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.

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