And they’re racing…

It is Spring Carnival time in Melbourne and the horses have come to town. It’s a great time of year where the Champagne flows and much fun is had. The fashion, beauty and food industries look forward to a well deserved boost but the big winners from Spring Carnival are the bookies. While punters hit the track armed with a fist full of cash and the dream of winning big, the statistics suggest that the overwhelming majority of punters will lose.

If you speak to someone that is uninitiated in the stock market, they too think that active investing is like gambling. And the truth is that if you go about it like the herd, calling it gambling is being kind. But there is a way to flip the odds in your favour to ensure that you are not gambling.

Firstly let’s define the term ‘gambling.’  According to the dictionary ‘gambling’ is:

• To bet on an event that has an uncertain outcome, as in a contest.
• To play a game of chance for money.
• To take a risk in the hope of gaining an advantage or a benefit, monetary or otherwise.

A definition of trading is “to engage in buying and selling for profit.”

Trading in the financial markets is also often considered by many as ‘speculation’, which is defined as:

• A conclusion, opinion, or theory reached by conjecture.
• Reasoning based on inconclusive evidence; conjecture or supposition.
• Engagement in risky business transactions on the chance of quick or considerable profit.

All business, to a degree, is speculative in that there are many variables that affect businesses that are inherently inconclusive, theoretical, conjecture or supposition and hence lead to uncertainty. However, the term speculative has typically been reserved for businesses with exceptional uncertainty.

As an investor or a trader, if you consider these definitions of ‘gambling’ and of ‘speculation’, I’m sure you would not like to view yourself as doing either!

Gambling, in my view, is risking money on an event even though the odds are against the player. The gambler takes the risk because the temptation of the large potential payout that is on offer, which is ego lead, is greater than any logic that may counter the temptation, or rather the idea of the great feeling that may come from cracking the jackpot.  That 10/1 or 20/1 outsider, or the 6/4 odds on ‘dead cert’ with a large outlay….

Logic and any counter proposition to gambling are discounted by the gambler, the uninitiated and initiated alike, because there is always at least one winner. The randomness of winning, even with a negative edge, seems to make winning more tangible and possible that it might be me! This is seen in horse racing, greyhound racing, lotteries, roulette, poker machines (the old name of “one-arm bandits” was more appropriate) and other casino games (except maybe Blackjack).

It amazes me that most people are unaware that poker machines are programmed to win and therefore for them to lose. The slot machine can be programmed to whatever ‘edge’ the “house” prefers but is typically set to between 90% and 98% depending on the volume of money that is put into the machine. If volumes are down then they can increase their profit margin from, say 96%, to 92%. This means that 92% of all cash inserted into the slot machine over a large sample of plays will be paid back to the players but 8% of the total will always be kept as profit.

Over a few plays the gambler on a slot machine can win because the wins are programmed to pay out randomly. In small samples luck can play a role. But over a large sample of plays the gambler is guaranteed to lose at the margin of what the slot machine is programmed to win. And the more plays that are completed the greater the certainty that all of the player’s money will be lost.

Gamblers become addicted to randomness, a randomness that has a certain edge against the gambler and a certain edge in favour of the “house”.

What amazes me even more is that many people are aware of this and they still “play the pokies.” Their justification, as for those that justify all the other forms of gambling, horse racing included, is: “I’m just having some fun.” That’s fine as long as the punter doesn’t become addicted to the randomness of the win.

With horse racing the tote offers odds that, over a large sample of races and wagers, are in favour of the tote. However, over a small sample of bets the punter can get lucky and win. But over a large sample of bets the chance of winning is negligible.

There are professional punters that do make money out of some forms of gambling like horse racing but they are few and far between and have developed systems and a finely tuned mindset to do so.

So what does this have to do with trading the stockmarket. A lot. In the stockmarket it is very possible to exploit trends such that the trader develops an edge in their favour that, when executed over a large sample, they can achieve certainty of a profitable outcome from the uncertain environment of the stock market. All they need to do is continue to execute their ‘program’ and in the same way that the slot machine has an edge so will the trader.

The condition for the slot machine, as for the tote, is that a large sample of plays is executed and that the gamblers abide by the rules of the house.

The condition for the trader with an edge in their favour is that he/she abides by the rules of their system and that they continue to execute a large sample of trades. Of course the rules of the trader’s edge must be substantiated via statistical probability and stress tested through a number of different market conditions to demonstrate its validity and robustness.

This way the trader can turn uncertainty into certainty and in so doing they are no longer “playing a game of chance for money” or “taking a risk in the hope of gaining…” or “using a theory reached by conjecture” or “reasoning based on inconclusive evidence.” Investors and traders with a substantiated and stress tested edge in the market are not gamblers or speculators, they become akin to the “house” or the tote with an edge and the other traders and investors that don’t have an edge are akin to the punters…