Are you investing or gambling? The important difference between the two
With more free time due to the Covid-19 quarantine, access to superannuation funds and accessible low-cost brokers, many Australians have started investing in shares at a time when markets are particularly unpredictable and volatile. Internet stock chat rooms are buzzing with stories of substantial investment gains in a short time.
In the past three months, the S&P/ASX 200 has recovered almost half the losses of the February/March sell-off. Some shares have led the recovery with staggering gains, which has led to frenzied speculation among investors who are searching for "the next big thing".
So, what's the problem? Both ASIC and the Reserve Bank have recently warned retail investors about the potential pitfalls of share investing, on the heels of the number of retail broking accounts and trading volumes increasing two to three times over the pandemic period.
Why the warning? ASIC has the ability to see how retail investors have performed. As it happens, most retail investors are actually losing money. Average investment holding periods are down from around four days to one day. So, literally, many new retail investors are "day trading".
The problem is that day trading is more akin to gambling than investing. Here's why:
- The casino always wins. In day trading, there are winners and losers. Historical data suggests that day-trading retail investors lose more often than they win, as there are professionals who know more than the typical retail investor playing the same "game" (selling when others are buying, and vice versa). So day trading is like walking into a casino of sorts. In gambling, the casino is there to prevent you from winning. The house edge may vary between games, but ultimately it always wins.
- A big difference between investing and gambling is concentration risk. Like gambling, day trading typically involves a "bet" (investment) on one or a small number of companies over a short time. As such, the upside may be high, but there is also the risk that underperformance by only one of the "bets" can significantly drag down the returns of the overall portfolio.
- Timing the market is hard. Sharemarkets can be highly unpredictable and irrational in the short term, as we've seen in recent months. Remember, each time you make a decision that buying a share of Company X will pay off, someone on the other end of the trade (who has probably done a lot of research) is "betting" that it's best to sell the stock. Even so-called experts have a hard time timing the market, so the average punter stands little chance of winning in the very short-term.
So if picking stocks and timing the market are so hard, how do you grow your wealth over time? That's where investing is different from gambling.
Successful investing is built on several foundations that differ from simple gambling:
- Time and patience. Investing is a long-term process. When you invest, you're betting that the global economy and sharemarkets will grow over time, and history shows that over the medium to long term markets generally rise.
- Diversification. Successful investors typically do not put all their eggs in one basket. Or even a couple of baskets. They tend to spread their investments across asset classes (growth/defensive), regions (domestic/international) and sectors (broad equity, infrastructure, technology, health care, etc). This smooths out volatility and investment returns over time, as there will be times when part of a portfolio falls while another part rises. ASX-listed exchange-traded funds (ETFs) can be a cost-effective way to achieve prudent investment diversification.
- Low costs. Day trading by definition can rack up transaction fees, which eat into investment returns. By investing for the long term, there are fewer transaction costs to erode returns. In this regard, ETFs are also effective investment vehicles given their low costs.
There are no guarantees in life or investing. While it can be tempting to try to pick winners, the volatility we've seen in markets over the past few months shows just how quickly things can change. Rather than gambling on short-term guesses, take a long-term approach - make an investment plan and stick to it over time, review it if your life circumstances change and avoid emotional decisions. That's a surer bet.