The Fine Line Between Gambling and Investment

Listener: 3 August, 2011.

Keywords: Business & Finance;

Various people have produced their slant on the global financial crisis. The film Inside Job had little new in it, although some found it valuable. I greatly enjoyed the Circa play-reading of David Hare’s The Power of Yes – it may have been didactic and static but it was a terrific account of the British events.

But the book I learnt most from was The Big Short by Michael Lewis, who earlier wrote the bestseller Liar’s Poker. To aid an understanding of what a short is, here’s an example. Suppose the bookies are offering odds of 100 to one on an outsider, Squeak. You know the horse is better than that, that in a long-enough race it is a near certainty to win. Pony up $1, Squeak wins and you get back $100. You have effectively “shorted” the race.

Financial shorting is more complicated. You expect the price of an asset to fall, and even though you don’t yet own it, you agree to sell it sometime in the future at, say, its current price – the plan is to buy it cheaper on the due date. Does it sound like gambling?

Lewis writes: “The line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet (you losing all your money in the hopes of making a bit more), and the wildest speculation has the salient characteristic of an investment (you might get your money back with interest). Maybe the best definition of ‘investment’ is ‘gambling with the odds in your favour’.”

Except you don’t know whether the odds favour you until the race is run. As with borrowing, there has to be someone on the other side of the market to make a deal. This person must think the opposite odds are in his or her favour, that Bubble is going to win.

Not quite. As Lewis noted, “What’s strange and complicated … is that pretty much all the important people on both sides of the gamble left the table rich.” However, the financial sector has not invented the mythical perpetual motion machine (it’s funny how many people think they have); rather the important people were gambling with the money of unimportant people who left the table much poorer, as did the taxpayers who had to bail the system out. The importants made money not from their gambling, but from charging others to gamble for them – even when they lost.

The Wall Street story is not quite New Zealand’s, although some financial advisors made money at their clients’ expense (in many cases without disclosing their conflicts of interest). Others took investors’ funds and invested them less than prudently, although not illegally, and also walked away from the table rich. The High Court tells us others misled their investors.

Some investment involving other people’s money was more secure. Property investors borrowed from banks, which made sure their investors funding the mortgage were not nearly as exposed.

Investing (or gambling) is critical to economic development. It is not peculiar to capitalism – consider China’s Three Gorges Dam. Given the size of projects, there will be a need for other people’s money to be invested.

But I’m afraid you cannot assume, even following recent legislative changes, that everyone involved will behave ethically (even if they behave legally). You have been told the higher the return, the higher the risk; add in that the greedier you are, the greater the likelihood you’ll lose it all.

As for recreational betting – albeit with an investment dimension – why not? Providing it’s your money, you can afford it and you expect to lose it. My dentist says go with a fixed spend, have a good day, expect to lose most – and if you do better, shout yourself a taxi home.