Investing and gambling – Can you tell the difference?

Once you step away from the cosy world of fixed-rate investments, it becomes much more difficult to tell if you’re an investor or if you’ve become a gambler.

For fixed-rate investors, the difference is clear.  They put money into an account, and the value of each pound saved never changes.  The account then provides an income which is known in advance and drops into the account several times a year.  The chance of an adequate return is high, and the chance of a permanent loss is effectively zero.  None of this sounds remotely like gambling.

A fine distinction

Ben Graham said that an investment should provide safety of principle and an adequate return.  Of course, adequate return is subjective, but if you’re happy with the lower and more certain returns of fixed-rate investing then it certainly fits Ben’s definition.

Gambling on the other hand offers the chance of an adequate return and perhaps a life-changing return in the case of the National Lottery, but it also offers a meaningful chance of a permanent loss and even a total loss; that is the key distinction.

Both investing and gambling can provide adequate returns and better, but only investing can do this with little or no chance of a permanent loss.  Strangely enough, the stock market can be a place for both investing and gambling.

Short-term gamble, long-term investment

If you had some money to invest for a year while you travelled the world, putting the money into the stock market would be a gamble.  This is true because returns from the stock market in a single year can range from perhaps 30% up to 50% down.  With a possible 50% loss in a year, the stock market over such a short time span is a gamble.

Instead, if you were investing a lump sum for 20 years then the FTSE 100 becomes an investment.  That’s because over 20 years the returns from the stock market are almost always positive, even in inflation-adjusted terms, so the chance of a permanent loss is virtually zero and the similarity to gambling fades away.   The same thought process can be applied to individual stocks so that they become investments rather than gambles.

Stock picking for investors, not gamblers

In most cases, investors don’t look for a 20-year holding period in an individual stock, so let’s take something a little more typical.  Say my investment horizon for each stock is five years.  It might be more, it might be less, but that’s the general ballpark.  If I were to invest in Balfour Beatty today at 290p, I’d get a stock that pays a dividend of around 4.5%, which is well covered by earnings and is expected to grow at least in line with inflation.

If I owned this stock for five years, I might receive dividend payments totalling around 25% of the purchase price.  For this to be a gamble rather than an investment, I’d have to say that there was a meaningful chance of a negative return over the expected holding period.  To have a negative return, the share price would have to drop by more than 25% (i.e. the capital loss would negate the dividend income).

If the share price fell 25% to 220p, then the dividend today (at 12.7p) would be 5.7%.  That’s high, but far from impossible.  In 5 years, however, the dividend could easily be nearer 15.5p (growing at an unspectacular 5% a year), and in that case, a 220p share price would give a dividend yield of 7%; again, that’s not impossible, but it is unlikely.

With almost no chance of a total loss, only a small chance of any loss at all and a good chance of ‘adequate’ returns (perhaps 10% a year), Balfour Beatty looks to me like a sound 5-year investment as part of a diversified portfolio of similar stocks (in fact I do already own it).

When you’re stock picking, it’s critically important to differentiate between investing and gambling.  Knowing one from the other can mean the difference between achieving long-term investment goals and missing them by a country mile.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

6 thoughts on “Investing and gambling – Can you tell the difference?”

  1. Balfour Beatty has been a beaten stock last year and it was probably oversold. I am concern of the sector as there will be cuts and that will affect future orders and their margin in the future.

    There are other stocks which were oversold last year, small and middle oil companies. There was a fear of stagnation and negative growth. But with oil prices so high I believe there is some profit to be made so I have put a few chips on them. I may be lucky if Iran makes a mistakes and push oil price even further, anyone for $200/barrel. I have bought Junior Oil Trust a fund managed by two experts, one of them is Jim Slater.

    Is that investing or gambling?

    1. I’d say that was gambling but it depends on how much you know about oil stocks. Also I guess it depends on position size and how willing you are to make a loss with the money.

      As for Balfour, there may or may not be cuts, but even if there were they won’t last forever and I’m happy to own the stock for a decade if need be. As long as the annualised return over the period works out okay (on average, across a range of diversified stocks of course).

      1. I am not good at oil stocks at all. That’s the reason I invested in a fund.

        Jim Slater came to us to promote his fund and he showed us a few stocks he owns how undervalued are. I am sceptic on holes in the ground but this time I believe the holes sell cheap. He did some calculations at $80/barrel and I was impressed.

  2. As Buffett would say investing is an analysis of the fundamentals. I don’t know how people invest in oil and gas producers or exploration companies? They are often valued in the billions with no turnover let alone profits. Obviously they have the potential to make huge profits but as an investor I can’t see any margin of safety to protect my investment. I think this is a specialist area of investment which I will leave alone so not to become a gambler, or speculator.

    1. Hi Alex. You’re right – many niche areas can be a gamble for the average investor, but if you know an industry or company inside out it might be a no-brainer investment. If you’re not so knowledgeable then it might be better to stick to things that don’t need quite so much expertise, and that doesn’t necessarily mean getting lower returns either.

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