What's the Difference Between Investing, Speculative Trading, and Gambling?
It is dangerous to confuse investing, trading, and gambling!
You've heard the stories. You've seen the news. People spending their money in casinos, mortgaging their houses to buy Bitcoin, and blowing hundreds of dollars on the lottery.
"No way", you think to yourself, "I know better than that. My money will be well invested and will grow for the long run."
Then, you see an online course promising to teach you binary options trading. "Hey", you think, "This looks like something that I can invest in and make my money grow!" So, you open an account and start to bet on whether AAPL will close above $250 in the next week.
Are you really investing, trading, or gambling? Is betting on the market via binary options, leveraged FX, and the like any better than entering a casino and putting down 10 chips for "22, Black!".
Knowing the difference between the three categories can save you more than a pretty penny - it can also lay a solid foundation for your future wealth, and drill in certain concepts that will stick with you throughout your working life and retirement.
If you confuse investing, trading, and gambling, you are on the fast track to lose money!
Let's start with what everyone should be doing - investing.
Investing should be the least controversial and the easiest to understand. After all, entire business models and many, many websites are dedicated to this topic.
I shall not try to reproduce the entirety of their content here. Instead, I will stick to broad principles with the intent to differentiate investing from the other two activities.
For starters, why would people even want or need to invest? The underlying principle of inflation is the cause. This concept says that generally, a dollar tomorrow is worth less than a dollar today. Stretch that concept over decades and your dollar 40 years down the road will be worth pennies of the dollar today.
As an example, if you buried $100 in your garden today and retrieved that same $100 a decade later, that same $100 will not be able to afford you the same level of purchasing power as a decade ago. This is because the prices of the goods and services you want to buy has increased, but your dollar has remained the same.
I don't need to elaborate this point, as I'm sure you are all aware of the dangers of inflation. So then, investing is one of (if not the only) way to grow your money, and to ensure that you are able to maintain your purchasing power into the future.
to commit (money) in order to earn a financial return.— Merriam-Webster Dictionary
So then... what IS investing?
In my view, the core principle behind investing is actually delayed gratification.
Because, the alternative to setting aside money to invest for the future is to spend money today.
Thus, investing is an active choice to deny yourself the pleasure of instant gratification and instead, put the money towards your future and delay your gratification.
This would be the core basic principle that I will use to determine if what you are doing is actually investing (as I personally feel there is some overlap with trading, but I will cover that later). The idea here is that you are setting aside money that you could have spent today, for it to grow in the future.
Of course, the methods of investing differ. I can argue that setting aside money in a fixed deposit account for future spending is still investing, albeit just not very efficient nor effective way of doing so (since the returns on that investment may not help you beat inflation at all - it is more like saving instead).
While saving is good and is necessary before investing, that is a different topic for now...
So, the idea here is that you are deferring gratification and putting your money to hard work at the same time! All to defeat this nasty thing, called inflation.
the act of buying something hoping that its value will increase and then selling at this higher price in order to make a profit.— The Cambridge Dictionary
Now, let's move on to speculative trading.
Why do I pair 'speculative' with 'trading'? Is it possible to trade without speculating?
I don't think so.
The whole idea behind trading is to 'buy low, sell high', and not necessarily in that order (as can be seen from the dictionary definition above). This differs from investing in both time frame and velocity (i.e. how fast you are in and out of the position).
Thus, if you are trading, it is almost always because you are speculating.
The confusion now arises between such trading and gambling. What sets the two apart?
Before I go into this, let's take a look at gambling, since the differentiation between the two is more nuanced compared to the difference between trading and investing.
the activity or practice of playing at a game of chance for money or other stakes.— Dictionary.com
What is gambling?
We now come to the last category - gambling. The dictionary definition is quite self-explanatory, since the whole concept revolves around luck and chance.
With mathematics, statisticians have built businesses relying on probability and human behavioural traits, leading to industries like casinos, sports betting, and lotteries. Such probabilities always skew towards the house, as long as sufficient numbers of people participate. (I mean, have you seen the profits that casinos make?)
This section about probabilities can take up a whole post (or three!) on it's own, so I will leave the definition here as a game of chance.
Now then, comes the important question - is speculative trading any different from gambling?
What are the main differences between speculative trading and gambling?
While speculative trading can seem like gambling, there are a few key differences between trading in a manner that can seem more like investing, and trading in a manner that is just outright gambling.
In my view, the questions to ask yourself to assess whether you are more likely to be trading or gambling are:
- Do you have a trading plan? This includes profit taking, stop losses, and a backtested (or at least theoretical) trading model.
- Is your intention to get rich quick?
- Is this part of your overall asset allocation?
Let's take a deeper look into these questions.
Do you have a trading plan?
If you have a trading plan, it is less likely that you are gambling, because this means that you have done the homework, analysed the probabilities, and are willing to accept the risk/return trade-off that accompanies the plan.
Of course, sticking to the plan (particularly when you have to cut losses) is another thing altogether, but the concept is there.
Some key elements of a trading plan include:
- The strategy. Trading is about strategy, particularly because short-term movements of the markets are notoriously hard to predict. There is still an element of chance, but you would have analysed the probabilities and developed the strategy to accept certain probabilities of loss and profit, which would enable you to make money (at least theoretically) in the long term.
- Entry and exit points. When trading, it is not about 'feelings' or 'hopes'. There should be a consistent way you do things, which will then allow you to have a sample to evaluate whether your plan is working as intended. If you do not follow your system and just enter and exit at will, it will be harder to see if your system is actually working, and would then seem more like gambling.
Just to note, this includes profit-taking and stop-loss points. I know that such points (stop-losses in particular) are hard to follow, and I'm also guilty of holding an investment for far too long when I should have cut my losses instead. But the idea is with proper money management, you will be able to trade in a systematic way that allows you to refine and tweak your strategy.
- Trade sizes. Even with a strategy, you do not just allocate your whole trading budget into one trade, no matter how good the probability is. You would need to have a trade sizing discipline so that you don't risk all your capital on one trade - there is always the possibility that things go massively wrong.
So, if you have a proper trading plan and follow it (reasonably), I would say that the chances that you are gambling are pretty low.
However, if you treat trading like your personal slot machine and just buy something 'because you felt like it' or 'hope that it'll go up/down', then it is more likely you are just gambling and not trading.
If you recall the definitions, when you start gambling, the odds are always against you (because the house would ensure it), and you will then lose over the long term. Yes, you may get lucky and win now and then, but just like any casino, the longer you gamble, the larger your losses grow.
If you need any examples of this type of gambling, you need not look further than all the rogue trader scandals (with a famous one bringing down a bank). Please don't let that be you.
Do you intend to get rich quick?
Ah, the famous "get rich quick" quote. Intentions are hard to determine, so this will require some level of self-reflection to understand your true motivations.
Even if you trade speculatively, the idea is not that you will be able to retire immediately as a millionaire after a few trades. Speculative trading is a hard business, especially as a retail trader, because the big institutions will deploy better, faster, and more sophisticated algorithms than you.
So, it will be a grind. You will not get rich quick.
Thus, if your primary motivation in trading is to strike gold and retire on a private island, sorry, but it looks like you are gambling, not trading.
I'll leave you with a statement that I remember from the trading classes I took previously:
"If you follow your trading plan properly, you should see decent returns of maybe 10-20% a year. If your trades start earning 20% a month, you should review your plan because it is likely that you are taking on too much risk in your portfolio."
This brings me to the asset allocation question:
Is trading part of your overall asset allocation?
This is more of a personal opinion, but if you do trade, it should be done within the framework of your overall asset allocation.
This is where trading can intersect with investing.
Of course, there are many people who invest without trading. There is nothing wrong with that. What I'm saying is that if you do trade, it should be done with regard to your overall portfolio and asset allocation strategy.
This will put your trading in perspective, since it gives you a more bird's eye view of your own portfolio. Using finance terminology, trading could sit within the 'tactical' asset allocation segment of your portfolio.
Conversely, if your trading is done in isolation, then there is a higher chance of it being just gambling.
Summing up - why it is important to know whether you are gambling
If you apply all the above, it should give you some indication of whether you are gambling or trading within a proper investing framework.
The danger is when you don't realise you are gambling, and instead think that you are trading or *gasp* investing. That is when people do things like mortgage their houses for bitcoin, leading to massive problems when they don't fully know what they are getting into, but just FOMO-ing into it and hoping to get rich quick.
Gambling, by itself, is of course not encouraged in the broader scheme of things, but if you do decide to gamble, that is your decision and I am not here to dictate what you should do. If you like playing blackjack, poker, or view the slots as a form of entertainment, that is your decision.
Just be mindful that if you transition from a casino to the financial markets without being clear on what you are doing, you may lose more than just your trading account.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2019 Russell