Bringing Down the House – When is it fair to label Speculation as “Gambling”?

                 This past week I stumbled upon an old book from Uni creatively called “Investments” by Bodie, Kane & Marcus (5^th Edition McGraw Hill Irwin Publishers – in case you’re interested, or in case they’re reading). As I flicked through it I came across a section which discussed risk, speculation and gambling and I was intrigued. After 8 years supporting various trading desks I thought it might be interesting to see how the literature determines the difference between speculation and gambling.

Speculation is, to quote the section (p.156):

““the assumption of considerable business risk in obtaining commensurate gain”…………By “commensurate gain” we mean a positive risk premium, that is, an expected profit greater than the risk free alternative”……….by “considerable risk” we mean that the risk is sufficient to affect the decision. An individual might reject a prospect that has a positive risk premium because the added gain is insufficient to make up for the risk involved”.       

Gambling on the other hand is defined as:

“”to bet or wager on an uncertain outcome”…………Economically speaking, a gamble is the assumption of risk for no purpose but enjoyment of risk itself, whereas speculation is undertaken despite the risk involved because one perceives a favourable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium to compensate risk averse investors for the risks they bear.”

      That last line for me is the most interesting because it suggests a fine line between gambling and speculation, and one which implies some level of one’s perception is the only difference.

                    Ever since I started in working in banking I have been asked by friends and family not in the industry “isn’t trading on the stock market just gambling?” More often than not I took the official approach – investors are taking informed decisions based on the information out there to take a calculated risk in determining whether a stock was going to go up, or down, and as such this enabled them to verify whether the risk premium involved outweighed the risk. Most people at that point nod politely (or nod off!) and admit they don’t understand the market and figure that other people must have more knowledge to be able to make truly informed decisions.

                 As the definition above lays out, in order for a trade to be truly speculative as opposed to a gamble, you need to determine an expected return based on the probability of a variety of outcomes on that trade, using all the information available, and not only for this return to be above the risk free rate (normally seen as being either US Treasury rates or in this country UK government Gilts), but also for the additional risk involved to be adequately compensated by the expected return above that rate.  

                  Of course to make that decision and not feel like you’re “taking a punt” you need to feel that you have assessed all the relevant available information. You then of course have to realistically assess the risk of successful and non-successful outcomes. If you’re looking at a longer time horizon, say 10 years, for your investment, then you have a decent time frame to realistically consider your potential investment’s risk vs reward profile and perceive yourself to be making an informed investment based on information you've gathered and that supplied by others.

          But what about on a day to day basis? Can we really say it’s possible to properly ascertain the risk versus reward in the very short term and conclude that on the whole we are making a speculative investment and not just a gamble i.e. we have perceived the risk premium to adequately compensate for the risk involved. I would say, at the current moment this seems unlikely in most cases. We’re currently living in a world where the market falls at an indication things might improve, rises when the economy performed worse than originally thought, but then can rise or fall when other economic indicators indicate improvement. 

        As I've mentioned in previous blogs a rational investor would surely have expected a rise in the S&P 500 off the back of the Fed announcement. But Let’s say you took the contrarian view. You “speculated” based on the information you felt you knew that the S&P 500 would go on a downward spiral for the next couple of weeks? After all if you felt that Fed tapering was bad news surely the closer this comes to being put into action then the more the market should fall. As a result you sold on the day of the news, June 19th. Well even then you’d most likely be disappointed with the market falling slightly again for the next few days but effectively as of the close last night it was only slightly below the closing level of June 19^th. So you’re almost back to where you started but you’ve also used resources in potentially going from previously being long to now being short as well as incurring transaction costs. Speculation of course doesn't mean you’re always going to be right and make money, but can an investor really make very short term perceptions as to market behaviour and risk/reward payoffs in the current topsy turvy markets and still call it speculation?  

        

              A few years ago I read a book called Bringing Down the House, by Ben Mezrich, in which he tells the true (well close to true) story of a group of pretty smart MIT students who have a remarkable ability to count cards to a high degree (There was also a film starring Kevin Spacey called 21, but the book was better). This group led, by their university professor, go to casinos around the country, and ultimately to Vegas, hitting the blackjack tables and raking in millions of dollars. Their biggest risk was non-financial – they had to hope to avoid physical intimidation should the casino ever cotton on to their method. It was a short term speculative investment which they knew they had a good probability of coming good from. The big difference here is that they knew all the elements and were able to produce a strategy which had winner written on it most of the time. 

            There is no such strategy or methodology attributable to the current markets in the short term. When good news could mean up or down then speculation cannot be possible. If you’re looking at an everyday individual investor and they think about the medium term, at least 4-5 years, it’s fair to say most people will be close to speculative in how they invest their money in the market. But try to “speculate” on a daily, weekly or monthly basis, you might find you’re just struggling to count cards in Vegas. The problem is you don’t know how many decks of cards they’re using!!