The difference between gambling and investing in the stock market
Frequently, you hear people say that investing in the stock market is like gambling. You are never sure of the outcome. But is this perception really true? Is there a difference between buying shares and gambling?
Former Central Bank of Nigeria governor, Sanusi Lamido Sanusi and now Emir of Kano once famously described the Nigerian stock market as a very ‘funny casino’ where people just think about how high a stock market will go without thinking of the fact that it could also go down. This was in the aftermath of the 2008 banking crisis in the country when many retail investors lost billions of naira in collapsed banks, most of which raised billions of naira from investors through public offerings of their shares.
Interestingly, the only reason investors put money in the stock market is because they expect to make a return. And one way investors can make a return is if stock prices go up and when companies pay dividends.
In some advanced stock markets where ‘shorting’ is allowed, an investor can actually buy a stock betting that its price will decline over time. This is where an investor suspects that a company is being poorly managed in such a way that it is currently overpriced. Where short trading is allowed, an investor can take a position on such a company’s stocks and wait for the price to decline. In the Nigerian stock market, short trading is not yet practiced. This means that when an investor buys a company’s stock, he or she is expecting it to appreciate. Just like a gambler, you are expecting a big pay day when you buy into a company’s stock. There is however a significant difference between the gambler and the ‘rational’ investor in the stock market.
The investor who buys the stocks of a company is buying into the ownership of a company. A unit of a stock represents a unit ownership in a company that entitles the holder to a part of the future profits of the company in relation to the number of units of shares held in the company. The price of a company’s stock moves up or down based on investors perception of the future performance of the company. For those who lose sight of the fact that stocks are only responding to investors expectation of the future performance of the company, they interpret these upward and downward movement of stocks as gambling which is not the case.
In the short run, a company’s stocks may not reflect its actual financial performance because of the activities of speculators, who may distort short run price movements for short term gains. Sometimes, management of a company may also engage in short term focused manipulation of profits to boost their short term value. However, in the long run, these short term distortions smoothen out and a company’s ultimate value is reflected in its stock price. This is why investors are always advised to buy into long term value rather than short term price movements.
A gambler, unlike a stock investor, is not buying into the ownership of any company when he or she places his or her money on the gambling machine. The money is not tied to any productive activity other than the hope that someone else will lose his or her money, so that the gambler can gain. Gambling represents a recycling of money from many losers to a single winner unlike a stock investor who waits for value to be created so that he or she can share from that value.
A stock investor can also rationally assess the risk of investing in a particular stock. Even though this is not easy for a retail investor, many institutional investors have in their employment financial analysts who carefully look at a company and are able to create testable analysis of the future earning potential of the company based on which a rational investment decision is made. A stock investor can therefore reduce his or her risk of investing ahead of making an investment.
A gambler, except he or she is a clairvoyant, cannot assess his or her chances of winning at the gambling table. He or she throws a dice and just hopes for the best. In most cases, he or she loses. He or she rarely ever win because the model of the gambling industry is built around many people always losing. If too many people win too frequently, the business model of the gambling industry collapses. A gambler also has no way of mitigating a loss other than by reducing the amount he or she is willing to bet. Once that bet goes wrong as it frequently does, he or she loses everything.
A stock investor has the advantage of being able to study historical information about a company’s performance in order to make an informed decision about the future performance of that company. A gambler at a table cannot study winning patterns of past players to forecast how to win in future.
However, it should be noted that investors can become gamblers in the stock market when they invest not based on facts but purely based on emotions. This often happens in a bullish market when investors, sometimes with little knowledge of the stock market, jump on the ‘good feeling’ of a bullish market, with an ‘irrational’ expectation that stock prices will keep rising. Often, this ‘irrational exuberance’ ends up badly for such investors who attempt to bring into the stock market, their gambling instincts.