In my previous post, I made the case that everyone is a gambler. I also posed the following question: “what’s the difference between gambling at the casinos and gambling in the stock market or with mutual funds?” I got some thoughtful replies and, after considering it further, decided I would continue the discussion with another post.
To me, casino gambling, stock market investing, starting a business … etc., it’s all a gamble. It’s all the same. There’s no intrinsic difference in the activities themselves. They are all games and they follow the same rules of risk, reward and probability of success.
The difference can only be found in how one approaches and plays the games. It is possible for someone to approach the stock market as a gambler, just as it is possible for a person to treat casino gambling like a business. In my opinion, the difference comes down to one thing: risk management.
Whether you invest your money in stocks or in casino gaming, you are only treating it as an investment if you practice a solid plan of risk management. Without this component, you are simply throwing money toward chance, and it is this practice of betting on chance that gives casino gambling its wasteful reputation. I would argue, however, that it is just as common for people to play in the stock market in a wasteful manner when they don’t practice risk management.
Risk management is a practice of understanding all of the factors that can influence the possible outcomes of your play, and building a solid plan around these principles. Risk management makes it imperative to have a plan in place for your trading or gaming. Without a defined plan, one is not managing risk because without a plan, one will generally just bow to emotion and give in to the feelings of the moment, which almost surely results in loss.
A person who makes a solid profession out of playing poker understands risk management. They have a plan and they practice that plan every time they play. They know how much they are willing to lose on each hand, each game, each month, each year … etc. They know the probabilities for every hand they are dealt and they know how they will react to every possibility they encounter. The professional poker player treats poker like a business. They preserve capital and operate with a plan. To me, this person is investing because they are putting money into a system, or business model, that they believe will be profitable over time. The casino gambler who doesn’t practice risk management, on the other hand, just throws money at chance without a plan in place. This practice relies purely on luck and, over time, this gambler will generally lose.
I think most would agree with the above point, but here’s where I think this intersects with a majority of Americans in ways that most don’t understand. The stock market is also a gamble and unless you practice risk management, you are not really investing, but rather just taking a chance. The “safety net” that has kept most people out of trouble while they have thrown their life savings into mutual funds and stocks is that, over time, the equity markets have appreciated. So, even though people don’t understand what they are really putting at risk, they have come out OK because the markets have saved them by being resilient.
Problem is, the more the market proves itself this way, the more people tend to forget about the risk. It is this psychological phenomenon that led to the housing and credit crisis we are now enduring. People got overconfident about the resilience of housing, thinking it could never go down, and they placed large bets on the belief that housing would always go up. I believe the stock market also holds this illusion of infallibility in the minds of most people. We come to believe that the stock market is a “sure thing” as long as you hold on for the long term. But it’s not a sure thing. The markets do tend to go up over time (at least in recent history), but what if you put your money in at the wrong time? Or, even worse, what if the markets stop going up, or start going down?
We recently got to witness the results of this problem. As the Dow fell from 14,000 to 12,000 recently, the nation started screaming for justice. Everyone looked to blame the politicians or the oil companies or whoever else they could find to blame. Nevermind the fact that the Dow was still holding 12,000, which up until a couple of years ago had never even been hit. Here we are exponentially higher than we have been in recent history and yet our nation was demanding that our leaders do something to stop the decline.
Why does this happen? Because most people have most of their money tied up in the markets or instruments that respond to the markets yet they don’t understand or manage their risk. They simply expect their money to grow year after year and to grow by a hefty percentage at that. This is what years of growth have taught us to rely on. It’s what most people believe to be true. But it’s unfortunate because the truth is that the stock markets, just like the casinos, are a gamble, and to be successful you have to either be lucky, or practice a solid plan of risk management. Most of us have been lucky for the past many decades. But what if that were to change?
