Monday, October 3, 2011

The Stock Market: Is it a Casino?

The fear of buying and selling shares arises from the belief that the stock market is similar to a casino.

Therefore, there is a tendency to keep away from the stock market. On the surface both stock markets and casinos may look very similar. You may have heard many people comment that stock market is meant only for gamblers and this view in fact discourages quite a few people from investing in the stock market and thus resort to a safer option like bank deposits.

For example, when you play roulette you don’t know whether you are going to be lucky and win. Similarly, when you buy a stock you have no clue whether the price will go up or down the next day. In both instances, the players take a calculated risk when they place their bet or decide to purchase stocks.

In the casino, despite relying on probabilities, not knowing what the cards are and the behavior of the other players makes gambling more of a game of “chance” than in the stock market. It is commonly believed that in a casino the odds are weighted in favor of the house. Despite this, gamblers come in with the hope that they can outsmart the odds and “break the bank.”  When winning, they continue betting to take full advantage of their luck and when losing, they continue to bet, hoping that the flow of their fortunes will change eventually. But in the end, it’s the house that generally rakes the money in with a few of the gamblers also emerging as winners with none able to “clean sweep” the house. Gambling is a zero-sum game. It merely takes money from a loser and gives it to a winner. No value is ever created.

All are players

However, in the stock exchange there is no house; rather there are players in the market. In gambling the result is dependent on the outcome of throwing a dice; only one participant will win. In equity markets, if five investors hold the shares of the same company, and if prices go up, all of them will gain. In the case of the stock market the investor can analyze the financial performance of the company, the character, experience, and expertise of the board and management; and analyze industry trends and the business environment before making his decision to sell or to buy. Therefore, when you invest money in the stock market and build a portfolio of 10-15 stocks, you are actually investing in the future of these companies. It is unlikely that if you have selected these companies with care, all of them will perform negatively and you will lose all the money that you invested. By investing, we increase the overall wealth of an economy. As companies compete, they increase productivity and develop products that can make our lives better
For a select few, however, the passion to make more money overrides their fear. Therefore, they dare to take a plunge in the stock market though not with very encouraging and positive results. Fear and the desire to multiply their wealth can often cloud our judgment and reasoning. As it is, investing demands one to be rational, disciplined and patient. Therefore, when we act with less reasoning and diligence with a blurred judgment, we only increase the probability of taking wrong decisions.

Awareness of larger picture

When investing in the stock market you have to be aware of the larger picture. Markets tend to be volatile by nature and in the short run luck does play an important role. If you look at historical data, there have been many occasions that the market has given a high percentage of returns. It suggests that if you have invested long enough you will gain from some of the sharp upswings and eventually make a reasonably good return.  However, it’s important to look at history over a long enough period of time. Doing so, you will realize that there are phases when markets have given continuous negative returns.

Because one can lose money in the stock market, most people are reluctant to invest in shares. But the questions we need to ask are:

Is investing in stock market same as gambling?

Does making money depend on one’s ‘luck’?

What is the probability of making a loss?

Let’s think rationally. What does buying a share mean? It means being part of a business and sharing its profits and losses. If businesses make profit, the share prices will rise; if not, the prices will fall. Now, does this mean a business runs on luck? Definitely not. It runs on hard work and efficient management. Therefore, more often than not, a well-managed business will make money and consequently the share price will rise.

Thus, if you invest in 10-15 good businesses, majority of them will make profits. Therefore, your probability of making money from such a portfolio will be much higher. Hence, a stock market is NOT a casino. Luck has a very little role to play. A portfolio of good companies will give good returns with high probability.

One more important point to keep in mind is that a business cannot double its’ profits in a few days.

Businesses take time to grow. Therefore, it would be wise to keep your return expectations in line with the business growth. If businesses are growing at 15-20 per cent per annum today, you cannot expect to double you money in six months or one year. Be patient. Give time for the businesses to perform. Concentrate on making money from the portfolio as a whole and not from each and every share.

Why lose money?

It seems simple, but then why do people lose money? There are various kinds of trades that you can do in the market. If you are an investor having invested in a portfolio of good companies and stayed invested for long enough, you are more likely to make good returns as mentioned earlier.

On the other hand, if you are a trader and are betting on day to day directional movement of the market, you can lose money if your bets are wrong. Your ability to absorb various conflicting information and technical cues coming from the market and your discipline in cutting your losses through stop loss will largely determine whether you last long enough to see potential upside even if you make losses. However, given the difficulty in understanding the overall trend, for most people high frequency trading is a better option than to those with good understanding of markets and a higher risk appetite.

Opportunity for wealth creation

Overall, stock market presents a good long term investment opportunity for wealth creation. Business is not risk free and to that extent neither can a stock market be so. But as explained above diversifying across multiple companies you are reducing your risk. For those who want to get significantly better returns by taking advantages of frequent market movements and betting heavily on the same, risk is high and given the challenges in predicting the markets right, can cause huge losses as well. Depending on your knowledge and risk appetite you can make your choice.

Buying an equity share means buying ownership in the company. Share prices will reflect the company’s performance and shareholders have a claim on the net profits. This means that a company creates value for shareholders. In gambling, no value is created. It’s the same money to be won or lost. Investing in the stock markets means picking fundamentally-strong stocks at the right prices. Stock investment needs time, patience and fund management skills, all of which is not gambling. There is an element of risk involved, but this can be minimised. Gambling doesn’t have such an option.

(Sources: Rajnish Kumar,“Is stock market just one big casino?”,  Sanjay Matai, “Why the stock market isn’t a casino”, Melito Salazar Jr., “Of Casinos and Stock Exchanges”)

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