Why buying shares is better than betting.
One mistake that people unfamiliar with investing make is to refer to stock markets as 'casinos' or 'lotteries'.
It's a market, not a casino
In other words, these individuals mistakenly believe that making money from investing in companies is largely down to dumb luck or random chance.
To these sceptics, buying shares in, say, global giants such as HSBC (LSE: HSBA) or Royal Dutch Shell (LSE: RDSB) is no better than buying a lottery ticket or betting on spins of a roulette wheel.
However, I disagree strongly with these doubters. To me, there is one rock-solid reason why gambling is not investing. It is that gambling -- wagering money on an event with an uncertain outcome -- comes with an inbuilt 'negative expectation'.
This means that games of chance are biased in favour of the provider. Thus, for every, say, £50 you bet, you'll more likely to get back considerably less than £50.
Then again, through chance or luck, you may come out ahead. However, as a rule, bookmakers, casinos and make a mint from unlucky punters. For example, Britain's biggest bookmaker, Ladbrokes (LSE: LAD) made an operating profit exceeding £200 million in 2010.
Thus, although investing and gambling both involve risking money for future reward, gamblers bet in hope, on uncertain outcomes, and against biased odds.
How much of a negative expectation you face will vary according to the type of wager you make, as I explain below.
In roulette ('little wheel' in French), there are 36 numbers for punters to bet on, plus a green 'zero' pocket.
If a ball lands on zero, all bets lose, thus giving a 'house edge' of 1/37, or 2.7% (reduced to 1.35% for even-money bets).
In popular casino card game blackjack (sometimes known as 21), the basic rules are weighted in the dealer's favour such that s/he has a winning margin just short of 6%.
However, by using an optimal playing strategy, the casino's edge can be cut to as little as 0.5%. Furthermore, by using statistical techniques such as 'card counting,' it is possible for expert players to beat the dealer, thanks to a positive advantage of around 2%.
Betting on the outcomes of sports matches usually includes an 'over-round' -- a margin in favour of the bookmaker -- of, say, 109%. In other words, for every £100 taken in wagers, bookies balance their books and adjust their odds so as to return approximately 92p in the pound.
This equates to a negative expectation of around 8%, but this can be lowered still further by using betting exchanges such as Betfair (LSE: BET).
The National Lottery
Lastly, the worst-possible gamble is the National Lottery and its variants. Thanks to a negative expectation exceeding 50%, the Lotto is sometimes referred to as a 'tax on people who are bad at maths.'
Indeed, lottery operator Camelot takes in around £100 million a week, but pays out less than half of this sum!
Listen to Lynch
So, if stock-market investors aren't gambling, then what are they doing? The best answer to this question comes from acclaimed US fund manager Peter Lynch, who once remarked, "Although it's easy to forget sometimes, a share is not a lottery ticket... it's part-ownership of a business."
In other words, investing in companies by buying their shares isn't betting, because it is done in the expectation of earning positive future returns, fuelled by improving corporate profitability. What's more, experienced investors do plenty of research before selecting company shares. By doing so, they are playing their own game, as well as tilting the odds in their favour.
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We're buying businesses, not betting
Over long periods (say, a decade or more), the UK stock market tends to produce positive returns. These come in two forms: the capital gains made from rising share prices, plus the dividend income regularly paid to patient shareholders, usually two or four times a year.
By reinvesting these dividends into yet more shares, you can dramatically improve your long-term returns in a 'virtuous buying cycle'.
Since 1899, UK-listed shares have produced an average yearly return of 9%, which easily beats cash, bonds and other mainstream investments, as well as inflation (the rising cost of living). As we've seen in the last decade though, returns from year to year have varied widely from this average figure -- in both directions!
Chosen with care
Over time, successful, well-run businesses tend to grow their profits, thus increasing the value of their shares and enriching their owners. By playing a long game, spreading your risk, and being patient, you can let top British and foreign companies create wealth for you.
Therefore, investing is a great deal more than hoping that Lady Luck is smiling on you. Then again, although there is no guarantee of a positive return from shares, there is no certainty of loss in aggregate. This is the primary reason why investing should not be confused with gambling.
Finally, I'll leave you with some wise words from Sir Ernest Cassel, banker to Edward VII: "When I was young, people called me a gambler. As the scale of my operations increased, I became known as a speculator. Now I am called a banker. But I have been doing the same thing all the time."
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