Gambling, Speculation, and Investment

We draw a very important distinction between gambling, speculation, and investment.

Today, many prospective investors do not understand this distinction, largely because the term "investment" is often misapplied to activities which should more properly be identified as speculation, or even as gambling, as we explained in a Taylor Frigon commentary entitled "Gambling, Speculation, and Investment" published earlier this year and available in the commentaries section of our web site.

Another important aspect of this distinction -- beyond the differences outlined in that commentary -- is the fact that both speculation and gambling are forms of a "zero-sum game." New wealth is not actually created in either gambling or speculation: wealth is often redistributed, but new wealth is not created. If four people walk up to a high-stakes poker table, each with one million dollars, only four million dollars will leave that same poker table. At the end of the night, one player may have four million and the other players may have zero, but nobody will walk away with five million. No new wealth is created in a zero-sum game (hence the origin of the term "zero-sum" -- nothing is added; there is zero "summed" or added in the process).

In forms of speculation in the financial markets, this same principle is evident. If you want to place a bet (in the form of futures contracts, for instance) that the dollar is going to go down against the euro, then someone else must be willing to bet that the dollar is going to go up against the euro. If you and I walk up to the exchange with a million dollars each, and you think the dollar is going down against the euro, and I think it is going up, then at the end of the contract (at expiration) you may have two million dollars and I may have zero, but no new wealth is going to leave the exchange: it is a zero-sum game. This is true for speculation on the price of oil and other commodities, as well as for foreign exchange speculation (forex), as well as for bets on volatility (I might bet that an index will stay within a certain range of volatility, and you might bet against me and win if the index moves outside of that range).

Investment, under the proper definition of the term, is the allocation of capital to an enterprise that will actually create new value. In investment, therefore, new wealth can actually arise where it did not previously exist. You can easily see this process from familiar examples of recent years. At one point in the recent past, there was no such thing as an iPod (or iTunes); today, there is an iPod and iTunes. Something of value has been produced that did not exist before. The pie actually gets bigger: it is not a zero-sum game. The same holds true for the creation of cures that did not exist before, or services that made something easier that previously was difficult or impossible to accomplish.

A zero-sum game is a much more unstable foundation for the creation of long-term wealth. It is difficult to win a zero-sum game consistently for decades. Just as in the gambling world of Las Vegas or Monte Carlo, there is a cost to participate in each zero-sum game, so the odds are already stacked against the player and in favor of the house (in the world of financial speculation, there are transaction costs and commissions involved in placing bets using futures contracts or financial derivatives) . Additionally, when involved in gambling and speculation, the game is often constructed such that the effect of a mistake is magnified (think of the phrase "double or nothing," for example).

It our hope that the distinction between gambling, speculation, and investment would become more widely understood, so that individuals are less likely to engage in speculation and gambling when they think that they are actually "investing."

[Of course, there is a place for both speculation and gambling, but it is important to know when that is what you are doing, so that you can make a conscious decision about doing so. Also, it is quite likely that poker is not really gambling under the definition outlined in "Gambling, Speculation, and Investment," but is really a form of speculation. The picture of the 1956 book on poker depicted here is really a picture of monetary inflation over the last fifty-one years, showing the diminishing purchasing power of thirty-five cents].

For later posts on this same subject, see also:
Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.


Post a Comment