Investing and betting

A recent article in Salon repeated the annoying comparison between investing and betting as a way of explaining the current mortgage collapse, which annoyed me enough to send a letter, and I'm apparently not done talking about this. Warning: this will be long.

I think calling investment betting is fundamentally broken. Worse than that, I think it betrays a fundamental lack of understanding of economic principles, and while that's to be expected from a lot of individuals, having a columnist whose job it is to explain subtle issues to people use the same broken analogy is disappointing and decreases the economic understanding of the readers.

You can stretch the definition of betting to mean any time you do something that may or may not make more money. Working hard to finish a project so that you get a bonus is in some sense "betting" that you'll finish the project and the work will be worth it, and sometimes people call it that. In that sense, investment (and many other things) is betting. But when someone calls investment betting, they don't just mean that. They imply it's like sports betting: it's speculation on some fundamentally meaningless activity, it's risky, winning or losing a bet doesn't do anything useful for the world, and it's vaguely shady. And, importantly, betting is something you can not do, and that indeed most people don't and shouldn't do. It's something people do for entertainment with money they can lose.

That last is what makes this analogy so broken. The implication is that investing (or at least some form of investment that the author doesn't like) is something that we can not do. And that's simply wrong. Our economy, any modern economy, would not survive without investment. Many of these investments that people complain about are natural consequences of markets; it would be almost impossible to prevent people from making these investments without draconian legislation, and passing such legislation would cripple things that free markets are quite good at.

Let's talk about some basics. Broadly speaking, you can divide investments into two basic types. Either you purchase something, or a share of something, that you think will retain its value and possibly grow in value (real estate, gold, stock in a company); or you loan money to someone who will pay you interest in exchange for the loan (bonds, treasury certificates, bank deposits).

Everything you can do with money that you're not spending, other than putting it all in your mattress, is investment. If investment is gambling, almost everyone in the world is gambling. Even depositing your money in the bank is investing. It's a loan to the bank, an investment of the second type. The bank pays you interest in exchange for the right to use your money (generally loaning it out to someone else at a higher rate of interest). It's a loan that, for most accounts, the bank promises to repay on demand whenever you want, but that's still a loan, just a fairly safe one.

This is where risk comes in. Risk is easiest to think about with loans. It is, simply, the chance that the person or entity to whom you loaned money will actually pay it back. We're all used to this: when you loan money to a friend, there's always a chance that they won't pay you back. You take that into account when you decide to make the loan. Just because there's a chance they won't pay you back, that doesn't mean that you're gambling; you're taking a "calculated" risk, which means that you're evaluating the level of risk and deciding that it's worth it to you.

Risk is a bit harder to think about when it comes to buying property, but think of buying a house. You're running various risks when you do that. The house may have some undisclosed structural problem that you'll then have to pay a lot of money to fix. Someone might build an airport next to the house, making the area very noisy and reducing the value of the house. Anything that you buy has this problem. Most things we buy to use and expect to throw them away when we're done. Houses are the main thing (outside of pure investments like gold or stocks) where we're used to thinking about both the use of the house and the value when we sell it later.

Obviously, risk is bad. Risk means you could lose something: the money of the loan, which is never paid back, or the value of the house, which was lost when someone built a trash dump next to it. The basic idea of an investment market is that when you take a risk, you should be compensated for it with higher profit if the risk pays out. This is for obvious reasons. Risk is bad, so unless people make more money from higher risk, they simply won't do things that are high-risk at all. If everyone always took the minimum possible risk, only people who had absolutely perfect credit with million-dollar incomes would be able to buy a house. We want people to take higher-risk activities occasionally; it's good for the economy, it lets average people buy houses, and it lets companies try things that may or may not work. So, in exchange, people are paid more for taking a higher risk, to give them some incentive for doing so. Someone who isn't a millionaire (more likely to not pay back a loan, and therefore is higher risk) pays higher interest to compensate the person loaning them money for taking a higher chance they won't be paid back.

Now, some people need all of their money and don't want to take any risk. They can deposit their money in federally-insured accounts, taking as low of risk as we can offer for an investment. In return, though, they get minimum income from that investment. People who take higher risk (buying stock, for instance, which runs the risk that a company may cease to be profitable and its assets won't be worth what the company is valued for on the market) get higher income.

And this is where we get to the part that people have the most trouble with, I think. Investments aren't just made and held all the time. They're bought and sold constantly, which can be confusing. But one of the major reasons for this is the notion of valuation. The basic economic principle at work is that you never really know how much something is worth until you sell it. Think of some family heirloom — you can have it appraised, you can guess, but you never know how much it's truly worth until you find someone who wants to buy it.

In order to make useful decisions about which companies are worth owning, or which loans are paying enough to be worth their risk levels, someone has to evaluate those companies or those loans and communicate how valuable they are. And you never know the results of that investigation until that person buys or sells for a particular price. That price reflects their belief of how much something is worth. Prices are communication of other people's knowledge.

An example. If you have a loan that, when held, returns 7%, and no one wants to buy it out for the price that you're offering, that means the market has decided that the risk level is high enough that 7% isn't enough. If you want to sell it, you'll have to sell it for less than the original value of the loan. That means that, for the new buyer, the loan will pay 8% of what they paid for the loan instead of 7%. See what happened? The process of selling the loan has adjusted the rate of return to match what the market decided the risk was. It fixed something that was inaccurate, and afterwards we have better information.

Markets are exceptionally good at this. In the long run, markets arrive at excellent estimates of exactly how much something is worth, or of exactly how much risk there is in a given loan. They do this through sheer self-interest on the part of the investers: if you can evaluate the worth of something better than other people, you buy things that are too cheap and sell things that are too expensive, and you make lots of money. And in the process of making all that money, you end up adjusting the market prices to be more accurate. This is the purpose of investment markets in a nutshell.

This is valuable and important work! If it weren't for investment markets, we would have no idea how much someone should have to pay for a loan given their chances of paying it back, or whether a company's business model is good enough to be worth investing in. The market enables millions of people to make decisions about their areas of expertise, collects all that information, and reflects it in prices with a high level of accuracy.

Sounds less and less like gambling, doesn't it? It is a little like gambling in that gambling odds serve the same purpose, and similarly arrive at very accurate estimates of probabilities. But unlike the gambling that people think of (sports, poker, blackjack), investments place a value on something that's real, and having that valuation helps the economy work better because the economy now has more information.

The normal, competent invester is doing something that looks nothing like gambling. They're buying investments to hold for the long term, based on their desired level of risk and profit. If they have a high risk tolerance, they buy things that have a high level of risk and pay a correspondingly high rate of return. If they have a low risk tolerance, they buy things like US treasury bonds that have a low rate of return but very little risk. It's really that straightforward.

Whenever you see people freaking out about investment markets or claiming that some investment is gambling, remember that the purpose of an investment market is to value something by buying and selling it and figure out what's being valued. For example, the recent market chaos is over home mortgages, specifically "sub-prime" mortgages (loans to people with bad credit). The securities that are being traded are essentially pieces of home mortgages, pieces of loans. We're discovering that many buyers in the past thought that these loans were lower risk than they actually are (probably because we've had an economic boom and an excess of borrowing that's now ending). Now, the market is doing what markets do and doing a mass revaluation of all those loans. Previous buyers are discovering that they were wrong about the value of the loans, or in other words that they weren't being paid enough interest on their investment to have the risk be worth it. New buyers are purchasing the loans at more accurate values (and hence higher interest rates for them). This shakeout is exactly what markets are for. At the end, we'll end up with a much more accurate view on what those mortgages are really worth.

Figure out what the market is putting a value on and suddenly the mechanisms make sense.

One final thing. There are certain types of investments that get an even worse bad rap, that people claim are just gambling. An example would be Dow Jones futures, where people buy and sell securities that represent the chances that the Dow Jones average will go up or down at the start of the next trading day. Isn't that gambling? Aren't people just making bets on their guesses of what the Dow will do, with no purpose outside of that betting?

No. Look at what this market is valuing. The Dow is a collection of stock in a bunch of companies (that happen to be considered the core companies of the economy in some sense). Stock in those companies only trades for a short period of time during each day. However, economic activity and news about companies doesn't stop when the market closes. What the futures market does is let people continue that valuation process while the market is closed, which provides useful information to the people in the market at the start of the next day and feeds in to the overall process of valuing all those companies and the economy as a whole. This kind of activity will happen. It can't not happen. People don't stop caring about the value of things while the stock market is closed. They will create ways to act on those opinions and additional information whenever they want, and the futures market in stock market indexes is part of that.

Posted: 2007-08-17 23:29 — Why no comments?

Well written. You might also want to look into the book "The Black Swan" by Nassim Taleb which has a lot of interesting insights into how the investment markets differ from gambling. One interesting point he brings up is that gambling differs markedly from investing because in gambling games you typically know with quite good certainty the range of results of the game, you just don't know what *your* result will be. With investment markets you don't even have any certainty what the overall results will be. Anyways, it's a very interesting book that I think you will enjoy given this article.

Another point that doesn't seem to get much coverage in the press is why sub-prime loans were made a such a low cost in the first place? I think the main culprit here was the Federal Reserve Bank drastically dropping interest rates in 2001. Normally in an economic slowdown interest rates are dropped to encourage businesses to borrow to make improvements to their capital equipment. However the problem in 2000-2001 is that the economy lost steam because it was working off the over-investment of the late 1990s.

The last thing that businesses needed was more money, but more money is what the fed put out there. Instead of businesses investing the money towards improving productivity and efficiency, the money the fed was pumping out had to go somewhere else. The money was there, so somebody had to do something with it.

The problem at the core is what happens when something is made artificially cheaper than it otherwise would be is that there is more demanded and people will tend to make inefficient and wasteful use of it. When this happens with the cost of money (interest rates) being artifically lowered, people will be more likely to take out or offer loans they might otherwise not make, including giving loans to people who have no track record of handling a loan.

I don't mean to sound like some conspiracy theorist blaming everything on wily central bankers controlling the economy, but the fact remains that the ability of the central bank to manipulate the money supply and interest rates fundamentally is not part of a free market, and there are inevitable downsides that result from this fact.

Posted by James Lick at 2007-08-18 00:32

Thanks! I'll look for that book.

Yes, the point about the incredibly low federal funds rate and the questions about whether that was really a good idea is an intriguing one, and I tend to fall on the side that says it was a bad idea. On the other hand, the overall economy has done okay so far, so we still have yet to see if there were long-term negative effects and if the benefits outweighed the problems. And will probably never know for sure.

The analogy I like to use is that the best role of the government in the economy is as a shock absorber. In welfare, unemployment, and federal monetary policy, I think it's dubious to expect the government to be able to fix fundamental economic problems. I don't think the federal government really has that much control over the economy. But the government can smooth out the extremes and help keep people from being caught in the wake of major market corrections. Sort of smooth everything out.

The problem is that, while trying to do that, you run the danger of creating moral hazards, where the government is underwriting or bailing out risky behavior and thereby encouraging people to do things that the market would normally punish by removing the negative effects. This is why I'm strongly opposed to any sort of bailout of the mortgage industry or of people who are in home loans they can't actually afford. Moving insurance, sure. Refinancing help for people who can actually make the payments when the market isn't freaking out to get out from under variable rate loans they were tricked into, sure. But the fact is that the market made a mistake, and you have to let economic mistakes be punished economically or people won't stop making them.

Posted by eagle at 2007-08-18 00:48

Another big difference between investment and gambling is that investment is rarely an all-or-nothing bet while gambling generally is.

I also find it interesting that derivatives such as futures, options and swaps, which, as you say, get the worst rap, are used primarily to *reduce* risk. All your sales are in US dollars? Then buy a Euro currency swap for part of those sales to guard against a drop in the dollar.

I think there are two main reasons why so many people view the markets as a casino: because derivatives make it difficult for the uninitiated to see what the underlying asset is, so it looks like a lottery ticket; and because there are some people who *do* play the market as if it were a slot machine. When those people inevitably crash and burn, they make big headlines even though they represent a minute fraction of market activity.

James: While your comments are spot-on, you need to cut the Fed a bit of slack. They've been struggling of late to deal with fundamental changes in the structure of the US economy. The impact of decades of IT investment is finally making itself felt as a boost in America's natural growth rate, a decrease in its NAIRU, etc. This is new territory for everyone. If you subtract out the housing market they're handling of the rest of the economy looks masterly. And the correction in the housing market couldn't have come at a better time, with the rest of the world booming (though of course I think the Fed got lucky on that one).

Posted by Dean Edmonds at 2007-08-18 22:11

In my mind's definition, the biggest difference between gambling and investing is that gambling is typically a zero-sum game, while investing is not.

People will buy and sell stocks equally, but over the course of the sales, equity builds in the companies, and dividends are handed out. The size of the pie can grow (or shrink).

In most forms of gambling, take for instance, a poker game, money is changing hands, but the whole pie does not change size. Nothing is produced by the money in the system.

The more speculative an investment, the closer it is to gambling.

Posted by Andrew S at 2007-08-28 16:06

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