5 gambling truths that apply to investing

Investing and gambling are not the same thing. Still, these pursuits have enough in common to make some lessons from the poker table relevant to the world of stocks and bonds.

Both gambling and investing require participants to judge how the laws of probability relate to specific situations. Both are also somewhat adversarial -- in gambling, there are winners and losers, while in investing, buyers and sellers are essentially making opposite judgments about the same investment. Also, both gamblers and investors have to fight a very powerful enemy: their emotions.

The gambler's wisdom

In the struggle to let logic rather than feelings rule your investment decisions, it can be helpful to keep in mind a few gambling realities that also relate to investing:
  1. It's not just what you know -- it's what they know. If you are dealt a hand of cards, you immediately know what you have. The trick is figuring out what everybody else at the table has. Similarly, with investing, you don't just have to make your own assessment of an opportunity, but you also have to get some sense of how the market views it. If you like a company for the same reasons as everybody else, it is hard to make money because the price will already reflect that assessment. Opportunities come when you have differing perspectives and expectations from the mainstream.
  2. It's easy to mistake luck for skill. It's easy to let it go to your head when things go well, but you need to stay humble and understand both what went right and what could have gone wrong. Luck tends to even out, so don't count on it repeating itself.
  3. Cold streaks tend to outweigh hot streaks. This reality is partly mathematical and partly emotional. The mathematical part is that a given percentage loss will more than wipe out an apparently equal gain. For example, if you invest $100 and make 50 percent, you now have $150. However, if you then lose 50 percent, you will down to $75 -- less than what you had at the start. The emotional part is that when things go wrong, judgment gets clouded. People try to chase every chance of breaking even, which often leads to throwing good money after bad.
  4. The odds are in the house's favor. Never forget that there are costs to every transaction. High-frequency traders are essentially paying more to stay in the market than someone with a buy-and-hold approach. Make sure every decision you make is worth the cost.
  5. Overestimating your winners can lead to trouble. It's human nature to prefer to forget your losers and dwell on your winners. The problem with doing that as an investor is that it can mislead you into thinking a given strategy is working, when it is actually failing more often than succeeding.

Investing does have a key advantage over gambling. Betting is ultimately a zero sum game - for every dollar won, someone else loses a dollar. Because sound investments are based on legitimate economic activities -- stocks in companies that earn money, bonds that pay interest, and so on -- there is an opportunity for all long-term players to come out ahead over time. The trick is not to let your investment decisions become gambling moves that stake more on short-term changes than long-term value.