Tuesday, March 29, 2011

Investing or Gambling? Part 7: Profile of a Typical Investor and Gambler

When we first began researching the profiles of typical investors and gamblers, we found many sources describing gamblers but relatively few discussing investors. The information we read about gamblers was written from either the "problem gambler" viewpoint, or that of a "casino operator". The investing articles were written for purposes of attracting "day traders" to discount brokers, or describing why investors typically lose money.

Rather than summarizing this information once again, we decided to explore the underlying traits and skills that both participants exhibit.   

In the old days, we all have images of savvy boardroom executives smoking cigars while formulating important business decisions in a smoke filled boardroom. In contrast, we also envision the small old wiry racetrack bettor studying his racing forms while the cigar ashes threatened to fall off.

Source: Frontier Gamblers - Poker Alice
Today, we find that the cigars have mostly disappeared and that the executives and gamblers have become much much younger.

It appears that youth has overtaken our society.

But not so quick. During the past few years, our economy has faltered, leading to widespread unemployment. Executives and thousands of regular employees have been laid off. Graduates from colleges cannot find jobs in fields of their study. Out of frustration, many of these individuals have turned to gambling or investing in hopes of earning a living to support their families.

From a demographic viewpoint, we find that age has no bearing on the profile of these persons. In Wall Street, the mentality is the younger the better. They believe the younger you are, the more mathematical and abstract you think, the better you will trade. However, the major difference between these individuals and the ordinary person is that they are playing with someone else's money. These young mavericks will earn a very handsome bonus regardless of whether they win or lose.

The illustration below was designed to describe the thinking of various gamblers. However, those involved in investing (or trading their own accounts) are depicted as well.  What we learn is that the average individual  is best described as an entrepreneur. They try to be middle of the road, balancing amusement with gaming while taking average risks. Whereas, individuals and amateurs lean more toward amusement, and elitists take more risk.
Source: Gambling - Contexts and addictions

According to the Forbes article, The Average Investor Is His Own Worst Enemy, average investors fail to succeed because they are overly confident, shortsighted, and have bad timing. The same is true with the average gambler.

What novice investors and gamblers believe is that they are playing on an equal level with all the other participants. Both fail to realize that they are actually playing against highly educated and highly financed professionals. These professionals have more information at there disposal, and know the underlying probabilities by heart. Consider a professional poker player. He knows his probability of winning as each card is drawn while the common individual just thinks in terms of luck. To further complicate the equation, the professionals are playing in teams while the individual is playing alone.

Whether the professionals work independently or for a company, they have dedicated their livelihood to learning their trade. Most began small and have worked their way up the income chain. Most have made associated contacts that help to keep them informed.

If you have dreams to pursue your own career as a professional investor or gambler, be prepared to study, memorize, and practice. Learn to make your own decisions but always consider the advice of others. You must always be retrospective and analyze the plays that succeeded and failed. And, never make reckless decisions, especially out of dispair.

According to Harrah's Gambling Survey 2006, successful gamblers (and we interject investors) believe they are more:
  • in control of their spending and borrowing
  • optimistic about the future
  • prepared financially for retirement
and more likely to:
  • view work as a career
  • research purchases more
  • dine out
  • have higher earnings
than the common investor. If you fit these profiles and are willing to spend years (rather than days) preparing for your future, then you too may become a successful gambler or investor as well.

Tuesday, March 22, 2011

Investing or Gambling? Part 6: Investment Options

Both gamblers and investors have a wide range of investment options in which they can place their money and hope to earn a profit. In both cases, a person puts down some money with the hope of having more sometime in the future.

From the investing side, the vehicles that are available range from near zero risk to highly leveraged and very risky strategies. The charts below illustrate various investments that a person can make, along with the associated risk taken. For purposes of this paper, we define risk as the chances of losing all or part of their money.

Source: Create Wealth Through Long-Term Investing ...
Below we have listed a number of investing options that individuals can make. Typically, most people are aware of putting their money in bank CDs and Savings Bonds. Additionally, many have purchased outright stocks, mutual funds, and sometimes commodities. As one's wealth increases, investors have branched out of these and invested in currencies, private equity companies, hedge funds, real estate, and various sports related items.
  • CDs & Bonds (Savings Bonds, US Govt Debt, Municipal, Corporates)
  • Asset Backed Bonds (Mortgages, Credit Cards)
  • Stocks
  • Commodities (Gold, Silver, Oil, etc)
  • Currencies
  • Mutual Funds
  • Hedge Funds
  • Private Equity (Small companies)
  • Collectibles (Fads, Antiques, Art)
  • Real Estate (Outright land, REITs)
  • Sports (Teams, Horses, Race cars)
Most common individuals that invest in stocks do so with the idea that they will always make money. However, that is not the case anymore. The graph below shows the Dow Jones Average from 1975 to 2008. As we can see, those who invested early were almost assured a profit. But from 1996 to 2008, there was a bumpy ride. Lots of money was lost around 2001 to 2003 and then again in 2008.

After a while, investors who have become comfortable with stocks begin to buy futures and options. These exotic vehicles allow the persons to leverage their investments by outlaying a small portion of their money and purchasing the underlying stock or bond only when a profitable return is met. The image below is a payout graph for a call option. In this example, the $40 call option would be purchased for $2 only. If the price of the stock rises above $42, then the investor would exercise his option to buy the stock at $40 and lock in a guaranteed profit. However, if the price never reached $42, then the investor would simply lose his $2 investment.

For the gambling investor, there are numerous legalized vehicles that allow participation. Most notably are lotteries, organized parimutuel racing, casinos, and charitable games. Without ranking these in order of risk, gamblers have the opportunity to play:
  • Lottery (+ Keno)
  • Card Games (Poker, Blackjack, etc)
  • Craps (Dice)
  • Roulette
  • Slot Machines
  • Sports Games (Outcomes, Scores, etc)
  • Racing (Horses, Dogs, etc)
  • Games of Skill (Backgammon, Chess, etc)

The risks of gambling are quite different than investing. Most notably is that the event horizon is relatively short. For example: a lottery drawing may take several days before it occurs; a football or baseball game may take hours to play; a poker hand may take minutes; and a roulette spin may take seconds.

A secondary difference is that the gambler usually has direct involvement in the game, whether he is a participant or a spectator. Third, gambling payouts are usually all or nothing, win or lose. For example, only one person wins a poker hand or racing event. Investors, on the contrary, do not typically lose their entire investment.

One may argue that the gambler has an advantage over the investor because there may be an individual skill involved. While that is true, a successful investor is also skilled in understanding their own underlying products. Thus, they too have control over their destiny.

Lastly, many may say that gambling only involves luck. That can also be said about investing. Luck has a lot to do with timing and market sentiment as well.

Tuesday, March 15, 2011

Investing or Gambling? Part 5: Spotlight on Successful People

Doyle Brunson in 2006 World Series of Poker - ...Image via Wikipedia
We are all enamored by the success stories of many individuals. For those of us interested in investing, we have role models that we wish to emulate. Similarly, for those of us who wish to be successful gamblers, we point to those people who have made it big and say we can do it too.

Below,  we have highlighted six practitioners from both the gambling and investing professions who have made significant contributions to their societies and amassed a fortune at the same time. The list is intended to be a cross-section of representatives who have helped their professions advance. The list is not prioritized nor is it complete, as there are many more people who have succeeded as well.

Successful Gamblers

Doyle Brunson: Considered to be the patriarch of modern poker, this famous gambler revolutionized poker in 1978 when he published his book called Super System. Times were not always easy for this Texan who went to college on basketball and track scholarships. But, after he shattered his leg in an accident, and was diagnosed with terminal cancer in 1962, this legend learned to become successful playing the game that he loved. Quote: Through the years I've never stopped doing things, thinking about things, and I still think young.

Gonzalo Garcia-Pelayo: A Spanish mathematician and record producer who believed that roulette wheels were not completely random. Began to exploit the game by recording winning numbers on thousands of spins, and then analyzed the data. Afterward, he used this data to win over €2 million.

Dominic LoRiggio: Became famous for controlling dice while playing Craps. Learned the skill through years of practice and identified ways to set, grip, and toss the dice to achieve a desired roll. Called the Dominator, he says it is a matter of simple physics. Claims to have won thousands of dollars at various casinos.

Edward Thorp: The creator of card counting, a technique by which a player can keep track of the cards that are played and those left in the deck. Most notably recorded in his 1962 book called Beat the Dealer. He has a M.A. in Physics and a PhD in mathematics, and taught at M.I.T. He published a second book in 1967 called Beat the Market and then started a derivatives based hedge fund.

Admiral Henry John Rous: Devised the first methodology for handicapping horse racing. It was based on the Weight for Age Scale which tabulates results based on a jockeys weight and a horses age.

Billy Walters: One of the instrumental managers of The Computer Group, a sports betting operation, that won millions by analyzing all the statistical data about the teams, weather, and more. The Computer Group was forced to break up in 1987, but Billy Walters has continues to win annually using a team of associates who specialize in various aspects of the games.

Successful Investors

Myron Scholes: Co-inventor of the Black-Scholes Option Pricing Model, he was a managing director and co-head of fixed-income derivatives at Solomon Brothers. Then, he co-founded the hedge fund, Long-Term Capital Managment which obtained annualized returns over 40%. The fund failed in 1998 after losing $4.6 billion in four months. He is now chairman of Platinum Grove Asset management.

Tutor Jones: the founder of Tudor Investment Corporation. Later organized the Tutor Group that includes the former and a variety of affiliates. Is actively involved in trading, investing research and more. Current estimated net worth is $3.2 billion. Quote: The most important rule of trading is to play great defense, not great offense.

Warren Buffet: Formed Buffet Associates in 1956 with 7 limited partners and $150,000. Buffet used $100 of his own money. After 10 years, his assets rose by 1,156%.  Then he bought control of Berkshire Hathaway and became Chairman in 1970. Now has net worth of $47 billion. Quote: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1

Peter Lynch: Earned the reputation of being one of the best stock-pickers in the world after managing Fidelity Magellan fund from 1977 to 1990. Those who invested $1,000 in 1977 would have worth of $28,000 in the 13 years during his control. Favorite Principal: Invest in what you know.

Benjamin Graham: The Father of security analysis and value investing. Wrote two books on these topics in 1934 and 1949 which are considered to be requites for all investors. A mentor and early employer of Warren Buffet. Principle: Know What Kind of Investor You Are

George Soros: Co-founded the Quantum Fund in 1970 at age 40. Aquired most wealth by acheiving  returns of 4000% during the next 10 years. Is now estimated to have $11 billion. Quote: The financial markets generally are unpredictable. So that one has to have different scenarios.. The idea that you can actually predict what's going to happen contradicts my way of looking at the market.

Michael Moritz: A journalist for Time that became a Venture Capitalist two years later in 1986. Joined Sequoia Capital and had made huge returns by investing in Google, Yahoo, PayPal, and many others. Fell out of the Billionaires club in 2008, but still has lots more money.

By reading the stories of the individuals above, we can identify certain traits common to all. First, most are highly educated.  They all share a deeper knowledge of mathematics and used this skill as a tool to analyze their content. All are hard working and highly dedicated. Success didn't come overnight, but after years of studying, practicing, and hard work.

For us to succeed then, we must conclude that we can't give up. Some have made mistakes, earning a fortune and then losing all or part of it. However, they never gave up on their pursuits and all succeeded in the long run.
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Tuesday, March 8, 2011

Investing or Gambling? Part 4: The differences between the two.

Thoroughbred racing at Churchill Downs.Image via Wikipedia
There are two primary differences between investing and gambling:
  1. Ownership of an asset, and
  2. Entertainment.
First, in investing, an investor purchases an asset with the expectation that it will appreciate in value and be worth more in the future than it is at the present time. When gambling, a participant also invests a certain amount of money with the anticipation of winning. However, most gamblers understand that the chances of losing their investment far outweighs their chances of winning.

Second, gambling is entertainment, it is fun. Many people love to go to casinos to play the slots, poker, roulette, or craps. Whether they return home with the same (more, or less) amount of money, the person is usually happy knowing that they purchased a few hours of entertainment. To the lottery player, they have purchased a day or two of dreams. However, investing is work and that is not typically fun. Except for those who purchase antiques or collectibles, an investor obtains very little entertainment value.

Aside from the outlay of money, there are few similarities to investing an gambling. In these, both:
  • Risk capital to earn a profit.
  • Are trying to predict the future outcomes of a certain event.
  • Require skill to be successful.
  • Are subject to external manipulation.
  • Hope to get rich.
  • Can lose money.
  • Value may be arbitrarily contrived.
Examples of Investing and Gambling
Real EstateHorse Racing
Cars & HorsesSlot Machines
CollectablesFootball Games

 When considering the two, there are many more differences between investing and gambling that can be identified:
  • An investor's time horizon is endless, whereas a gamblers horizon is fixed.
  • An investor expects to earn a profit, but a gambler expects to lose.
  • The financial return on most investments is quantified, but a gambler's is infinite.
  • Investing returns are incremental, but gambling is all or nothing
  • An investor's asset fluctuates based on supply and demand. A gambler's asset changes only on anticipated success.
  • Investors do not typically influence the value of their asset. Gamblers have direct control over the value of their asset.
  • Investors rarely lose their entire investment. Gamblers usually lose most of the money wagered.
  • Investments are subject to economic pressures. Gambling games have no economic pressure.
Negative, Zero, and Positive Sum Games.
Most educators consider most forms of gambling to be Negative Sum Games. This means that less money is returned back to the players than the money raised. However, economists liken investing to a Zero Sum Game, meaning that all the money invested is returned back to the investors. Depending on your viewpoint, this may or may not be true. For example, assume that you bought an asset that was destroyed in a fire, lost or stolen. Unless you had insurance (and paid more for this risk), you would lose your entire investment. Depending on the type of asset, others may then become more valuable, or not change in value at all. Investing in bonds can be a Positive Sum Game to the purchaser. Depending on the security, there would be very little risk of losing money, and the payouts would certainly exceed the amount invested.

In summary, most investors and gamblers participate with the ultimate intention to earn more income. Investors utilize their financial capital to purchase assets that they hope will appreciate. Gamblers, on the other hand, play games with the hope of winning money. Both want to become rich and are faced with skillful competition that can out buy or out play them. Thus, our conclusion is that both these are risky and the unprepared are subject to losing all or part of their money.
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Tuesday, March 1, 2011

Investing or Gambling? Part 3: Why Its Important.

Americans are enamored by wealth. We all dream about being independently wealthy, working as little as possible, and obtaining the most amount of money as possible. But, the harsh reality is that very few of us achieve our goals of becoming millionaires.

For the past few years, the United States has been in a recession. Many individuals have lost their jobs and have remained unemployed for two years or more. At the same time, students graduating from college have found it increasingly more difficult to find employment opportunities. Many students have taken the opportunity to earn a Graduate degree with the hope that they will be more marketable when they finish their advanced education.

People are desperate.

With financial pressures mounting, many unemployed individuals have sought alternate avenues for generating family revenue. Some have become day traders, and others have become professional gamblers.

Temptation is everywhere.

The radio and television advertisements are full of get rich quick schemes, telling us to buy gold, refinance our houses, play the stock market, play the lottery, go to a casino, and more. We are bombarded with stories of successful investors such as Warren Buffet, George Soros, Donald Trump, and Wall Street tycoons who made fortunes playing the markets. At the same time, we see the glamorous lifes of the ESPN World Series of Poker stars, and hear about the fabulous casino and lottery winners.

Taking a gamble.

In the past, the division between gambling and investing was clearly defined. Our images of gamblers were those betting at race tracks, the down on their luck poker player, or the gambling addict. Investors wore suits and ties. They attended meetings and lunches, and put together multi-million dollar deals that rewarded them handsomely.

The internet breaks the barriers.

But with the recent advances in technology, the trading tools previously available only to those in the investment business are now available to all of us. We can now learn to use technical trading tools right in our home for buying and selling stocks. As we learn more, we can buy more exotic products, like options. A few years ago, everyone could play online poker. Although this is now banned, players can continue to refine their skills by playing for fun on a variety of sites.

This past January, 60 Minutes aired a Sports Bedding feature on Billy Walters, a sports betting legend who has never had a losing year.

Because temptation is everywhere, many individuals are attempting to earn a living as either a professional investor or a gambler. I have several friends who stopped working years ago and now earn their income solely from trading stocks. Lately, I've seen a few young college graduates decide to become professional poker players in Atlantic City and Las Vegas, rather than working in the corporate world.

Everyone wants your money.

What I've learned from analyzing lottery games and talking to these individuals is that achieving success is difficult.  Everyone out there wants your money. The more desperate you are, the easier it is to lose everything. Regardless of whether you participate in investing or gambling, you are competing against professionals that have much more money and much more knowledge. They all know the odds of winning and losing, and make their bets accordingly.

Don't be a fool.

Therefore, we felt that it is important to write this series of articles about investing and gambling. In last weeks article, we defined these two concepts and showed how they are different. In subsequent weeks, we will illustrate why the distinction between the two is blurred. In the end, we hope to educate you to the risks of each profession, and to help you keep your hard earned money.
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