Buying blindly into the stock market may as well be considered gambling. If you can't offer an explanation why you made an investment, then you shouldn’t really be making it. But with the help of three trusty friends, there are plenty of reasons why buying stocks can become educated predictions.
So who are our three friends? Well, say hello to…
There are some key differences between gambling games that just rely on luck and investing in the stock market. To help us explain, we’ll use roulette as an example to help us unravel some of these differences.
⏱ Just before we do though, this is one of our longer pieces and so here’s a nice little TL;DR for you busier folks:
The past and present have no bearing on the outcome of the roulette table, but it can in the world of stocks
Diversifying often decrease your odds of profiting in gambling, but is useful in reducing risk in the stock market
Time is not an ally in the gambling world, but sure is when investing thanks to compound interest
Researching in roulette
When you walk into the casino, you're presented with games that are statistically against you. Some games like roulette may only be 52% against you when sticking to just red vs black, but they're still against you nonetheless.
There’s a bigger problem though. And that’s no matter how much research you do into the colour red's history, it won't increase your odds of winning.
Let’s say Bob knew every shade of red, what red translates to in every language and even how many times red has won over black since the game of roulette began. Good job Bob, but you still only have a 48% chance of winning I'm afraid.
Bob also believes if red has landed 20 times in a row, it has more chance of landing on black next time. But the roulette wheel has no memory, and so Bob still has a 48% chance of winning.
No matter which way you look at it, gambling in a casino will always come down to chance. And that chance is always fixed in favour of the house and no amount of research can alter the probability of winning (unless you're counting cards in blackjack of course, but that's not our area of expertise!).
Researching in the stock market
Research in the stock market, however, is a tool that can help you make more informed decisions.
Prices of stocks move due to cause and effect, not chance. We are taking more of a chance if we buy stocks without doing our research. As we said at the start, buying stocks blindly may as well be considered gambling!
Let's take the example of insider trading and say it wasn't illegal for a woman called Emma. If Emma knew classified information on the upcoming plans of a company, then she would be able to make a lot of money buying and selling the stock. If we use the same comparison on the roulette table, it doesn't matter what information Bob would have access to, his outcome would still only be driven by luck.
Now I don't want to get your hopes up, insider trading is highly illegal and can result in 7 years behind bars. My point is, a stock price isn’t affected by just chance.
A company’s future plans are confidential information, but past and present info is available and we encourage all Sharians to look at this when investing. The buzzwords for this are 'historical trends' and 'current affairs'.
By looking at the past, we can begin to make more educated guesses to what will likely happen in the future.
For example, the stock market took a dip due to the COVID-19 global pandemic. During times of uncertainty people begin to speculate which causes a lot of fear and doubt within the market. Naturally, a lot of people bought stocks during this time as the past has shown us the market has recovered from global pandemics before.
We might also want to look at what's going on in today's world. If there's a global war going on right now, how might this affect the stock market? Or, how are Elon’s tweets impacting stock prices? Yep, that's right, Elon uses Twitter to tweet that Twitter is full of bots, causing the company to become less valuable. If you managed to follow that, bravo 👏.
Diversifying in gambling
Diversifying means spreading your money so that if one bet fails, you’re not completely broke.
The issue is, when you add more bets in roulette, you’re decreasing your chances of profiting because every other bet has a lower chance of winning than the standard red vs black odds.
So it’s a double-edged sword – stay with red vs black and be at risk of losing all your funds at once. Or, diversify your bets and have a worse statistical chance of winning. The choice is yours!
Diversifying in the stock market
History has also shown us that investing across different sectors, industries and countries helps reduce risk.
For example, you invest £50 into the healthcare sector and £50 into the retail sector. If healthcare performs badly, but retail has steady growth, then your portfolio isn’t completely lost – far from it in fact.
We can play things even safer by ensuring we’ve invested £10 into 5 companies within the retail sector, so we’re not relying on just one specific business to perform well. Our options for diversifying in the stock market are a lot deeper than in the casino.
Sticking to just one stock is a bit like red vs black. The stock could begin to fall in price and we’d have no other investments to help control the damage. At least though, we could sell the stock and ‘cash out’ at a certain price as the worst case scenario. This helps limit our loss.
Time in gambling
This one's pretty simple. The longer you stay gambling, the more likely you are to lose.
In our example of red vs black, if 1 in 52 times you win, but lose 1 in 48 times, then eventually the odds will wipe out your hard-earned cash.
This applies to any game where the result is based on luck alone. The longer you play, the more likely your results will result in the actual probability.
Time in the stock market
Time works differently in the stock market. Although there might be ups and downs along the way, the stock market has returned an average of 10% each year meaning even if you are down on your luck, there’s a good chance your portfolio will pick up again.
Compound interest is a buzzy term in the investing world, but it’s a fancy way of saying ‘money makes money’.
When we buy certain stocks, we get paid for owning them (this is known as a dividend payment). We don’t need to do anything, just simply own some shares and wait. If we reinvest dividends, then our amount of shares becomes greater at no extra cost to us. We’ll also be paid more next time as the more shares you own, the more you're paid.
Told you, money makes money!
So is buying stocks gambling? Well, that comes down to your overall definition of gambling. Nothing in life is 100% risk-free, but I would rather invest in the stock market than gamble at a casino thanks to research, diversifying and time all helping me form more educated predictions.
As with all investing, your capital is at risk.
Shares is a trading name of Shares App ltd. Shares App Ltd is an appointed representative of RiskSave Technologies Ltd, which is authorised and regulated by the Financial Conduct Authority.