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Risk – the thin line between Investing and Gambling.

Risk

“This business, [project, stock, person, etc.] promises a 20% return on investment, monthly! Should I invest or not”? This is a common and quite interesting type of question that advisers and non-advisers get asked a lot. One thing that makes this question interesting is the promised return (20%).

There have been increasing reports of “investment gurus” recently promising extremely attractive returns on investment, over relatively short periods of time. There have, unsurprisingly, been increasing reports of some of these investing gurus “disappearing” the capital (money invested) of their investors. These and a slew of other reports inspired a discussion between Obiora (my partner) and me, and we decided to create this post.

This post has a simple objective – to explain how to know whether your current or next money-parting endeavor is an investing or a gambling exercise. With that out of the way, let’s get started.

 

Investing and gambling, what do they have in common?

Something in commonImage by lipstick alley

 

There are numerous definitions of investing and gambling. For this article, we have chosen the following as the most appropriate definitions which will allow the comparison of both terms.

Oxford Languages defines investing as putting money (letting your money go) into financial schemes, shares, property, or a commercial venture with the expectation (to receive it back) of achieving a profit.

Gambling, on the other hand, and as defined by Oxford Languages, again, is to take a risky action with the hope of success. While these definitions may seem like they have little or nothing in common, a deeper look will reveal that they have more in common than appears. If we interchanged some of the terms in these definitions of investing and gambling, we would arrive at some similarities. Let’s give it a try.

Investing and gambling are activities where you let your money go (take a risky action – there is a possibility it may never return or return incomplete) because you expect to receive it back (a hope, not a guarantee) with a profit.

How do investing and gambling differ?

Since we went to the dictionaries to get definitions when looking to find similarities, it is only appropriate that we go to the dictionaries again to discover how investing and gambling differ. This time we will focus on another definition of gambling. Oxford Languages, again, defines gambling as “playing games of chance for money”.

The keyword in that definition, that we need for comparing both investing and gambling, is chance (the possibility of something happening). The higher your chances of success, the lower your risk of loss, and vice versa. Remember that when we created a link between investing and gambling, we discovered that both terms have a hope of success. If we replaced hope with chance, we would be adding a new context to this picture, and in this new context lies the difference between both terms.

When you decide to invest or gamble, you choose distinctly different chances of success, as well as different levels of risk. This is because while neither investing nor gambling ever guarantees the return of your capital, or a profit, investing carries a higher chance of success than gambling does. A bold claim, right?

 

Risk and reward.

 

Before explaining why I posited that investing carries a higher chance of success, and a lower risk of loss than gambling does, there is a need to touch on another important concept.

Money is a scarce, and hard-earned resource. Anyone who has earned it (meritoriously) deserves the right to enjoy it as she or he pleases. Hard-earned money can either be:

  • Saved – Do not part with it now,
  • Spent – Part with it now, for instant gratification,
  • Gambled – Part with it now for instant or delayed, but exponential gratification, or
  • Invested – Part with it now, for delayed but reasonable gratification.

Investing and gambling, etc. are among the options an investor can choose from when deciding to make the money grow. The problem with gambling and investing, which saving and spending do not have, is that they both carry an inherent risk that the gratification may never materialize.

For an investor to insist on taking the risk of parting with hard-earned money, knowing that he may not get that delayed gratification, there should be some commensurate reward promised to that bold investor. That promised reward is what will become known as the return on investment.

Risk and reward, are, therefore, two sides of the same “return on investment” coin. The more risk an investor is willing to take, the higher the promised return and vice versa.

 

Risk-free investments and the risk premium.

Many studies have been carried out to determine whether there is any correlation between investment and economic growth. Saylor Academy, in 2012, published a text which clearly demonstrates how changes in investment cause aggregate economic demand to change. An understanding of this concept is why many countries create legislation to govern how investment activities are defined and should occur with the best chances for economic growth.

Within the scope of the regulatory environments that countries create for investments, securities are classified as low-risk and high-risk investments. Low-risk investments are those that have the least chance of default (reneging on the promises made by the investment manager when collecting an investor’s money).

Investment products with the lowest risk usually have the lowest returns on investment and are called risk-free securities. These risk-free securities include treasury bills, low-yield bonds, commercial papers, etc. The return on these risk-free securities is usually the foundation upon which an ideal rate of return is determined. Some investors may not be attracted to the low return on investment promised by risk-free schemes and would be looking for higher returns, and higher risk as a result. This higher risk would require a premium on the risk-free rate. Therefore, a higher risk investment scheme would require:

Return on investment = Risk-free return on investment + Risk Premium

 

How the risk and reward relationship affect your chances of success.

If you are wondering why I posited, earlier, that investing carries a higher chance of success than gambling does, I will try to explain why here. To be clear, by success, we mean receiving your money back with the expected return (profit).

In the preceding section, we made the case that there is a minimum expected return on investment that is acceptable (the risk-free rate of return). We also inferred that as the investment risk (likelihood of not getting your capital and profit) increased, so does the premium, and ultimately, the total return on investment.

You will observe that the premise of this post has now converged around our earlier statement, “…when you decide to invest or gamble, you choose distinctly different chances of success” and different levels of risk. Based on all these different positions, there is a strong case to be made that investing and gambling are both events that lie on different ends of the same spectrum. On one end of the spectrum are low-risk (risk-free) securities, and on the other end of the spectrum is gambling.

You, the investor, choose exactly where you want to be on the investing-gambling spectrum. If you want a higher chance of receiving your capital and promised return, you can choose from a pool of schemes with lower risk and lower return. If you do not mind taking on a higher amount of risk, there is also a pool of gambling options.

 

So, how do I know if I am investing or gambling?

 

As we alluded to earlier, we believe that both investing and gambling are on different ends of the same spectrum. Where all investing ends is where all gambling begins. As an investment’s risk of loss rises to its extremes, it enters the realms of low-risk gambling activities.

While it is tempting to assume that I am implying that every low-risk investment offer is a safe alternative and should not be regarded as a gamble, this could not be further from the truth. Even countries, with their sovereign guarantees, default, and cause investors to lose their money unless bailed out. You can read about sovereign defaults here.

How, then, do you tell whether the amount of risk that is inherent in an investment offer is within the realms of investment or gambling? It is in your level of understanding of the subject matter! It all comes down to how much information you have, to make an educated and reasonable guess.

The same way a forex or crypto guru can promise xyz% return on investment is the same way that a brilliant entrepreneur, a fund manager, an institution, a state, or a country can promise you whatever return and default. Your level of understanding of the subject matter will give you enough information to reasonably guess how likely it is for the business to deliver on its promise, barring any unforeseen circumstances.

 

Conclusion

How do you know whether you are investing or gambling? You’ll know by determining how much knowledge and understanding of the proposed investment you have. The more knowledge (not information) you have, the more likely you are to assess the plan and determine whether the promised return on investment makes sense or not.

If you are comfortable with your level of understanding, then you would have significantly reduced the risk that your money would not return. The better your understanding, the easier it will be to determine whether the promised return on investment justifies the amount of risk you are taking as well as whether that return on investment meets your expectations.

So, back to the initial and popular question. When a trading expert comes to you and offers you an opportunity to invest for, say, a 20% return on investment monthly, how would you know whether your decision to invest is an investment or a gamble?

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