Wait don’t go! This post is not about GameStop and Robinhood! But I have to admit that they appear in today’s post as bit players.
I’ve been slowly researching the relationship between investing and gambling over the last few months. When I started that research, nobody was predicting anything like the GameStop-Robinhood-WallStreetBets-AMC-Nokia-SilverSqueeze-etc. turmoil. (Let’s just call it the “GameStop fiasco” for short.) But in hindsight, there were clear warning signs months, and even years, ago that something like this could explode on the markets. But before we read the warning signs, I want to address a more fundamental question.
Is Investing Just a Form of Gambling?
I was dismayed to find that when I searched for the word “gambling”, Google told me that people who searched for “gambling” also often searched for the word “investment”. But perhaps that’s not so surprising if you consider the similarities between the two. In both cases, you place some money on a desired outcome, like the white horse will win or the price of Stock A will go up, and you can either gain or lose money. And in both cases, you have no control over an uncertain outcome. So, what’s the difference?
The Britannica website defines gambling as:
- The betting or staking of something of value, with consciousness of risk and hope of gain, on the outcome of a game, a contest, or an uncertain event whose result may be determined by chance or accident or have an unexpected result…[my emphasis]
Put another way, gambling involves high levels of uncertainty. In contrast, I’ve advocated here at Mindfully Investing that, when done properly, investing is nearly certain to be successful.
Uncertainties of Gambling vs. Investing
At the casino, the odds depend on the game and whether you know how to play it well. The best odds you can get at a casino are about a 51% chance of losing (or a 49% chance of success). And most casino games offer higher chances of losing. Even with sports betting, the odds are set such that you have more than a 51% chance of losing, assuming that you can’t know more about the outcome of a sports contest than the person making the odds.¹
So, what are the odds of losing money when investing? Just like gambling, the answer depends on the particulars. I’ve written before about the chances of losing money in stocks based on historical data. This graph shows the chances of losing money in stocks on an inflation-adjusted basis over different holding periods using historical data from the S&P 500 going back to 1928.
History suggests that there’s a 13% to 17% chance of losing inflation-adjusted money when holding stocks between about 7 and 12 years. And if data going back to 1871 are included, these chances decrease a bit more. So, I’ve previously summarized these estimates as a roughly 10% chance of a loss over 10 years of stock investing. And notably, the chances of a loss after 18 years of stock investing is zero, if history is any guide.
What about bonds? Here’s the same graph for investing in the 10-year U.S. Treasury bond.
It might surprise you that the chances of losing money with “super-safe” bonds don’t decline over time and are generally higher than the chances of losing money with stocks. But recall that 1) bond returns are typically lower than stock returns and 2) this graph presents chances of a loss on an inflation-adjusted basis. In other words, 10-year bond returns have often failed to keep pace with the rate of inflation. Nonetheless, the chances of a loss with bonds hover around 35%, which is still better than the odds you’ll ever be offered at any casino.
Knowing How to Play
The odds for gambling and investing I’ve presented so far all assume that you know how to play both “games” well. Mindfully Investing is predicated on the idea that the investing game is actually pretty simple, so it’s easy to learn how to play well. I use the shorthand phrase “mindful investing” when referring to playing the investing game well, which I define as:
- Buying a moderately diversified set of low-cost stock index funds and holding them for as long as possible, but certainly no less than 10 years.
For example, my daughter’s 16-year-old friend sent me a screenshot of his investment “portfolio”, which consisted of small lots of a dozen penny stocks. He said that he intended to sell everything within 3 months, which is the kind of short timeframe associated with so-called “day-trading”. As we’ve already seen, the shorter the period you hold stocks, the greater the chances of a loss. And his odds of winning are further diminished because it’s well established that successfully picking individual stocks and timing the market’s ups and downs are both incredibly difficult.
It’s nearly impossible to determine the odds for specific market gambles like the portfolio of my daughter’s friend. But if we look at the aggregate result of many trades over time, multiple studies have shown that 85% to 97% of day-traders lose money over the long haul! Investors speculating with such high levels of uncertainty have moved, perhaps unwittingly, from the realm of investing and firmly into the realm of gambling.
Signs of Gambling Everywhere
All evidence indicates that my daughter’s friend is just one fish among an ocean of gamblers in today’s investment markets. A January 2021 study by Kumar, Nguyen, and Putnins examined the presence of gambling in global stock markets from 2003 through 2015. They defined stock market gambling as short-term trades taking place in stocks with low prices, high skewness of returns, and extremely high volatility. Put another way, the study focused on highly uncertain trades just like the portfolio of my daughter’s friend.
Here are some key findings:
- The amount of money devoted to global stock market gambling is at least 3.5 times larger than gambling in casinos, lotteries, horse racing, sports betting, gaming machines, and online websites.
- Gambling represents between 14% and 33%(!) of all stock market activity in the 38 countries assessed.
- Market gambling is more prevalent in countries with higher rates of traditional gambling.
- When some governments restricted traditional gambling during the study period, market gambling increased in those countries.
Well before the GameStop fiasco, it was clear that global stock markets included a massive amount of gambling.
The Kumar et al. study also references other preliminary data showing a spike in retail investor trading that coincided with the 2020 pandemic shutdowns of gambling outlets and sporting events that normally attract substantial betting. It appears that some people feel compelled to gamble by any means available.
Free Flowing Money, Boredom, and Lost Income
But the recent spike in market gambling may be caused by more than just gamblers using the stock market as last resort. Many observers claim that increased market gambling is also driven by the Federal government’s fiscal policies, the boredom of quarantined folks who don’t normally gamble, and attempts to replace income lost due to the pandemic.
The theory goes that the Federal Reserve’s zero interest rates and government stimulus checks have flooded the financial system with easy money. For example, there’s pretty good evidence that market investing was the second to the third most common way that stimulus checks were used or partially used. In all fairness, some of that money likely went into sound investments like index funds in long-term retirement accounts.
But many stimulus checks went to the employed, or financially independent folks like me², who couldn’t access normal entertainments. So, it seems very possible that many people viewed some or all of their stimulus checks as fun money to be gambled, rather than invested, in the markets. And worse, some people likely viewed the stock market as a potential way to quickly replace lost income, even though we’ve seen that short-term trades are a highly uncertain gamble.
The free-flowing-money-and-boredom theory is backed up by the irrational exuberance that seems to be taking over the markets. The popular stock market valuation measure known as the CAPE Ratio is currently at 35.4, the most expensive reading of all time, except for a relatively brief period around the peak of the dot com bubble in 2000 as shown in this graph from Multpl.
Similarly, one of the best indicators of so-called “overbought” conditions in the stock market is the average allocation to stocks by individual investors. Here’s a graph from AAII of the average allocation to stocks since 1988.
While the current allocation to stocks is below all-time highs, it’s reached a pretty high level of 67% and has rebounded dramatically from the lows seen during the March 2020 stock market crash.
Free Trades and Internet Herding
Even before the pandemic and stimulus, there were concerns that the trend toward “no fee” trading was removing most of the resistance to gambling in the markets. If it apparently costs nothing³, why not trade frequently and jump in and out of positions on a whim, particularly if you were inclined to that sort of gambling in the first place?
Further, a 2020 study by Ammann and Schaub examined data from European “social trading platforms” from 2013 and 2014. They found that in social media environments:
- Traders turned over their portfolios an excessive 9 times per year on average!
- Postings about trade ideas were followed by a statistically significant average 6% increase in similar trades by followers.
- Traders on the platform averaged -9.8% below the market return over the period studied.
- And followers of trade idea posts achieved even worse returns at -13.2% below the market return.
Another 2020 study by Barber, Huang, Odean, and Schwarz looked at more recent Robinhood user data from May 2018 to August 2020. They focused on “extreme herding events” and found that:
- Robinhood users purchased more of the stocks that were gaining the most attention (herding behavior).
- About a month after herding events, the same users suffered return reversals that averaged -5%, with extreme herding events averaging -9%.
Although Barber et al. don’t emphasize it, any quick perusal of the WallStreetBets subreddit makes it pretty clear that a lot of Robinhood users hang out there. And the daily chatter in WallStreetBets likely magnifies the herding effect into popular, money-losing trades within the Robinhood app itself.
A Predictable Storm
With all these factors acting together, it’s no wonder that something like the GameStop fiasco occurred. Likewise, it should come as no surprise that the GameStop rally, and the rallies of other recent short-squeeze targets, have pretty much petered out in less than a month. GameStop went from a price of $17 at the start of the year up to nearly $500, and now it’s back down to $64. And given the fundamentals of GameStop as a business, I have a funny feeling that the stock will slide even more very soon.
I was listening to Planet Money on NPR yesterday, and they interviewed a WallStreetBets guy called “Imposter22”, who claimed to have invested $200,000 in GameStop and cashed out on February 3rd to the tune of almost $4 million. Just like all the other market bubbles I’ve lived through, the lucky few winners are proud to trumpet their massive gains.
On the losing side, I’ve heard that WallStreetBets posters are uncommonly forthcoming about declaring losses. But I strongly suspect that an extremely small proportion of losers will ever post or accept media interviews about being the embarrassed “bag holders” in the GameStop fiasco. The bag holder is the investor who’s left holding the stock after the peak has passed and is forced to take a loss. Remember, for every seller, there’s a buyer. The studies I’ve reviewed today strongly suggest that the vast majority of traders involved in various aspects of the GameStop fiasco will eventually end up as either small or large bag holders.
Further, we rarely get to hear whether the few winners manage to hang onto their gains for the long term. I’m almost sure Imposter22’s massive win will eventually seduce him into the idea that he’s smarter (not merely luckier) than all those stupid bag holders. So, he’ll probably dive back into more longshot day-trades, but now with even bigger bets befitting a “smart” millionaire.
So, when does investing become gambling? If the odds of an inflation-adjusted loss are higher than 10% to 35%, then the “investment” is getting into the realm of gambling. And once you start market gambling regularly, day-trading studies suggest the odds of long-term losses are more like 85% to 97%.
Beyond trying to lay specific odds, the studies in this post help identify some hallmarks of market gambling, such as:
- Short holding periods (really anything less than about 5 to 10 years).
- Individual stock picking.
- Focusing on highly volatile stocks with skewed returns.
- Focusing on low-priced stocks.
- Trading frequently.
- Investing for entertainment, quick income, or because you have an unexpected windfall like a stimulus check.
- Trading based on hot stocks, tips, pumping posts, or strategies championed within social media groups.
- Following the herd in general.
- And most obviously, investing to replace traditional gambling.
You can use this as a checklist. If you can check the box on any one of these items, then you may be a gambler. If you check the box on more than one, then you’re definitely a gambler in my opinion. And if you find yourself gambling, or you simply like gambling, remember that there’s a very good reason why they say, “The house always wins.”
1 – I know nothing about gambling and have almost no experience with it in actual practice. So, I may have oversimplified this a bit. But in my mind, unless you have crucial personal knowledge that almost no one else has, the chances that you know substantially more about a sporting event than the bookie seem virtually nil. This makes any sports wager no better than a 50/50 bet, and that’s before the bookie sets the odds slightly in her favor.
2 – Not to humblebrag, which is a red flag for an imminent humblebrag, but we donated all our stimulus money to charity. So, I certainly didn’t do anything to exacerbate stock market gambling in 2020; it’s clearly everyone else’s fault!
3 – Of course, “free trades” have hidden costs, as I explain here.