Tuesday, February 22, 2011

Investing or Gambling? Part 2: The Definitions

In this second installment of our analysis, we will examine the definitional differences between gambling and investing. This information will form the basis by which we will judge future comparisons of each discipline.

To begin, there are fundamental similarities and differences between gambling and investing. Both involve a participant's initial outlay of money for purposes of receiving future payments that exceed the investment amount. The definitions below describe the expectations that each monetary outlay will purchase.

Investing Defined
Those who invest receive partial or full ownership of a physical asset, whether it be a company, commodity, real-estate, manufactured good, production rights, etc. which can be redeemed at a future date at the discretion of the owner. The vast majority of investors typically have no direct financial control of the asset. Appreciation of value is acheived based on fundamentals of supply and demand, and operating efficiencies. When an asset grows in value, an investor may realize a profit on his investment; and when an asset drops in value, the investor may incur a loss. But, the actual profit or loss is only realized when the investor sells the asset. The key here is that the investor has the sole opportunity to act.


Gambling Defined
Gambling involves purchasing the right to participate in the possible ownership of a product or prize based on a certain outcome of a particular event. Depending on the prize structure, a gambler only receives income if his predicted guess correctly matches the ordered result of the event, such a lottery drawing, horse race, the win or loss of a sports team, a poker hand, etc. Once the event is completed, the gamblers asset value (if any) is returned to the player. These investors either win or lose, and the participation right is valueless once the event is over. Important here is that gamblers have no influence over the outcome of the event.

  • To play a game for money or property (Merriam-Webster)
  • To bet on an uncertain outcome
  • To bet on an uncrtain outcome, as of a contest (TheFreeDictionary)
  • To play a game of chance for stakes
  • To take a risk in the hope of gaining an advantage or benefit

Three Major Distinctions
From the definitions above, we can identify three major distinctions between investing and gambling.

First, the primary distinction between investing and gambling is ownership of an asset. An investor purchases an asset of value whereas a gambler purchase an outcome. The investor's asset maintains value for the life of the asset. Whereas, a gambler's outcome has no value in itself. The only means of profit is derived from the investments of the other gamblers involved.

Secondly, an investor's asset derives value from market demand, which can cause the value of the asset to fluctuate. However, a gambler's asset has value limited by the expectations of others. Any changes are based on parimutuel betting odds or a gambler's expectation of winning. Please realize that neither of these are physical factors.

Third, an investor has an option to sell his asset. But, a gambler's asset rarely has any secondary retail value. It's not very often that: a race track bettor or lottery player will sell his ticket; or, a poker player will sell his hand. But stock market and bond investors continually buy and sell these assets.

Hidden Ambiguity
Occasionally, the lines of distinction between investing an gambling can appear to be blurred. For example, consider an options investor. In this case, the investor purchases the right to buy (or sell) an asset for a predetermined period of time. At the expiration of the term, the asset may or may not have any value. This sounds like gambling.

However, two things differentiate options investing from gambling. First, there is an underlying physical product to the option. Second, the investor has the opportunity to sell, exercise, or expire the option. These are all directly under the investors control.

Summary of the Subtle Similarities
Both successful gamblers and investors understand that favorable outcomes involve probabilities. The skilled player of both professions understands the risks and chances for success. They invest (bet) accordingly.

Both are investing in the unknown. Neither the investor or gambler knows what will happen in the future,  but both are willing to invest their earning with the hope of receiving a future profitable payout.

In our forthcoming articles, we will utilize these definitions to clarify and identify the differences and times to show when investing becomes gambling, and when gambling becomes investing.

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