Are you investing or betting?

To my way of thinking, putting your money behind the Bitcoin represents a bet rather than an investment. Of course, the distinction can be confusing — outside of sports pages, the place you might most often see people referring to bets is in the financial news. Any large or prominent financial stake in something is likely to be referred to as a bet.

I believe there is an important difference between a reasoned assumption of risk (i.e., an investment) and an all-out win-or-lose gamble (i.e., a bet). With each passing year, I appreciate that distinction more and more because I’ve seen people put their money at undue risk when they mistake a bet for an investment.

There is no hard-and-fast definition that captures the distinction between the two, but below are some thoughts on how to tell the difference.

It’s a bet rather than an investment when:

  1. It’s an all-or-nothing type of proposition. Relatively few publicly-traded companies suddenly go completely out of business, so in most cases when you invest in the wrong stock, your downside might be 10, 20, or 30 percent. Bets, on the other hand, are all-or-nothing — you win or you lose. This doesn’t just apply to cases like betting on the Broncos in the Super Bowl. Certain financial transactions, such as uncovered options, can also mean your entire investment is riding on whether you are right or wrong.
  2. It depends entirely on a single event. If you make an investment in a good company that happens to miss one quarter’s earnings, you will have plenty of chances to make up for it in subsequent quarters. Like bets on a sporting event, though, some financial propositions are based on one outcome or have short-term expiration dates, and so they don’t give long-term fundamentals a chance to come into play.
  3. You live or die depending on popular opinion. Shorting a stock is a good example of this. It is a risky proposition, because you might be right that a company is overpriced, but as long as people keep paying more for it, you lose. Shorting a stock is also a risky proposition because your downside is theoretically unlimited.
  4. Your interests are not aligned with those of the people in control of the enterprise. Gamblers are often frustrated when they have bet on the Wildcats to win by ten, only to see the Wildcats sit on a nine-point lead to run out the clock. This is a reminder that the Wildcats’ coach is interested in winning the game, not beating the point spread. These days, you have to look carefully at executive compensation packages before you invest in a company. Executives might have specific incentives which are not lined up with your goals for the company as a shareholder.
  5. You cannot obtain fundamental business information. For all the media coverage that precedes the Super Bowl, much of the game plans the teams have in store is kept top secret. You can bet on the game, but you don’t have all the information you need to understand how it will be played. Similarly, investment schemes like hedge funds with intentionally opaque investment strategies put you in a position of making a blind bet rather than an informed investment.
  6. You do not perform fundamental analysis. Then again, often the right fundamental information is available but people do not bother to do the analysis. There is more to a business plan than having a hot product, and an investor should have a good feel for a company’s business plan. Also, even a great company can be overpriced, so you need to know how the current price relates to projected earnings.
  7. It is driven by emotions. Part of the reason people bet is for the emotional rush — plus, having a different kind of stake in the game can make a blowout like the recent Super Bowl more entertaining. Investing, on the other hand, should be cold-blooded, with decisions driven by the head rather than the heart.

Don’t get me wrong — this distinction between a bet and an investment doesn’t determine whether or not something is a good idea or not. There can be bad investments just as there can be good bets. However, the distinction does relate to whether or not the decision is speculative by nature; and based on that, you should determine whether your financial future should be at stake or just a little pocket money.

3 Responses to “Are you investing or betting?”

  1. Anonymous

    Excellent piece. There are a lot of people predicting a crash in 2014 and I’ve completely changed my mentality insofar as my investments. I will use Warren Buffett’s analogy of being greedy when everyone is fearful and being fearful when everyone is greedy. Great Post..

  2. Anonymous

    I guess I use a simpler definition– an investment is when you exchange capital for an income stream. A bet (aka speculation) is when you purchase an asset that you hope to be able to sell at a future date for more than what you paid to acquire it. Investors care only about dividends and interest while speculators care only about capital gains. Which column you look at on the stock page, yield or price?

  3. Anonymous

    Great post! I would add one more thing: impatience. Warren Buffett says what sets him apart from others is he’s mastered the art of doing nothing. Too often, it’s too hard to just let the investment do its thing on its own.

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