Thursday, August 26, 2010

About Investors and Gamblers

If you read some of the earlier postings of my blog you already know this: my earlier attempts to invest resembled more gambling than anything else. I searched for all kinds of hints and signs of stocks that could go up quickly, and then picked the ones that seemed the best, mostly based on my intuition. I wanted to be an investor, but in reality I was just another gambler – even if I didn’t notice and would have never admitted it.

What then is the difference between a gambler and an investor? Both in gambling and in investing the results are volatile over any shorter period of time. You will win some, and you will lose some. This is why it’s so difficult to notice any difference between gambling and investing in the short term. They resemble each other so much that you could assume they are just the same: the goal is to make money, the results seem about the same over short term, and the only real difference appears to be in the methods.

Luckily for us investors, there are things that do make us different from gamblers. Of course there is the location (yes, Vegas does seem cooler than Wall Street!) and then the methods of work (I admit a roulette table has a bit more glamour than punching numbers into an Excel sheet). More seriously though, to me it all comes down to two things that really separate investors from gamblers: probabilities and time span.

A gambler “invests” money in order to win money, just like an investor. However, the gambler is ready to make bets where his odds are either not know or on the losing side, whereas an investor only makes bets where the odds are known and on the winning side. Gamblers bet because they think they might get lucky – they don’t mind the odds so much because they trust their luck.

The other key differentiator between gambling and investing is the time span. The idea in gambling is to get rich really quickly. Of course this rarely happens, but still this is what many gamblers hope for. Therefore they are ready to make big bets when there is a chance for really big wins, never mind the odds for these bets. Naturally also investors hope to get quick rich the quicker the better, but they don’t really expect it to happen suddenly. Instead, investors know that it takes time for probabilities to work out. Therefore, for any give method that works, the investor is prepared to stick to it in orde to get the results become clear and significant.

The graph below shows what the results of an investor look like compared to the results of a gambler. The key difference, as you notice, is just the trend. In gambling, the odds are unknown or outright against you. You will at best keep your money and more probably lose it all, either little by little or quickly, depending on the kind of gambling you do. In investing, as you will make sure the odds are on your favor, you will win more than you lose. Therefore your assets grow over time as long as you stick to the methods behind the positive odds.

Judging from results, a really big share of people who want to be investors actually end up being gamblers. Obviously, they would not invest if the odds of success seemed low. Instead, they invest in cases where the odds were really not known: they know the price but have no solid analysis of the actual value of the investment. Due to this, they often end up getting erratic results that are roughly in line with market performance. If they trade frequently, the results tend to lag the market more significantly due to the trading costs. Also, due to market psychology, they tend to buy when prices are high and sell when prices are low. Accordingly they catch more often falling markets than they catch rising ones, further dragging down their overall investment performance.

The frustrating part in all this is the following. If you think you are an investor but actually are a gambler – like I was – at some point you are bound to notice and want to change. The frustration comes from the fact that making that change is much harder than it seems.

First, finding a method that enables you to identify investment with favorable odds is very hard. You will sift through all sorts of people, companies, and methods, all of whom claim to be able to make your investments successful. When you dig into the details, though, you’ll notice that many of them cannot explain what their success is based on, exactly, and very few have any proof or track record of sustained success. Some of them are very expensive to access, and some have limitations that make them unpractical for you.

Second, when you finally find something promising, it feels initially hard to stick to it, especially when things go south (and they always will, usually even rather soon!). You are so used to jumping into new things based on the latest hints or newest advice, that it actually feels kind of boring to keep doing the same thing over and over again. And when your investment underperforms for the first (or second or third) time, the feeling is the same as the one you had when your gambling style investments didn’t pan out. The temptation to jump ship can be almost overwhelming, even after all that homework you did in the first place in order to make sure you are really investing, not gambling, this time.

Finally, there is all that noise around you: all sorts of people telling what’s going to happen next, where all the smart money is moving just now, how things are totally different this time, why the methods that worked in the past can no more work at all, and how this investment or that is the one you really must make right now. It’s hard not to pay attention, especially when you know many of these folks make their living from their advice. It seems also natural to drop what you are doing and follow their advice, especially as so many others seem to be doing exactly that.

Luckily, where there’s will, there’s a way. The key to becoming an investor – rather than a gambler – is eventually in choosing the right methods and people to work with. This is more challenging that it may sound. So many of those offering to help you to invest your money are nothing more than fortune tellers and snake oil salesmen. The rare gems of advisors and methods that really can help your investments to succeed are few and far apart.

Fortunately, such gems do exist. Identifying them is what my next posting will focus at: how to avoid the fortune tellers and snake oil salesmen, and how to recognize the real gems that can help you too to be a real investor. Until next time!