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Gambling and Gaming
Gambling and Gaming: A Common Thread of Risk

Gambling and Gaming
Gambling and Gaming: A Common Thread of Risk

Michael Stegemoller, Baylor University



[Editor's Note: This is Part Two of a Five-Part Series on the Intersection of Gambling and Trading. To return to Part One, Click Here.]

 

In its simplest form, gambling is when a person risks money specifically for the mere chance of receiving more money. Chance is the probability that a particular outcome will occur—e.g., on a spinning roulette wheel, how likely it is that a ball lands in a red compartment marked “13.” 

Notice that our knowledge about the gamble, about the odds of winning, is irrelevant to the outcome of the gamble. Thus, if we are asked to guess a number between 1 and 24, our knowledge of the odds of guessing correctly has no influence on whether our guess is the correct one. 

The outcome is solely based on probabilities. Furthermore, there is no underlying product or service exchanged in a gamble. When we walk away from a slot machine, our pockets only contain either more or less money than when we arrived. So, there is nothing with any inherent value in a gamble. 

Finally, in order for organized gambling to exist, the house (the organizers of a gambling game) must win the vast majority of the time. Put another way, the sum of gambling winnings must be less than the sum paid to gamble. This certain loss of money is why no rational person goes to the casino to fund their child’s education or earn money for groceries. This last point cannot be overstated as it introduces the main problem with gambling: Imprudence. It is imprudent to participate in a venture that requires the participants to ignore what they know to be true. In the case of gambling, this knowledge is that the gambler will, on average, lose. 

So, the one gambling must willingly believe a lie. 

Perhaps this is why casinos market themselves as entertainment, categorizing themselves alongside movies, water parks and baseball games. Yet casinos are particularly adept at prostituting leisure, commonly producing despair and addiction instead of laughter and freedom. 

The basic form of investment, on the other hand, consists of an investor giving money to a business manager in exchange for, at minimum, a claim on some of the future cash flows of the business. This definition stands in contrast to that of gambling in three important ways. First, knowledge is relevant to the outcome of the investment. Investors may be better off if they understand the business of their investment, and they certainly will be better off if the manager of the business knows what he is doing. 

For example, one might think twice about patronizing a barbershop in which the barber claims that though he does not know how to cut hair, one out of 10 haircuts turn out alright. Knowledge matters in investment, though it by no means assures monetary gain, nor does it preclude either party from being wasteful or foolish. Nevertheless, unlike gambling, investment depends upon knowledge. The second way in which investment contrasts with gambling is that an asset is purchased in an investment. 

Financial assets derive value from their claim on future cash flows from a particular real asset or groups of assets. A share of Starbucks Corp. (SBUX) is an ownership claim on the cash flows of Starbucks after they pay all of their debt obligations, and the holder has the right to vote on certain issues at Starbucks’ annual shareholder meetings. So when we purchase stock, we are obtaining partial ownership in a business. Similarly, a bond (or a loan) is a specific claim on the future cash flows of a firm, and if the principal or interest payments are not made, then the debtholder can force the firm into bankruptcy, thereby laying claim to the firm’s real assets. Even the more complex financial assets, which are often the target of claims that investment involves gambling-like behavior, depend upon the value of some underlying asset. 

These derivative securities (options and futures) derive their value from an underlying asset: A farmer can sell a futures contract today that allows him to sell his cotton crop at some future date for a price agreed upon today. Therefore, when we invest we purchase the claim on an asset, but when we gamble no such underlying asset exists. Furthermore, the intention of the investment is for both the businessperson and the investor to gain from the transaction. Both parties agree to the transaction because it is mutually beneficial. The businessperson will have the money needed to invest in some useful piece of equipment and the investor will share in the success of the business through money received in the form of interest, dividends or appreciation in the value of the business. 

Capital markets depend on this arrangement. Thus, the proliferation of investment depends upon both parties gaining, while the existence of gambling depends upon one party winning at the other party’s expense.

Risk 

Though gambling and investing are dissimilar in many important ways, there is a common thread in both: Risk. It is the imprudence associated with inordinate risk-bearing that makes some aspects of capital markets like casinos. A good working definition of risk is the uncertainty regarding the difference between a present value and some future value. In general, one can assume that the more risk a transaction has, the more return is expected. A certificate of deposit (CD) at your local bank has very little risk and very little return. The probable outcome of the CD is highly concentrated around the original deposit amount plus the interest promised.

There is a chance that the bank will fail and the federal deposit insurance will fail too, but these are very low probabilities. As one invests in increasingly risky securities, the return is expected to increase. A large knife is not risky to a chef, but can be catastrophic to a child; likewise, securities that are neither complex nor risky to the people that employ them for their original purpose can become risky for some purchasers of these securities. Indeed, many such securities were originally developed to reduce risk. For example, selling wheat futures is not a complex financial transaction to the manager of a large farm. The purpose it serves is to reduce the farm’s risk by selling a future wheat crop at a particular price today, thereby locking in a known price today. 

The buyers wanting to purchase wheat in the future (e.g., bakeries that regularly purchase wheat from a grain elevator) also are reducing their risk of fluctuating wheat prices by buying the wheat today. Yet, because these futures contracts are tradable, they are often bought by people who will neither have any wheat nor want delivery of wheat when the contract comes due. Most of these people are merely speculating on wheat prices, and their behavior is not discernible from gambling. 

Strictly speaking, speculation is purchasing an asset that is risky. However, the way in which this term is used in reference to investment connotes unusually large risk along with apparent ignorance about the underlying asset. Often in literature (like Charles Dickens’ “Nicholas Nickelby”), speculation is associated with tremendous gain or the wholesale loss of one’s wealth. So, the wheat futures contract mentioned above is speculative if the purchaser or seller has no interest in or knowledge about the wheat. Thus, the very security that reduces risk in one set of transactions (for the farmer and the baker) can be used as speculation in another. Both sides: The hedger and speculator are essential to a market. The reason futures markets have been allowed to exist instead of being banned as gambling is because the speculator serves the essential purpose of helping to make a market. 

Further, it is true that capital markets not only do not restrict speculation, the businesses built around markets often encourage the assumption of risk without the prerequisite of knowledge of any sort. When a recent commercial for a stock trading house features a cute baby buying and selling stock over the Internet, what exactly is such advertising saying? 

Even though gambling and speculative investing divorced from knowledge involve tremendous risk, the risk is experienced in different ways. For the investor (or speculator), changes in the value of an investment occur over time, and there is usually ample opportunity to get out of the investment without experiencing a total loss of principal. For the gambler, the change in monetary status is immediate and with no exit potential. Thus, though risk is present in both transactions, knowledge about the risk continually can be assessed by the investor, but not by the gambler. 

If you want to get to the bottom of a canyon, you can either jump from the heights or walk down. Both ways of getting to the bottom involve risk, but the former offers no time to turn around.

Part Three: Is Investing a Pretentious Word for Gambling

Note: This story was excerpted with permission from “Investment vs. Gambling,” published by Baylor University. 
















































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