Most investors instinctively know that investing and gambling are not the same thing. At the same time, they may find it difficult to articulate exactly why they are different. They are both often considered in a similar context — in fact, when asked to describe their personal investment strategy, investors sometimes resort to using gambling terminology. For example, they might mention “placing their bets” on particular stocks, bonds, mutual funds, “letting it ride” or even “doubling down” to increase their exposure to a certain investment. In the end, if they are lucky (or skillful), their bet will “pay off” and (hopefully) they will make some money. If not, they can always “cash out their chips” and go home. But can investing really be compared to gambling? If not, is there a better analogy that could deepen our understanding of investing in general?
While investing and gambling do share one major feature in common, namely risk, the similarities pretty much end there:
- With traditional casino games, your expected return is negative (typically between -½% to more than -5% on each wager, depending on the game). In other words, the “House” (the casino) has the advantage, not the player. The longer you play, the more you tend to lose as the law of large numbers kicks in and ensures profits for the casino and losses for the customers.
- True investing is exactly the opposite – the player (the investor) has the advantage, their expected return is positive, and the longer they “play” (invest), the more likely they are to receive those expected long-term positive returns.
- Perhaps most amazing, a successful investor requires neither luck nor skill! They do, however, require a good deal of patience and some knowledge — in particular, how to efficiently build and maintain a globally diversified portfolio to gain exposure to existing market premiums.
So, the gambling analogy is deeply flawed as applied to the art of true investing, but fortunately there is a much better analogy to help us understand why investing works, and one which also reveals the source of positive expected returns in financial markets. This analogy comes from the familiar world of banking, and is simply the concept of borrowing and lending.
Imagine two companies that both want to raise capital for their expansion. The first company is Apple, the giant consumer technology company; the second is a struggling, small company with a name you’ve never heard of. In order to fund their expansions, they could each borrow from a bank, issue bonds or issue new corporate stock. If they both decide to issue bonds, it’s almost certain that the small unknown company will have to offer a much higher rate of interest to potential bond investors than Apple would. In fact, Apple is considered such a low credit risk today that they can borrow at favorable terms on a par with many sovereign governments!
Why does it cost the small company so much more? In a word, risk – because the risk of the small company not meeting all of its obligations is much greater, which translates directly into their higher cost of capital. The difference in bond yields makes it obvious which company is perceived by the market as riskier. But cost of capital applies to all forms of capital raising, including issuing new stock – meaning the small, unknown company would need to offer a higher expected return to potential share buyers as well.
This leads us directly to the key insight – a firm’s cost of capital is equal to your expected return, and this is true whether you are a bond or a stock investor. This is also why investing is more akin to lending than it is to gambling, and explains why expected returns are positive on all true investments. Furthermore, it even explains why certain companies have higher expected returns than other companies, due to differences in perceived risk. Gambling may be a lot more exciting than long-term investing, but only one provides the positive returns you’ll need to help you meet your financial goals.