This article of ours first appeared in Mint on 21st March 2018.
I have heard many people say investing in stocks is like gambling in casinos. People find both situations uncertain. They say, “You never know what’s going to happen in either circumstance”. But in reality, risk and uncertainty are very different from each other. So is gambling from investing, and it is important to know this difference.
In case of gambling at a casino or playing the lottery, risks are in fact calculable. Sure, a gambler or lottery player can’t calculate the exact probability of winning, but the odds of winning are always in favour of the casino or the lottery owner because it has to survive, cover costs and make profits. While it makes some gamblers and lottery players highly optimistic and thus overestimate their probability of winning, it leads others to stay away owing to the risk of losing money.
On the other hand, when investing in stocks, one must remember that businesses and economies are ever-changing and uncertain. The risks cannot be calculated by a mathematical formula like calculating the probability of winning or losing in a casino or lottery. That, of course, makes people scramble to create complex formulae to calculate the risks of investing in stocks, because our brains can’t deal with uncertainty. The need to feel certain is a deep human desire, which leads us to suffer from what behavioural economist, Nassim Taleb, calls the Turkey Illusion.
Taleb uses the example of a turkey to illustrate this. Imagine you were a turkey. On your first day on this planet, a man came towards you. You were afraid that he might kill you, but he was kind and gave you food. Next day, you see the man approach you again. You feel scared, but again he is kind and gives you food. So after the first day, the probability that the man will feed you the next day is 2/3. If he does feed you, the probability increases to 3/4, and so on. On Day 100, the probability that the man will feed you and not kill you is 99/100. You are almost certain that you will be fed. But it’s Thanksgiving. You are dead. You didn’t know about Thanksgiving. Wrongly assuming that a risk can be calculated has been termed the Turkey Illusion. Thanksgiving was an unknown risk.
Likewise, not every risk is known in the stock market; therefore it can’t be calculated. I’m not trying to scare you, but that’s the reality with any investment—shares, real estate, gold…. Confidence in housing was the highest in the US before the onset of the sub-prime crisis because the risk estimates in the housing market were based on historical data.
At the same time uncertainty associated with investments in stocks, real estate or gold doesn’t make them riskier than playing a lottery or gambling in a casino. It’s just that the risk cannot be accurately calculated because there are just too many variables that affect the price of investments—from the economy of the country to the economy of other countries, the amount of liquidity in the market, the amount of liquidity in the world, and many more.
However, even though uncertainty in investments can be high, the risks can deliberately be reduced by ensuring, for example, that one doesn’t pay a steep price for the investment. If you buy any investment at a high price, the risk attached becomes proportionately high, because it may take that much longer to profit from it. It also increases the risk of the price going below the price you paid, due to uncertain circumstances.
In stock investments, it is recommended to buy a stock of a company keeping in mind a margin of safety. Margin of safety is one of the main principles of Benjamin Graham, who was the guru of acclaimed investor Warren Buffett. According to the principle of margin of safety, one should try to assess a realistic value of the business, its corresponding price of a share in the company, and buy if it is available for, say, 20% lower price than its worth. Therefore, 20% is the margin of safety against any uncertainty in the business or external variables.
What this also means is that one has to take efforts at arriving at a reasonably fair valuation of the investment; otherwise, there is no way of knowing whether the investment is over-priced or fairly priced. In doing this, the risk gets reduced, even though uncertainty continues to remain present.
Know that gambling in casinos and investing in stocks is not the same thing. Risk and uncertainty are not the same thing. Gambling in casinos comes with certainty as defined by probabilities, but the risk of losing money is high. Investing in stocks comes with a lot of uncertainty as defined by probabilities, but the risk can be managed reasonably well.