Investing vs Gambling Meta-Post

Please allow me to babble out loud (in pixels?) here for a minute… This won’t be the first nor the last time I make the comparison between the financial markets and casino gambling, but there are important distinctions that need to be elucidated.

One of my first exposures to financial markets was the interview process coming out of MIT.  I related some stories from interviews with Susquehanna in an earlier post.    In that same post, I made some analogies between sports betting and investing in CDOs.  Anyway, Susquehanna was by far the most “gambling” oriented firm I ever spoke with.   That doesn’t mean that they want their traders to be free wheeling, loose swinging, risk taking cocaine cowboys – quite the opposite, in fact.  The crux of Susquehanna’s training program was to teach their new-hires that like poker, craps, blackjack and sports betting, trading and investing have a large “luck” component too, and that you need to be aware of all of the factors that can alter the balance of luck and skill in the equation.

When you sit down at the poker table, you need to try to put yourself inside your opponents’ heads.   When you’re trading stocks, bonds, options, seashells, or anything else, you need to do the same (I’ve written about that before too – in the form of avoiding confirmation bias).  When you walk into a casino and sit down at a Spanish 21 table, you need to understand the rules of the game and know what you don’t know, instead of saying “holy cow – no bust! this is awesome! free money!”   When you’re trading stocks, (achem, perhaps, TVIX?) you need to do the same.

That doesn’t mean, however, that you should treat your investing portfolio like your gambling portfolio.    I mention this because I’ve seen a bunch of people write things lately like “only invest what you can afford to lose.”  It’s not that this is necessarily terrible advice – it’s more that this is a terrible “investing” strategy:  that’s not how you invest, that’s how you gamble.   When I plunk down $500 at the blackjack table at the Palazzo to play some green chip blackjack with The Big Show, I know that I could lose the whole buy-in.   When I buy a stock position, however, I’m almost never expecting to be anywhere near the position of being able to lose my entire investment.   That’s because I treat my “investing” portfolio different from my trading portfolio.

There are certainly times where I am in a trading position that could lose 100% – I wrote about one such time with Sino Forest last year.  I think what I’m trying to say here – and yes, I realize I’m babbling (disclosure: I warned you in the first sentence!) – is that when you’re in a “only invest what you can afford to lose” situation, it’s obviously essential that you 1) realize that a total loss is a possibility (you probably already realized that with the mantra about “only what you can afford to lose”), but more importantly, perhaps: 2) ask yourself why you’re putting yourself in such a “gambling” position, what you think your edge is and why you’ll be able to come out on top.

I actually tried to explain my reasons for “gambling” on Sino Forest in the comments of that prior post – the gist of it was that even though I wasn’t an expert in Chinese Forestry, I didn’t think that most of the people trading the stock were experts either – I thought that they were selling first and asking questions later,  and I thought it was an opportunity to buy panic for a trade.   It turns out that I managed to escape this trade with a nice gain, even though I was wrong about Sino Forest in the end – the stock was halted and hasn’t yet re-opened for trading.  The important thing is that I had my reasons for the trade, and they were never “everyone is wrong about Sino Forest and I’m right even though I haven’t been to see all of their forestry operations for myself and I have no basis for belief that they are a long term value play.”  It was a trade (not a long term value investment), it worked (although it’s important for me to understand that I can’t be sure it worked for the reasons I thought it was going to work!), and it may have been very lucky that I escaped before the hot potato exploded.

Anyway, I don’t know if this post made any sense – my point was to try to give some thoughts on the Venn-Diagram inside my head that represents investing, trading, gambling, and how they all interact.

-KD

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