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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