I was once asked, what is the difference between gambling and investing as it relates to financial markets. At the time I gave some generic answer but if I am to be honest with myself that question requires deep thought and analysis. As with most things of financial matters, the topic of investing is subtle and rigorous and requires deep critical analysis. As with most things of financial matters, the topic of investing is subtle and rigorous and critical analysis. In this blog post I will attempt to broach a key concept of investing; minimizing risk. In my experience, the difference between an investor and a gambler, is that an investor is one who considers and manages risk successfully.
For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it? - Jesus, Luke 14:28
It is amazing to witness many people who don’t really challenge their ideas and implement rigorous self analysis. In the financial world this is a fatal mistake that investors make. I am astonished at how many investors simply don’t understand the investments that they make. I believe this is because people are not taught how to think like an investor. All too often, people get into investments with the lack of information needed to make sounds decisions. Furthermore, many lack the discipline and patience to make good investment.
“Risk comes from not knowing what you are doing” - Warren Buffett
The cornerstone principle that separates an investor from a gambler is that an investor top priority is to minimize his/her losses. In order words, an investors looks for ways to maximize his minimum return! This is in contrast to a gambler who’s mindset is focused on maximizing his overall returns (focus only on the upside) but ignores (or is ignorant) to the downside risk. Now to many this may sound simple but it is a core principle that even many professional investors (myself included) at times forget and often pay dearly for it.
Pulling out the Probability Tool Box
Let’s say we place a hypothetical bet with a bookie on an single NFL game (let’s say the Dallas Cowboys vs. New York Giants), we place a $500 bet on the New York Giants with a bookie. We receive a 1000 to 1 odds. In this hypothetical wager; if the Giants lose then we walk away with $500,000 but if we lose then we are out of $500. In our scenario, let’s say that the Giants are winning 35-31 with 6 minutes left in the 4th quarter. We are super excited of the possibility of winning $499,500 in profits!
Then your bookie calls with an interesting offer. He offers to buy you out of your bet and guarantees you a payout of $150,000. Although you are guarantee a nice payout you will lose out in receiving $500,000 if the Giants win. However if the Cowboys pull off a come back in the last 6 minutes of the game we lose our $500 and get nothing. So, what do we do?
Again, this is all theoretical and in real life other factors and assumptions must be considered. Other factors to consider in real-life would be:
• What are the probability that the Cowboys will mount a comeback the last 6 minutes of the game?
• Are there any key injuries on both sides?
• Are the Giants playing at home or away?
• Are their weather conditions to factor in?
That being said, what is the best choice to make in this scenario? The obvious choice (on paper) is to take the buyout and guarantee $150,000 return.
The reason being is that initially we were living life on the edge because the odds (1000 to 1) suggests that the Giants have a .001 chance of winning the game. Although it is tempting with 6 minutes left in the game to gamble it all and decline the guarantee $150,000. The alternative is to pray and wish that the Giants can keep the lead for next grueling 6 more minutes.