What is the difference between investment and gambling?

Investment, especially stock trading, Forex trading, has been compared with gambling by some people, as investment and gambling have indeed some commons. Both actions have risk and it is important for participants in either field to understand the risk they are facing. In general, people have to be over 18 in order to participate in either activity. Of course, gambling has negative externalities and investment has positive externalities, this is why governments put more restrictions on gambling than on investment. I only want to focus on the nature of actions of investment and gambling, and their private costs and benefits. I will discuss the similarities between the two activities then move to their differences, and point out my beliefs about how to conduct rational investment strategies.

Similarity

The biggest similarity is investment and gambling both deal with risk and uncertain future. Both activities are trying to betting based on investors’ or gamblers’ expected future. As investors and gamblers are dealing with risk, their actions are no longer only based on their utility preferences or expected returns, but also based on their individual risk preferences. This is why we can see some investors have many similar behaviours in the financial markets as gamblers behaving in casinos. Individuals have three types of risk preferences: risk-averse, risk-neutral and risk-loving; however, their risk preferences can change according to their wealth changes. If we believe, risk averse is the most common risk preferences among the whole population, the Arrow-Pratt measure of risk aversion tells that the tolerance for risk of an individual with positive (negative) absolute risk aversion will fall (increase) as his/her wealth increases (decreases). Therefore, individuals in casinos and financial markets have different risk preferences and act differently, but the general behaviour in financial markets has lots in common as the general behaviour in casinos, and this usually is an important factor that makes many people link investors and gamblers together. And frankly speaking, investors and gamblers are more risk-loving than the rest of the population.

Moreover, either gambling or investment is a money game that people inject money and hope for higher returns. Moreover, the market power can be controlled by individuals with significant amounts of resources. Although theoretically in either investment or gambling, all participants should receive the same information (public information), some have much stronger analysing abilities than the others and some inappropriate abilities (including controlling games or inside trading). Therefore, many people think that there are many frauds within financial markets as well as casinos that people with significant resources have control of information and pricing. Such frauds could make a significantly large number of small investors and gamblers more easily lose their money to larger investors and casinos and gambling companies. Although governments and regulators have imposed many regulations and laws on financial markets and the gambling industry, it is impossible to clear all frauds and such frauds make small participants feel they are bullied by the large participants in both sectors.

Difference:

However, there are many differences determining the two actions have different natures and participants have to have different strategies in the two sectors. Firstly, the outcomes delivered by financial markets are continuous outcomes, there are an infinite number of outcomes for financial markets; however, the outcomes delivered by gambling are discrete, usually there are only two or three possible outcomes (win, lose and draw). Therefore, it is much harder to predict financial market outcomes than gambling outcomes precisely.

Furthermore, the possibilities in financial markets are floating but the possibilities in gambling are mostly fixed. This does not mean there are more uncertainties in the financial markets, instead it means there are more market volatilities in financial markets. Although possibilities in gambling could be floating, for example, when a football matching is progressing, the possibility of winning can change; however, the gambling companies normally tend to fix the possibility by closing betting after the game starts, in addition, they hire actuarial professionals to calculate the possibilities. Here comes another difference between investment and gambling, investment assets are tradable when the events are progressing but gamblers cannot trade their bets with each other. The activities of investment are far more flexible than gambling.

Lastly and most importantly, the results delivered by investment and gambling are totally different. Gambling is for no doubt a zero-sum game that winners win everything, and losers lose everything; however, investment is something different, if the investment target or the economy is growing, there is no clear definition for winners and losers, some may win short term profits but gain no further profits in the future, and some may lose short term cash but gain profits in the future. Therefore, gamblers are directly competing with each other, as they literally take money out of other gamblers; however, investors are making trades with each other, just like other ordinary goods, it is certainly inappropriate to say a fruit seller is winning over a fruit buyer. Buyers may find the utilities of the financial products are higher or lower than their expectations but such mistakes are not caused by their sellers.
 

Conclusion

There was news that some institutional investors will soon be able to try sports betting fund by using algorithms to predict game results. Such fund may be seen as an asset class (as it is issued by financial institutions), but it is just purely gambling. Although there are many outcomes, but outcomes of such fund are still discrete, as the final outcome must be one in the set of all combinations of possible game results, and the possibilities are relatively stable though their calculations are very complicated.

My belief is that investment is no different from buying ordinary goods, like apples, investors should only consider buying assets which have higher utilities (expected returns in financial markets) than the costs, their decisions should be independent of the sellers’ activities or opinions; and investors should sell their assets when the market prices are higher than their expected returns, without considering the opinions from the buyers. This sounds extremely simple, but it is true that many investors have been trying to be smarter than other investors, but forget their preferences. For example, some investors look for fixed returns without too much risk, then government bonds with low returns are not a bad choice for them. Investors should balance their preferences towards return and risk, and only invest assets that fit their demands for future incomes. It is possible that there is some whispering in financial markets, if it cannot be proved to be accurate, then see it as an uncertainty rather than an opportunity.