Tuesday, April 19, 2011

Investing or Gambling? Part 10: Conclusion

During the past 9 weeks, we have presented a series of articles questioning whether investing and gambling are synonymous.
  • Week 1, we provided an overview of the topic and laid out an outline of the posts to follow.
  • Week 2 we defined investing and gambling. We noted the three main distinctions that an investor has verses a gambler: ownership of an asset; value derived from market demands; and option to sell. We also summarized the two similarities: success is based on probabilities; and the future outcomes are unknown.
  • In Week 3, we discussed why this topic is important at this time. We pointed out that because of the weak U.S. economy, many people are desperate to earn a living and that temptation to invest and gamble is everywhere.
  • Week 4 concentrated on the differences between investing and gambling. Again, we reiterated that investing involves ownership but gambling does not. Also, we indicated that gambling infers fun while investing infers work.
  • Week 5's article focused on a few of the successful gamblers and investors or our time. Most of these individuals are currently earning substantial livings concentrating on both of these disciplines. We pointed out that most: were very highly educated and possessed a deep knowledge of mathematics; worked very hard to refine their skills; and dedicated many years of their lives to perfecting their livelihood.
  • In Week 6, we presented the various investment products that investors and gamblers have the options buy or play. Investors can be conservative and focus only on CDs or Bonds, or they can get excitement and thrills buying derivatives, commodities, collectibles, or other unique items. Gamblers can also vary their risk by buying lottery tickets, analyzing sporting events, playing board games or casino poker.
  • Week 7's discussion focused on the profile of typical investors and gamblers. We noted that  successful gamblers were more: in control of their spending; optimistic about the future; and were more prepared for retirement. Both professionals were highly educated and made analytical decisions. Neither view their profession as gambling.
  • In Week 8, we indicated the two mathematical skills that both investors and gamblers possessed were the ability to mentally: construct complex decision trees; and know the probability of success of each outcome by heart.
  • Lastly, Week 9 presented the concept of manipulation in the two different industries. Our current belief is that the gambling industry is more regulated and less likely to be manipulated. Whereas, the investment industry is regulated only on a macro level, which leaves the doors to manipulation wide open.
In our opinion, we believe that investing is much more risky than gambling is to the common man. Both professions are comprised of individuals whose sole purpose is to earn a substantial amount of money. Those who gamble usually understand their odds of winning and of losing. They typically wager small amounts of money and participate for the enjoyment or entertainment factor.

However, these same individuals invest comparatively large sums of money in the stock market and 401k accounts. Rarely do they understand the products they are buying or the potential risks of losing money. Far too many people have lost their children's educational funds during the collapse of the dot.com bubble, and are now underwater on their home's real estate investment.

Those who are against legalized gambling will point to the losses of the compulsive gambler, saying how those individuals are sick, irresponsible, and have lost everything.

Yet the losses of our entire population during the recent financial meltdown serve as a lesson in understanding risk. We truly believe that you should never buy anything that you do not understand, and more importantly, never invest with only the hope of attaining a win-fall, because this is when investing becomes simply another word for gambling.

Tuesday, April 12, 2011

Investing or Gambling? Part 9: Is Manipulation Possible?

The Last Days of Lehman BrothersImage via Wikipedia
So now that we have: defined the differences between gambling and investing; looked at successful professionals of both disciplines; listed a subset of gambling and investing instruments; and identified the mathematical foundations of both, we are ready to ask ourselves:
Can Gambling & Investing 
Outcomes be Manipulated?

Given the recent events that have driven oil prices through the roof once again, and the exposure of the Madoff Ponzi scheme, we can quickly agree that certain investments may indeed be manipulated.  Additionally, we have all been taught the risks of gambling with regard to: horse races being fixed; people who cheat at poker; three card monte; card sharks; pool hustlers, etc.


Unless the common investor or gambler understands the outside risks that they face from their competition, they are merely sitting ducks for the professionals who specialize in certain products.

While it is beyond the scope of this article to identify all places where an market prices and game outcomes can be manipulated, we believe it is important to illustrate some of the potential schemes that are aimed at taking your money.
  • Buying Commodities. With all the turmoil in the world, the price of gold has increased dramatically. As this metal increased in value, many small Gold retailers have aggressively advertised the reasons why you should buy gold. However, most of these firms are only cashing in on the buying frenzy. They do not care if the price increases or declines. They will make a commission either way. You are the one that will lose.
  • Same is true if you buy stocks as an individual investor. For every 100 shares that you buy, someone else may be buying thousands. Most of those who buy in large quantities have much more timely information than you. Unless you can time the market right, there is a good chance that the market will turn against you. All you can do is to go along for the ride.
  • Playing casino poker. If you enjoy visiting a casino and playing at a poker table, chances are that you are playing against one or more professionals. These folks play every day and this is their living. They usually have much more money than the common visitor and can therefore influence your playing decisions. You may be lucky to win a few good hands, but in the long run, you will probably lose most of your money to these individuals.
  • Horse racing. This is a sports gambling event that you bet against others. Many of those study the past performances and understand the subtleties of individual tracks. However, your main competition is the horse owner, trainer, track workers, and rider community. These are the folks who make a living off their investment. While many of the owners may not make a profit, they will probably not lose money either. This is a small community and they keep everyone in business by taking your hard earned money when you least expect a loss.
As a small investor or gambler, you are always at the mercy of those professionals who specialize in a particular investment type, sporting, or gambling game. Always be aware that they have more money than you which can alter the payout odds or investment prices. Most of the people working against you are in business to earn their own living. As such, they are not targeting you as an individual, but rather you as a member of a class of the uninformed.
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Tuesday, April 5, 2011

Investing or Gambling? Part 8: Mathematical Similarities

Mathematics plays an important role in the decision making of both investors and gamblers. While some of the analytical quantification methods are substantially different, we believe that there are two common techniques that inherently similar. These are:
  • Decision Trees, and
  • Probability Analysis.

Decision Trees
Whether written or conceived, both gamblers and investors continuously make (and often repeat) decisions based on possible outcomes. After each decision is reached, a new set of possibilities brings forth a new set of possible outcomes. Each decision node may have two or more potential choices that can then be made. The diagram below illustrates a sample two level set of possible decision paths.

Source: Decision Tree: How to do it
From a financial viewpoint, a stock market investor typically has three choices he can initially make: (1) buy a stock; (2) sell a stock; or (3) do nothing. Once these decisions are made, the choices will vary depending on the path taken. In the case of one who buys a stock, he now has at least 4 new options available: (a) continue to hold; (b) sell the position; (c) buy more; or (d) hedge. Had the investor sold a stock short initially, he too has various choices to make regarding his position. And, if the investor initially did nothing, then he would circle back to the initial set of choices to be made.

From a gambling viewpoint, a player makes decisions based on the type of game or activity he is entertaining. If the person is playing poker, he has the choice to: (1) fold; (2) pass; (3) raise; or (4) call after each different card is dealt. Each time, his decision will be based on his previous choice and the final possible outcomes. Lottery players have the choices of: (1) playing; (2) not playing; or (3) playing and buying a multiplier. If the person decides to play, he must then decide to: (a) ask for quick picks or (b) pick his own number. If he choose the latter, then he decides: birthday numbers; even odd; hot cold; etc. Lastly, if he wins a large prize, he must then begin making decisions based on the financial decision tree above.

Probability Distributions
Most of the decisions that the investor or gambler makes are based on the underlying probabilities of success. These probabilities are based on some type of mathematical model. In the financial world, a Normal Probability Density Function is typically used. Ranges of numbers are quantified, or counted, in terms of Standard Deviations as shown in the figure below.

Source: SPC Tools - Control charts
Let us return to the investor above who initially purchased a stock at decision point 1. His decision to sell, hold, or buy more will be determined by the the price change in his stock. If the change remains within 1 standard deviation (based on volatility), he will most likely hold. If it drops more than 2 or 3 standard deviations, he will probably sell. If new positive economic information about the stock is released, he will probably buy more.

Some financial instruments are priced and valued strictly on the amount of price change and probability of occurrence. In particular, Call and Put Stock Options are priced this way. As seen below, a call option price increases when the stock goes up, but this is based on a probability weighted amount. Thus, the stock price change movement must be positively larger than the initial premium paid in order for the investor to earn a profit.
Source: Option Pricing Models
Similarly, poker player make similar decisions based on probabilities. Consider a 5 card stud player that remains until all 5 cards are dealt. If he holds a pair, then he knows that approximately 42% of all hands will have pair. He also knows that his hand is better than 50% of hands, and that approximately 8% of all hands will beat his. Using this information, he will then decide to call, raise, or fold.

In this brief article, we illustrated how similar investors and gamblers are in decision making. Underlying each conscious decision is the understanding of the underlying mathematical probabilities of successfully earning a profit. While the investments or games may vary from simple (buy a stock or flip a coin), to complex (derivative options & swaps or poker and backgammon), nearly the same mathematical properties can be used to quantify success.
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