I’m writing this while at the airport on the way to Las Vegas, so please bear with me. The analogies might be a bit of a stretch, but here are some ways I think gambling is a lot like investing… Debate as you like.
Costs matter. If you believe that the stock markets are very efficient, like I do, then the market is already priced with all the information publicly available. Any market moves are in response to fresh news like unexpected earnings report results, which are unpredictable unless you have insider information. Thus, the best you can do is try to match the market. Any costs like expense ratios, fees paid to financial advisors, extra taxes from turnover, or commissions, simply cut into your returns.
Take the house edge in gambling games. Obviously, the best way to keep your money is to simply not gamble. (Or maybe play the nickel slots slowly, tip well, and end up getting drinks for $1 each…) If you do gamble, then you have the chance to win money, but also a chance to lose money in the short run. But over the long run, your chances of winning get very very slim due to that house edge. All you have to do is look around Vegas to see this.
The house edge is like your investment costs. With investing, you try to pick your own stocks or go with actively managed funds which try to beat the market, usually with a significantly higher cost. Over the short run, they might beat the market handily. But over the long run, the odds of your fund beating a similarly allocated lower-cost index fund are very very small. (Not impossible by any means, but small.)
Most people don’t really understand costs. What’s the most profitable game per square foot in Vegas? Slots. What’s the most common game in Vegas? Slots. You see a bank of slots under a sign that says “up to 99% payout!” You know what that means? One of those machines is set to a 99% payout, and the rest are at 80%.
Why does everyone play slots? Lots of reasons, but one big reason is that they are really simple. You don’t need to learn any rules. You mash a button repeatedly. That’s it. But the odds are the worst by far. In fact, you don’t even know the odds. I hate playing the slots (again, except as a tool for getting cheap beers).
Personally, this makes me worry a lot about the self-directed nature of many people’s 401k/403b/TSP plans. Do they really know that they are investing in? The 401k industry seems to rely on the fact that most people just go with the default choice given to them. Few people question their investment choices. I don’t have the article on me right now, but something like 80% of 401(k) holders have no idea what expenses they are being charged on their retirement accounts.
People see patterns where there are none. One brilliant invention of casinos is adding the marquee display to roulette that displays the last 10 numbers hit. If a person sees 6 reds come up in a row, they might think “Oh, it’s due for a black” or “Red’s on a streak”. In fact, it remains an equal chance for red or black. One of my hobbies is listening to people’s wacky betting systems at tables. If there were any such patterns, you can bet people would exploit it greatly for profit.
Of course, Vegas is just entertainment. But losing 1% or more of potential return every year by paying excess costs is huge. Now that I have spouted all this analytical reasoning, wish me luck in Vegas!