Are Speculators Gamblers?

 

Speculate or gamble?

 

The Suits Versus The Gamesters

 

Speculating and gambling are two thrilling methods for getting rich quick.  It should go without saying, but the thrill quickly turns to terror when things start to go wrong. Many people assume the two concepts are the same. After all, when you speculate you take enormous risks with your money, and isn’t that also true of gambling?

 

What is the real difference between speculating and gambling?

Are they both the same thing? Does either have a place in the world of investing?  Let’s explore these questions, and discover the truth.

 

Though speculating and gambling can mean the same thing under certain circumstance, there are important differences.

 

Remodeling is speculating.

A speculator might remodel a house knowing the odds are good he’ll recoup his costs and make a handsome profit on top.

The true speculator plays by the odds, making sure the odds for a return are always positive. In other words, a speculator seeks investments that will generate a positive return on average.  This means he expects some deals to fall through with significant losses, but overall his wins are big enough to cover all losses and still generate a handsome profit. Otherwise, he won’t play.  A speculator never invests casually.  He analyzes every deal with care in order to determine the odds for success.

 

Coming up short.

A gambler loses regularly, but still holds hope for a big win.

The gambler also lives by the odds, but he is far more tolerant of losses than the speculator. Although he knows the odds are in the casino’s favor on every bet, he plays anyway. He does this knowing that probability is fickle, and there is always a slim chance that lady luck could turn his way.  For gamblers, the odds for a return are always equal or negative. Gamblers never tire in their hope for that rare stroke of lightning—the winning streak, or the fluke lotto win.

 

Not everyone who calls himself a speculator qualifies as one. Some people invest in speculative things, when they’re actually gambling. A “speculator” becomes a gambler when: (a) he hasn’t carefully studied the investment to learn its pros and cons, (b) he hasn’t analyzed the probabilities for getting a good return, at least in terms of his personal experience with similar ventures, or (c) he invests in a deal knowing that its average return is likely to break even or generate a loss.

 

For more information on the four basic strategies of investing, and speculating and gambling in particular, refer to the article, “What kind of investing is best?”

 

A Helpful Idea:  Expected Return

 

The concept of average return or “expected return” turns our to be a handy and effective tool for comparing investments.  Though it requires we delve into a little basic arithmetic, it also allows us to clear up any remaining confusion between speculation and gambling

 

Do the math.

Calculating expected return requires some basic math.

When first considering an investment, you have no real basis to judge the possibility of a successful outcome. At this point, your real chances are unknown—you have as much chance of winning as losing. That makes it a gamble. Only after analyzing it using your knowledge and experience will your real chances for success become clear.

 

One way to analyze investments is to estimate their expected return. Expected return is calculated with a formula that returns a number.  The number turns out to be an average.  When the average is positive, it becomes one means to evaluate whether or not a particular investment is worth the risk.

 

The Meaning Of Expected Return

 

Expected return is the profit you can expect to receive from a single investment on average. On average implies you have the ability to repeat an investment more than once. It is easy to imagine different outcomes if you repeated an investment several times.  Each time you would either succeed or fail, and over the long haul you’ll begin to gain an appreciation for the odds.  For example, you might learn that a particular investment to returns a substantial profit three out of four times.

 

To show how averaging works, let’s suppose we repeat one investment many times.

 

Real Estate investment.

You might speculate in real estate by building small office buildings with some partners.

Pretend you will do ten similar real estate deals in the next few years. You invest $20,000 each time. Each deal has a possibility of gaining $20,000 or losing $20,000.  From your prior experience, you expect about 8 of those 10 deals to succeed and the other 2 to fail. If so, what is the average return for each investment you do? Let’s calculate it.

 

For the 8 winning deals, you would earn 8 x $20,000, or $160,000. For the two losing deals, you would lose 2 x $20,000, or $40,000. So overall, you would earn $160,000 – $40,000, or $120,000 total. Based on these numbers, what is your average return per deal? It is your overall earnings of $120,000 divided by 10 deals, or $12,000. This is the average return, or “expected return” from one deal.

 

Distinguishing between the real gain or loss from a single deal and the average gain or loss from multiple deals is crucial:  In our scenario, each single investment will generate an actual gain or loss of $20,000.  At the same time, when we assume making multiple deals we need to talk about our average return, which in this case we determined is $12,000.

 

If you only do one deal, a $12,000 gain is not possible—you’ll either gain or lose $20,000.  In this sense, average return has meaning only when speaking of multiple deals. However, a $12,000 average return says the odds are in your favor every time you do this deal. As we’ve seen, it even tells you how much you should expect to make after doing several deals. If you did five deals you should reasonably expect to earn (5 x $12,000 or) $60,000.  That is why we call it the expected return.

 

Calculating expected return.

All other things being equal, Deal 2 is better.

Expected return turns out to be a useful tool for selecting between various investments.  Suppose you did all the calculations for two different investments and you found that the expected return was $17,000 in one case and  $12,000 in the other.  Now suppose you invested $10,000 in the first case but only $5000 in the second.  Which is the best deal?  By dividing expected return by the amount of your original investment you can find the answer.  In this case $17,000/$10,000=1.7 and $12,000/$5,000=2.4.  Since 2.4 is more than 1.7, the second deal is the better choice.  Another way to talk about these numbers is to say you’ll earn 2.4 times your original investment by doing the second deal and only 1.7 times by doing the first.

 

It is interesting to note that casinos use expected return to calculate how much money they’ll make on average for each possible game play. The casino only makes money by stacking the deck.  They want to insure their expected return is slightly positive for each bet you make. That way, the averages always work to their advantage.

 

Gambling Vs. Speculating

 

Once you understand expected return, you can see the difference between speculation and gambling. A gambler always has an expected return of zero or less. On the average he makes nothing or even loses a little.  On the other hand, a speculator seeks a positive expected return by using his experience or special knowledge as a means to earn it.  He expects to make substantially more than zero.

 

The deal we analyzed above had a positive expected return, so it is a speculative deal, not a gamble. On the other hand, flipping a coin has an expected return of zero, so it is a pure gamble. Spinning a roulette wheel at the casino is also a gamble as it has an expected return of slightly less than zero, i.e. you lose a little every time, on average.

 

 

A Shortcut Calculation Of Expected Return

 

We can take our same real estate example above and calculate expected return faster using a formula.

 

First, identify all cases. Here there are two: win or lose. Next, identify the chances of each case happening, and the “size of the prize” in each case. Your chances of winning are 8 out of 10, or 80%, so your chances of losing are 20% (since 100% – 80% = 20%). The prize if you win is $20,000. If you lose, the prize is -$20,000.  To calculate expected return for each case, multiply the chances of the case happening by the size of the prize. Then to calculate total expected return, add up the expected return for all cases:

 

 

Expected return from:

 

Winning = chances of win x size of prize = 80% x $20,000 = $16,000

Losing = chances of loss x size of prize = 20% x -$20,000 = -$4,000

Total expected return = expected return from winning + expected return from losing

= $16,000 + -$4,000 = +$12,000

 

Once again, this means that on average, this deal pays off. To some speculators an average return of $12,000 would be fine. Others would say it is too small compared to the potential loss of $20,000 for one deal. This is still a high risk speculation, because there is a 20% chance you will lose your entire investment. Unless you are so wealthy that the potential loss of your principle is insignificant to you, an investment like this one is a huge risk to take.

 

A note of caution:  Our example oversimplifies the real world.  We assume one outcome—a total loss or complete success.  We also deal with totals and do not provide any indication how the numbers are derived.  For example, a real estate deal includes commissions, fees, expenses, insurance, the costs of materials, etc.  We use a ballpark estimate of how many deals are likely to succeed, though it is based on experience. A true and complete detailed analysis would consider all possible outcomes and risks. Expected return is therefore a good predictor of outcome only to the extent investors do their homework.  Even so, this type of modeling can be useful as long as your basic assumptions are on target.  It provides a sense for likely outcomes, and it can help determine if a deal is speculation or gambling.

 

Should You Speculate, Or Not?

 

As we’ve seen, speculative deals that offer a good return on average can support the high risks involved. Over time, completing a number of speculative deals may result in a handsome payoff. Does that make speculative investing the smart way to go?

 

The short answer is no. You should not consider speculating unless you have very “deep pockets” (i.e. a large fortune to work with), or unless you set aside a small portion of your portfolio for this type of investment (no more than 5% to 10%).  Although good speculative deals will pay significant returns on average, any particular deal holds the risk of losing both your principle and any money you borrowed.  A disastrous financial wipe-out could be possible with only three or four losses in a row—a sad and far too common scenario.

 

The wise investor sticks to safer forms of investing with almost all of his money. If and when he judges the risk and timing right to make a speculative investment, he never invests money he can’t afford to lose, and he never goes beyond his preset limit for speculative investments.

 

It is important to remember the close relationship between risk and reward.  With higher reward comes higher risk, and bigger losses.  Major losses are very hard to recover from. After you’ve gained confidence and experience in investing, and can set aside a small portion of your portfolio for speculative plays, you may discover the potential rewards worth the added risks.

 

If you are confused or unsure about the risks of any investment, seek professional advice before you proceed.

 

 

Comments are closed.

Categories

Favorite Pages

Comics-2quotes-buttonFood-Recipes-2Recipe-Index-butHome-Project-Tips-2Famous-Ducks-2Personal-Growth-2Great-Savings-Tips-2Investing-Ideas-2

Archives