So just what is the difference between gambling and investing, is it really so easy to split the two activities apart?
The Dictionary.com web site says:
To put simply, the difference is unclear. Both involve risking money for potential financial gain.
An argument could be made that gambling is a zero sum game where as an investment is not. In gambling for every winner there must be a loser, whereas investing can benefit both the individual and society in general. Investing is widely regarded as the engine that drives capitalism. It tends to put money in the hands of those with the most promising and productive uses for it, and drives the economy gradually upward. Investors aren't merely betting on which companies will succeed, they're providing the capital those companies need to accomplish their goals.
All of this is true and would have stayed so, if it hadn’t of been for one thing – derivatives. Derivatives began to proliferate in the 1980s, they are investments 'derived' from other investments. The financial world have made these purposefully as complex as possible and many who work in the financial sector cannot succinctly define what a derivative actually is, so let me do it for them, a derivative is a bet that something will go up or down, that’s it. As an example, if you hold an equity derivative you don’t own part of the company, you’re not investing in its future, instead you are merely betting whether its share price will go up or down. The notional amount of outstanding over-the-counter derivatives contracts remaining in June 2015 was $553tn according to the Financial Times...... that’s a whole lot of betting.
Even in the modern financial world, gambling is still generally looked down upon by society. Trading on the other hand is seen as an activity that is worthy, smart and an investment in ones future. It’s the accepted view of the majority that gambling is a mugs game, where the odds are against you, that it’s for risk seekers using luck and emotion rather than skill to try and earn a buck. Lastly as the old cliche goes, the house always wins.
But what if this all wasn’t true, what if the distinction between trading and gambling was lazy and simplistic, what if you could make risk averse well informed decisions to make money gambling and what if the gambler remained disciplined in his or her decision making. There are many ‘gamblers’ out there already doing this and they are as savvy as any investor. Gambling, if handled sensibly, can be a very sound investment approach, and a viable alternative to traditional investment philosophies.
THE GAMBLING INDUSTRY IS ROUGH AROUND THE EDGES. To use the investment vernacular, the markets are inefficient. The market participants can be slow to react and equally, they often overreact on the spur of the moment.
In the financial world, mis-pricing is seized upon in milliseconds by automated systems. In the sporting world, arbitrage opportunities can be picked off by hand hours later. There are cracks in the system that are unlikely to be rectified. All of these inefficiencies lead to opportunities that can be exploited for profit. Layer on top of this the plethora of cashback, bonuses and refunds that get thrown about to entice the mug punter, and the kicker that it’s all tax free in many countries, and you have quite an interesting investment vehicle. It certainly looks more attractive than a 3.1%, 60 day notice cash ISA.
So, are there any lessons to be taken from the world of ‘professional investment’ that can be applied to sports investing?
Yes… given the similarities, there are many, but the three that I’ll concentrate on are portfolio theory, value and behavioural biases.
LESSON 1 – PORTFOLIO THEORY
There is no getting away from the underlying fact that the sports punter and the fund manager are both essentially gambling. They are taking views on an uncertain future and put their money where their mouth is. As hard as they try, they aren’t going to hit winners every time. So, how can we make money despite this uncertainty?
Some people enjoy the highs of winning the big gambles, but if you are being paid to look after somebody else’s money, this probably isn’t the most responsible strategy.
One fairly risk averse strategy, but one that works well in both the financial and gambling world, is the concept of a pyramid based portfolio, with a large, solid, low risk base at the bottom, and smaller more speculative layers on top. As you move up the pyramid, each layer gets smaller, but adds more risk and the possibility of higher returns. The intention is here that income from lower levels provides enough upside to cover any losses on the more speculative layers. If you make £25 each day on risk free offers, and then punt £15 a day on a speculative 12/1 shots, you can only profit in the long run. There will be variance in your returns, but it will always be heading in the right direction.
Another key idea when constructing your portfolio is that of risk management and diversification. As well as evaluating each investment on its own merits (see the section on value below), you should also consider its effect on your overall portfolio. The fund manager will look at the correlation of one security’s returns against those already in the portfolio in an attempt to diversify and reduce overall risk (variance).
You should do the same with your bets:
OK, thats it for now, I'll carry on this blog next week where i'll be dicussing lesson 2, how to spot value....