What’s the Difference Between Gambling and Investing?

So just what is the difference between gambling and investing, is it really so easy to split the two activities apart?

The Dictionary.com web site says:

 

  • Gamble: “To bet on an uncertain outcome, as of a contest. To take a risk in the hope of gaining an advantage or a benefit.”
  • Invest: “To commit money or capital in order to gain a financial return.”To put simply, the difference is unclear. Both involve risking money for potential financial gain.An argument could be made that gambling is a zero sum game whereas an investment is not. In gambling for every winner there must be a loser, whereas investing can benefit both the individual and society in general. Investing is widely regarded as the engine that drives capitalism. It tends to put money in the hands of those with the most promising and productive uses for it, and drives the economy gradually upward. Investors aren’t merely betting on which companies will succeed, they’re providing the capital those companies need to accomplish their goals.All of this is true and would have stayed so, if it hadn’t of been for one thing – derivatives. Derivatives began to proliferate in the 1980s, they are investments ‘derived’ from other investments. The financial world have made these purposefully as complex as possible and many who work in the financial sector cannot succinctly define what a derivative actually is, so let me do it for them, a derivative is a bet that something will go up or down, that’s it. As an example, if you hold an equity derivative you don’t own part of the company, you’re not investing in its future, instead you are merely betting whether its share price will go up or down. The notional amount of outstanding over-the-counter derivatives contracts remaining in June 2015 was $553tn according to the Financial Times…… that’s a whole lot of betting.Even in the modern financial world, gambling is still generally looked down upon by society. Trading on the other hand is seen as an activity that is worthy, smart and an investment in ones future. It’s the accepted view of the majority that gambling is a mugs game, where the odds are against you, that it’s for risk seekers using luck and emotion rather than skill to try and earn a buck. Lastly as the old cliche goes, the house always wins.But what if this all wasn’t true, what if the distinction between trading and gambling was lazy and simplistic, what if you could make risk averse well informed decisions to make money gambling and what if the gambler remained disciplined in his or her decision making. There are many ‘gamblers’ out there already doing this and they are as savvy as any investor. Gambling, if handled sensibly, can be a very sound investment approach, and a viable alternative to traditional investment philosophies.THE GAMBLING INDUSTRY IS ROUGH AROUND THE EDGES. To use the investment vernacular, the markets are inefficient. The market participants can be slow to react and equally, they often overreact on the spur of the moment.

    In the financial world, mis-pricing is seized upon in milliseconds by automated systems. In the sporting world, arbitrage opportunities can be picked off by hand hours later. There are cracks in the system that are unlikely to be rectified. All of these inefficiencies lead to opportunities that can be exploited for profit. Layer on top of this the plethora of cashback, bonuses and refunds that get thrown about to entice the mug punter, and the kicker that it’s all tax free in many countries, and you have quite an interesting investment vehicle. It certainly looks more attractive than a 3.1%, 60 day notice cash ISA.
    So, are there any lessons to be taken from the world of ‘professional investment’ that can be applied to sports investing?

    Yes… given the similarities, there are many, but the three that I’ll concentrate on are portfolio theory, value and behavioural biases.

    LESSON 1 – PORTFOLIO THEORY

    There is no getting away from the underlying fact that the sports punter and the fund manager are both essentially gambling. They are taking views on an uncertain future and put their money where their mouth is. As hard as they try, they aren’t going to hit winners every time. So, how can we make money despite this uncertainty?

    Some people enjoy the highs of winning the big gambles, but if you are being paid to look after somebody else’s money, this probably isn’t the most responsible strategy.

    One fairly risk averse strategy, but one that works well in both the financial and gambling world, is the concept of a pyramid based portfolio, with a large, solid, low risk base at the bottom, and smaller more speculative layers on top. As you move up the pyramid, each layer gets smaller, but adds more risk and the possibility of higher returns. The intention is here that income from lower levels provides enough upside to cover any losses on the more speculative layers. If you make £25 each day on risk free offers, and then punt £15 a day on a speculative 12/1 shots, you can only profit in the long run. There will be variance in your returns, but it will always be heading in the right direction.

    Another key idea when constructing your portfolio is that of risk management and diversification. As well as evaluating each investment on its own merits (see the section on value below), you should also consider its effect on your overall portfolio. The fund manager will look at the correlation of one security’s returns against those already in the portfolio in an attempt to diversify and reduce overall risk (variance).

    You should do the same with your bets:

  • Evaluate the potential profit and loss on each possible outcome.
  • Assess how it would interact with your current open positions.
  • Are you already exposed to a particular result?
  • Does it increase the risk on a particular outcome or reduce it?
  • Don’t put all your eggs in one basket and all that…

LESSON 2 – VALUE

No matter how you decide to structure your portfolio, when selecting individual positions, you should always consider what something is worth versus what you pay for it.

To quote Warren Buffett, “Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

In finance, this is emphasized most by the value investing strategy, which, in a nutshell is buying something for less than it is (hopefully) worth (or, conversely, selling something for more than what it is worth). Like the casino with its house edge on the roulette table, or the bookmakers 110% book, if you are getting more in than you are paying out, you are tilting the game in your favor, and despite not winning every bet, you increase your chances of being up in the long term.

In the financial world, analysts concentrate on determining the ‘intrinsic value’ of securities. They scrutinize the company’s financial results, their management plans, and developments within the wider operating industry in order to try and find something that hasn’t been factored into the price by the market already. They make forecasts on the sales, revenue and operating expenses of the company, and perform ‘what-if’ style scenario based analysis all with the aim of trying to determining a fair value stock today based on what they believe will play out in the future.

In reality, there is no ‘correct’ answer when determining a security’s intrinsic value. It is all a matter of opinion and as with gambling, the future is uncertain. To reflect this, the analysts will include a margin of safety and set buy and sell targets either side of their estimates. For instance, if they estimate a company’s intrinsic value to be $12 per share, they may set a buy target at $10.50 and a sell target at $13. If the market price still falls outside of this range, say at $10.28, it is a potential trade, and in this case a buy.
In the sporting world you could do the work of an analyst, do the in depth research and price up the market. If you can do a better job at this than the bookmakers and enter into mispriced gambles, again, in the long term, you should be up. Admittedly this is beyond most people, but there is many a good tipping service attempting just this. If you do fancy trying your hand at it, ‘The Definitive Guide to Betting on Football’ is an interesting read.

One slightly easier route is to try and get an edge by responding to news before others. If you can think one or two steps removed, much like the financial analyst assessing how problems at a copper company impact the downstream technology company that they supply, you start to see some great opportunities.

A common occurrence is that markets overreact to events that are happening right now, as capitalized on by swing trading strategies on in-play Tennis and NFL, but are slow to adjust prices on distant or correlated events. The evening I first drafted this, Bradford were playing Aston Villa in the Capital One Cup semi final.

The moment Bradford scored an equalizer against Villa the news was rapidly factored into the price of Bradford to qualify for the final. However, it also had a secondary effect of shortening Chelsea and, in particular, Swansea’s chances of actually winning the cup outright. These kind of long term knock-on effects can be easier to take advantage of than the frantic swings in the here-and-now markets.

Another easy source of value is related to ‘arbitrage pricing theory’ (APT), which is a grand term that suggests you shouldn’t be able to get money for nothing. Although sentiment is a strong driver of prices, particularly in financial equity markets, other markets are driven more by pure mathematics. The argument here goes that assets that have identical cash flows should be priced exactly the same. Likewise, something with a fixed future value (like a bond with known coupons every 6 months and a return of face value at the end) should be priced today such that no advantage is possible after discounting for costs of borrowing, storage, etc. If assets were mis-priced, we could take advantage of this by endlessly buying the cheaper and selling the higher.

Arbitrage opportunities in the financial markets are typically gone in milliseconds. Thankfully, the sports markets are much less efficient and leave us with many low risk opportunities. The most obvious is the straight arbitrage that can exist between the bookmakers and the exchanges. As with the financial markets, you should adjust for costs such as commission, the inconvenience of tying up your money at a bookmaker, or the opportunity cost of possibly losing your bookmaker account completely should you win on that side.

A “dutch book” is another such arbitrage opportunity where you take best price (again, think value) on all outcomes and produce the equivalent of the bookmakers over-round for yourself.

Finally, the bookmaker refund offers are also another analogy to APT. If you can manufacture a £50 refund on an event that is priced at 3/1 on the exchange for a qualifying £2 loss, then you have an arbitrage opportunity. You can ‘buy’ it low from the bookmaker and ‘sell’ it high at the exchange for an arbitrage based profit, or going back to what we discussed before, you could just treat it as a value gamble and tilt the game further in your favour in the long term.

LESSON 3 – BEHAVIOURAL BIASES

The final topic I’ll discuss is related to psychology, and this is probably the hardest aspect to master.
In reality, it is far easier to digest the various economic theories and master the mathematics than it is to actually recognize and change your own behaviours. Fundamentally, humans are quite irrational and our decision making processes are often affected by a number of behavioral biases. Have a read through the list of biases on Wikipedia and see how many you recognize in yourself.Loss aversion is an interesting one in both the financial and gambling markets. Somebody may claim that they are risk averse, when in reality they are ‘loss averse’, and actually take on more risk in order to avoid a loss.There is an asymmetric relationship between how we react to losses and how we react to gains, such that we feel losses much more than gains. We see this manifest itself where people will keep a losing position open in the hope that it will turn around, but at risk of
making a larger loss, yet the same person will close a winning position early and lock in a reduced profit. I’m not necessarily saying that locking in small profits and risking large losses is always wrong, as things should be evaluated on a case by case basis, but behaviours such as this can distort and erode the value you find elsewhere.Other biases to be careful of are overconfidence or optimism-based effects, and, if you spend too much time on gambling forums, the ‘fear of missing out’ which may lead you to over-trade, entering into questionable positions and again eroding value.

FINALLY – IT WILL GO WRONG!

Lastly, try to be aware of the probabilities and the real likelihood of both exceptionally good and exceptionally bad runs. We are very good at misinterpreting probabilities. The likelihood of losing a fair coin toss 5 times in a row is actually greater than 3%. If you have a large sequence of coin tosses (say 100), the likelihood of hitting 5 losers in a row gets quite large (I’ll leave calculating the exact probability as an exercise for the reader

It’s interesting that faked experimental data can be identified by the ‘absence’ of sequences like this. We massively underestimate the likelihood of bad runs and have trouble accepting them when they occur. They will happen and there is no point getting depressed about it.

Aim to construct your portfolio so that you can weather the bad runs, concentrate rigorously on finding value, try to be aware of any behavioural biases that may be affecting your decisions, and try to develop a Zen-like attitude to the randomness, and you will be well on the way to becoming a successful investor in both the world of sport or finance.

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