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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?

I’m a pretty serious student of the financial markets these days. The other morning on CNBC, they were doing a little shtick where they were simulating a poker game with some big name hedge fund managers. All the while they were (sort of) playing, they were discussing the similarities between poker and trading. These hedge fund managers had also done well in some professional poker tournaments.

This little vignette solidified something I’d been thinking about for a while. That is, everyone is a gambler.

When you study the markets and people who make a business of trading in the markets, you slowly become aware that everything is simply a game of probabilities, risk and reward (for more of my thoughts on this, you can check out a post a wrote a while back specifically on this subject). These very same principles that allow an individual (or a professional) to make money in the markets also guide the games of chance at the casinos. They also guide pretty much every other decision we make every day of our lives.

When asked about the similarities of trading and playing poker, one of the hedge fund guys explained that in both cases, you are presented with a certain amount of information, but there is always a piece of information that you don’t have. You have to make a decision on how to handle that missing piece of information based on your understanding of the information you do have. You make a decision, place your bets, and hope for the best.

Honestly, can you say that this is different than anything else in life? There is no certainty about tomorrow. We are always dealing with an incomplete information set and making decisions the best we can based on what we know. When it gets right down to it, we always have to move forward, choose our path, and hope for the best.

This is why I say everyone is a gambler. So, why do we consider gambling to be “bad”? What makes tying up hundreds of thousands of retirement dollars in equity-based mutual funds (which can lose their value) any more virtuous than hitting the casinos? Or, what about the person who invests a large portion of their net worth into a new business venture — are they somehow more noble than the blackjack player? I have some thoughts, but I’d like to hear yours first in the comments. What do you think?

NPR’s Morning Edition is doing a series this week on borrowing money. Seems like a good topic since the economy is in a big bunch of hurt, caused mainly by over-extended credit.

Monday’s episode really struck me as they explained how research shows that the average American today saves about 1/2 of 1 percent of their income. That’s 0.5%. That’s like … nothing. In 1982, Americans saved an average of 11% of their income. From 11% to 0.5% in about 25 years. That is staggering.

So, I’ve decided to start my own series here on the blog. I’ll be covering how to manage money. This post is step one and in it I am going to share with you the secret to financial bliss. Wait for it … here it is:

Spend less than you earn.

How much less? I say at least 10% toward retirement, then another 10% at least in non-retirement accounts. All together, that’s 20%. More would be even better.

“But what am I saving it for,” you ask. See, that’s the big question. Why save money if you’re not ever going to spend it? You can’t take it with you, right?

But here’s the little secret — it takes money to make money. If you save up money, you can then invest that money into efforts that will produce more money, until eventually you can earn substantial income off of the assets you have accumulated. This is what builds financial freedom.

I don’t believe that enormous wealth is necessarily a good goal to shoot for, but I do believe financial freedom is a good thing which can be achieved by most anyone with the discipline to spend less than they earn.

A McDonald’s hamburger costs around 80 cents, but when my parents were young, I think they were around a dime or something. But nobody complains about the price of a McDonald’s hamburger. Prices rise. It happens.

People my age grew up with gas that was considered expensive any time it broke $1. Now, there are growing outcries as the price tops $3.50 (regular unleaded, OKC prices). True, this over 300% increase has happened largely over the past eight years. Such a rapid move up in prices on a product we all use is sure to get attention.

But here’s why I think gas prices aren’t really that high — because demand for gas hasn’t fallen off. Most reports have shown that throughout this dramatic move up, people have continued to consume gas at the same rates, and I’ve heard some speculate that oil will have to reach $150 per barrel before demand really lessens. I know I’m just an outsider looking at this from a limited perspective, but I also know that in my own life and the lives of most people I know, our driving habits haven’t truly changed much in reaction to the rising costs.

So if gas can increase 300% without seeing much change in demand, I don’t believe it’s overpriced. Rather, I believe it was artificially under-priced previously.

When demand falls, prices will stabilize. But for demand to fall, we’ll have to make some changes. We’ll have to start treating energy like any other budgeted item — separating what we “need” from what we “want” and managing our consumption accordingly. Businesses might have to do more web meetings to reduce their airfare costs. Families might have to recognize that every trip, even in town, has a price tag, then let that impact the number of trips taken.

How do you plan to adjust your energy consumption in response to the rising prices?