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Are you investing your money or gambling your money in the stock market?
In the early 1930s, U.S. government officials proclaimed the stock market was "evil", and that the New York Stock Exchange ought to be "Shut down and padlocked." British government officials declared stockbrokers and dealers were "parasites" and that the stock market was none more than a "plaything for wealthy speculators." The Japanese minister of finance even declared the stock market as little more than a "gambling den."
But is this true? Is investing in the stock market akin to betting your paycheck on Seabiscuit?
In 2020, Covid unleashed stir crazy gamblers on the stock market due to the lack of professional sports to bet on. Celebrities were live-streaming their stock picks, retail traders were organizing "pump & dumps", and day trading went bananas.
Yet, despite the noise created in the stock market from speculation, it's important to define the difference between investing and gambling. Investing, if done correctly and consistently over time, tends to reward those who are disciplined and patient. Gambling, despite the thrill, is a losing game over time.
Here's how to know if you are investing or gambling:
Investing vs Gambling
At the surface level, I understand why people may think investing and gambling are the same. Probably because the dictionary definitions are quite similar.
Let's start with the Wikipedia definition of gambling:
Gambling (also known as betting or gaming) is the wagering of something of value ("the stakes") on an event with an uncertain outcome with the intent of winning something else of value. Gambling thus requires three elements to be present: consideration (an amount wagered), risk (chance), and a prize. The outcome of the wager is often immediate, such as a single roll of dice, a spin of a roulette wheel, or a horse crossing the finish line, but longer time frames are also common, allowing wagers on the outcome of a future sports contest or even an entire sports season.
There are elements of this definition that match perfectly with the ideas behind investing. For example, uncertainty, risk, and profit.
But we will later explore the data behind just how unlikely it is that a gambler is successful.
Now let's look at the Wikipedia definition of investing:
Investing is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is to generate a return from the invested asset.
Again, we see similarities in the definition. For example, sacrifice(risk), return (profit), and effort (uncertainty).
So how do you know if your portfolio is set up as a casino or a long-term wealth-generating machine?
The answer lies within diversification.
What was the original intent of the stock market?
In 1602, the Dutch East India Company issued its first paper shares.
This was the first formal stock exchange that allowed partners to buy, sell, and trade ownership with other shareholders.
Before having a formal market. Their business model was risky. Thus they needed outside investors to fund voyages, in which they offered a percentage of profits for capital.
At the height of its success, it boasted 40 warships, 150 trading vessels, 10,000 professional soldiers. All are financed by a formal exchange.
What we learned is that issuing company stock in the form of shares can spread out risk and prove to be a great way to provide capital and create shared value for many people.
Can investing turn to gambling? Absolutely.
And that's what we saw following the foundation of the Dutch East India Company in the 1700s.
In years following the creation of the Dutch East India Company, Dutch investors madly purchased tulips, pushing their prices to unprecedented highs. For example, people were trading their homes for tulips at the time.
Eventually, prices peaked and tulips crashed, causing tulip hoarders to lose their fortunes.
Stories like Tulip Mania, the Dotcom bubble, and the housing bubble all can be seen as times when investing turned into a gamble.
What's the psychology behind gambling and investing?
Investors and gamblers can be similar in the fact that they have a striking ability to lose money in a myriad of ways.
Research findings from psychology show that humans in general have a sense of overconfidence about their abilities to perform a variety of tasks such as driving, predicting election outcomes, picking stocks, and gambling.
This overconfidence explains why investors may prefer an undiversified portfolio despite the patchy record of outperforming indexes from stock picking.
Just like picking a winning horse, the average investor may be willing to have a below-average return for the small chance of jackpot success.
The difference between proper investing and gambling investing is the long term mindset.
Gambling is a zero sum game because you are betting on an outcome.
How has the stock market performed vs a gambler's performance?
Has the stock market become more gamified in recent years?
The importance of diversification
How to gamble responsibly?