When it comes to the stock market, there’s a fine line between gambling and investing. Sometimes it’s hard to tell the two apart. Both strategies attempt to make money in the market and the differences can be so subtle as to go unnoticed. When is it gambling and when is it investing? What’s the difference?
Long-term vs. Short-term Focus
Investing is about being patient and seeking consistent returns over the long-term. The focus is on buying stocks that will perform best over a period of years. The investor wants a portfolio full of such stocks, knowing that the deck is stacked in his favor over the long haul. Ups in downs either in the stock itself or in the overall market don’t change the investor’s strategy because the real payoff is spread out over many years.
Gambling is more of a short term focus. It seeks immediate, high returns, but often encounters the opposite because of market fluctuations. For that reason, gambling is often more of an in-and-out trading strategy, the kind that an investor would find hard to take. Because of the high number of trades, gambling will involve paying more in the form of transaction fees, something investing seeks to avoid.
Buying Cash Flow or Price Appreciation
Investing is concerned with building cash flows. That centers the focus on dividends and companies that have a long track record of not only paying them on a consistent basis, but also of regularly raising them. As the dividend increases, the underlying stock becomes more valuable.
Not only does the stock provide a regular income, but capital appreciation on the stock as well. The investor wins on both immediate income and long term growth. Because of the dividend, and the potential for even higher dividends later, the investor will hold onto his stock even if the price drops.
Gambling is typically a play on price appreciation. The gambler is interested in selling at a higher price, and will hold onto a stock only as long as it’s rising in price. Should the price rise come to a halt, the gambler will sell the stock and search for better prospects.
Betting on the Trend, Not the Stock
The most fundamental rule of investing is buy low, sell high. If you’re investing you’re taking that advice to heart. You’re looking to buy a stock at a time when either the stock itself or the overall market is at or near a low point. For this reason, you might prefer to be a buyer in down markets (“bottom feeder”), or to buy stocks that are out of favor with the general market. Both offer opportunities to buy stocks at low prices.
If you’re gambling, there’s a very good chance that you’re buying on trends. That means you might be a buyer even in rising markets, or that you might be focused primarily on the hot stocks of the day. You’re buying on the current trend and betting that trend will continue in the same direction for long enough that you’ll be able to make money and move on.
The Importance of Fundamentals
Investing is concerned with valuation measures, such as price-earnings-ratio (P/E) and book value. The investor will also be concerned with a company’s position in it’s industry, the competitiveness of it’s product lines as well as new products and services under development. Investing will also involve careful consideration of a company’s management team and what it’s experience and management style are.
Gambling might involve largely ignoring fundamentals, under the assumption that if a stock is performing well, the fundamentals must be right.
Gambling might also seek to exploit certain potential speculations, such as take over candidates. The gambler might specifically seek the stock of companies that are considered likely acquisition targets. While that can be lucrative if it plays out, the game is usually over as soon as the takeover occurs, after which the stock is sold. The gambler never bought the stock for it’s long term potential but rather on the expectation of the outcome of a single event.
Diversification as a Dividing Line
Since investing is more concerned with fundamentals and the long-term, it typically involves diversification into various stock sectors and asset classes. An investor’s portfolio will usually contain a mix of stocks, bonds and cash, with the stock portion spread out over various sectors, including growth, emerging markets, technology and natural resources. Investing is about building a mix of assets likely to grow over decades.
Gambling is usually focused on chasing return. The gamblers money will usually be tied up in the best performing investments at the moment. It’s not that a gambler won’t diversify at all, but more that he’ll be more likely to load up his portfolio with the best performers. For example, if energy stocks are performing well, he might have 70 or 80% of his money in that sector alone.
It’s a strategy that can payoff handsomely while the trend is in motion. But when it stops, the gambler usually gives it all back and more.
What do you think the differences are between investing and gambling?