest way to overcome the House Money Effect in investing is to forget your buy price. I do this by using a day-to-day tracking spreadsheet with no buy price and no P&L on individual positions visible. Instead, it compares my current portfolio weighting to my target weight for each stock. While it can be hard to achieve in practice, with the number of biases it can introduce, it is worth ensuring that the buy price is as irrelevant as possible to future decision-making.

Trying to win back losses in the same way

This is the downfall of many a gambler. When faced with a losing bet, they try to win their money back at the same game by taking more risk. This can quickly snowball so that small initial losses become large ones as the gambler ups their stake. There is even a betting strategy called the Martingale system that originated in 18^th Century France that aims to do this systematically. The idea is that if you bet on a 50-50 outcome, such as a coin toss, and double your stake each time, you are guaranteed to win your initial stake….eventually. The problem is that a run of bad luck sees exponentially increasing losses. If a gambler has a limited bankroll and can’t make the next double-sized bet, they lose everything. Martingale betting is a good way for Warren Buffett to win a dollar by risking his total net worth.

In recent articles, I’ve looked at companies that have struggled. When a company has dropped 90% or more, and investors face a considerable loss, the temptation is to add significantly to the position to win their money back. Of course, a stock that has lost 90% or more of its value in a short period is facing very serious issues. So, the gamble may pay off, but it is equally as likely to end in further disaster. I am not averse to averaging down where appropriate, but the must-win-it-back behaviour is certainly not investing.

The Hot Hand Fallacy

This name comes from basketball, where it was often believed that a player who has successfully made several shots in a row has a” hot hand” and is more likely to score with future shots. The reality is that while great players will score a greater proportion of shots, the likelihood of the next shot being successful is much closer to their long-term average. A recent scoring streak makes little difference to the chance of making the next basket. This effect may be a form of recency bias, where people overweight recent information at the expense of longer-term averages.

We see this effect in investing, where we believe that a previously successful CEO should be backed in a new venture. Or that a previously successful CEO will turn around a failing enterprise. Dan Rasmussen studied this hypothesis using empirical data and found no evidence for persistence in performance (at least as measured by share price returns) when a leader switches companies.

Likewise, we may see a fellow investor who makes a series of good calls about shares that make significant gains and think they are worth following. While it probably makes sense to listen to experienced investors with good long-term track records, mindlessly following anyone into a position, especially based on just a few recent results, is a recipe for disaster.

Illusion of Control

Illusion of Control describes the false belief that one can influence an outcome when there is no causal link. This fallacy is behind many gambling superstitions, such as wearing “lucky” socks. As investors, we tend to think we are above such craziness, but we can often fall for less obvious effects. Many investors like to buy stocks where they live near the headquarters or a factory, in an extreme form of local bias. It can feel like being nearby may give an investor more access or the ability to influence management. However, it is usually impossible to articulate how that gives an investing edge. In such cases, investors are suffering from an illusion of control.

Statistical errors

Finally, gamblers tend to make common statistical errors. They forget base rates, the average frequency that something happens over a long period. Or they miss the impact of sample size and make undue inferences from only a few (usually successful) bets.

These errors tend to show themselves in investing amongst those who make general market predictions. The typical example shows a chart pattern similar to the Great Depression or Black Monday and infers that a market crash is coming. Such soothsayers miss that these are rare events where many other factors differ in today’s markets beyond simple chart patterns. Such predictions of calamity are best ignored entirely, as they are almost certainly statistically insignificant.

---

While investors and gamblers are engaging in very different activities, they tend to make very similar errors. By studying the common gambling biases, investors can avoid losing behaviours and become better investors.