In this post I explain the fundamental differences between gambling and trading and explain why trading is not gambling. This is an important distinction as those seeking a steady income from the stock market should not be seeking thrills and praying for good luck. I will also introduce the concept of expectancy, the determinant of a trading method’s profitability over time.
What does gambling look like?
We were chatting over a cup of coffee one morning in Singapore, a few years back. I was talking about stock trading to one of my friends who didn’t work in the investment industry. He was asking me about what stocks I was trading, which is something people often like to ask me. So I gave him a brief on what I’d been making money on and what I’d lost some money on.
I then asked him what he was doing with his trading these days. He told me he had vowed against trading stocks after his experience in 2008 when he lost a bundle of money. No more gambling for him! He was sticking to only buying ETFs from now on.
This is a point of view I’ve never really gelled with.
ETF cheer squad
When someone buys an ETF or index fund, they are not a long-term investor in a company whose cashflows that have modeled and whose valuation they understand. They are buying a financial asset that they expect to be able to sell at a higher price at some point in the future. Buying index funds and ETFs therefore fits the definition of trading.
Now consider that just about every smart financial commentator in the world is today recommending ETFs and index funds to every (potential) investor who will listen to them. All the while, nobody is recommending that people devote 40% of their net worth to playing Texas Hold ’em. How come? Because poker is gambling.
So then why is it ok to put 40% of our assets into ETFs? Because, apparently, ETFs are not gambling. So my mate calls trading stocks gambling but billionaire hedge fund managers say trading stocks is not gambling.
Who is right?
To answer that, we need to understand motivation, intent and odds.
Motivation, intent and odds
What are gamblers looking for? What is their motivation?
Gamblers are looking for an out-sized, lottery-style payoff and something they have not worked for. Something they know they will be lucky to get.
If I put $100 on red at the roulette table, I know I don’t deserve to win. Over time, my odds of winning one spin after a bet of red or black are just 47.37%. Of course, I might win that one time, but I know I can’t win over the long-term. If I’m playing the long game, it is statistically very probable I’m going to lose money.
And therein lies the thrill of it! If I put $100 on red and win, I’ve done something a bit naughty, something I know I shouldn’t do, but I’ve gotten away with it! If I get away with it, I’ve successfully beaten odds that were clearly against me and come out the other side smiling. A bit like surviving a wipeout on a monster wave, it’s a rush, and some people love that rush.
“Money won is twice as sweet as money earned.”
“Fast” Eddie Felson in “The Color of Money“
There’s nothing thrilling about buying an index fund – or any other “safe” “investment”. We know that over a long enough time frame we’re going to win. Nothing naughty or exciting in that. Putting money in a term deposit or a government bond is a yawn-fest. There’s zero chance I’m going to somehow make 100% on my money but also a (near) zero chance I’m going to lose money either. I’m going to make 2% on my money and that’s it.
But trading is not passively buying an ETF. And it’s certainly not a term deposit. There are no guarantees in trading. So does that make trading, gambling?
It depends.
When buying shares is like gambling
If I pick a random penny stock to buy, this is gambling, and I’ll explain why.
Again, it’s all about the odds and the intent. The only reason I’m buying a penny stock is my belief/hope that I will make a lottery-like return on it. But the odds of my penny stock achieving a 10x return are unknowable. It might? But it probably won’t. But my intent is to do make out by getting lucky.
When the odds are unknowable or when I’m wishing for incredible luck – THAT is gambling!
How about picking a “blue chip” stock? If it’s a random pick, it’s not so different. It’s less likely to go to $0, but our odds are still unknowable as is our expected payoff.
What if it’s not a random pick, but rather a careful selection based on research? First question we need to ask is, what are the odds? Looking at the fundamentals, we could ask the question how many stocks have had similar fundamentals of the stock we like, and then went on to achieve x% gain within a year? If we can’t answer this, we’re still gambling because really we’re still hoping to get lucky.
If we do know the answer to this, then we’re making an informed decision. Some might call this an investment decision. If we know our odds and our profit target, we know when to get out if it’s going badly, and we know when to take our profits when it’s going well.
So, what about trading?
The first thing a good trader asks herself before she places a trade is “what’s the risk on this trade, and is the potential reward worth the potential risk?”
Once we have found a high probability trading setup we like the look of, the first thing we need to define is our stop loss. This is our line in the sand. The point at which we are happy to be proven wrong, take a small loss and move on.
“Mike, I learned it from you. You always told me this was the rule. Rule number one: Throw away your cards the moment you know they can’t win. Fold the f*cking hand.”
Jo to Mike McDermott in “Rounders”
Then we need to look at our profit targets. Factors like support and resistance, volatility and momentum all play a part in determining where we are likely to take our profit.
If we’re risking 8% on a trade that looks like it may only rise 4% before slamming into resistance…well, we don’t want to be placing trades (bets!) like that on a regular basis.
The other question a trader needs to keep asking is “what can I expect my trading system to do for me over the long term?”
We want to know when using a trading method that our profits over time will exceed our losses (yes, there will be losses!). I personally prefer it if the profits are a lot more frequent than the losses but this is not a prerequisite for a successful trading system, as I’ll show you in the example below.
Trading Expectancy
The profitability of a trading method over time is determined by expectancy.
Expectancy is calculated as follows:
Expectancy = (Probability of a Win * Average Win) – (Probability of a Loss * Average Loss)
For example, assume a trading method produces profitable trades 30% of the time. The average winning trade gains 10% while losing trades on average lose 2%. For a $10,000 account the expectancy for this trading method will be:
(30% * $1,000) – (70% * $200) = $160
This means, on average (over many trades) each trade will contribute $160 to the overall profit and loss on the trader’s account. Which is fantastic!
People don’t go to their regular day jobs hoping that today it will be announced that they’ve won $10 million. They go to their regular jobs knowing that the odds of their job producing a certain amount of income are high and their goal is to accumulate that income over time.
Successful trading is the same way.
If we have a handle on our expectancy and we aren’t in it for the thrill, it’s trading, not gambling.