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Are You Investing or Gambling in the Stock Market?

Coryanne Hicks

Investing can take many forms, from buying stocks or bonds to investing in yourself by getting an education. What all investing has in common is the expectation of a future return for the use of your capital.

That return should be commensurate with the risk you're taking. It "presumes that you are making your money work for you as hard as you work for it," says Terry Savage, a nationally syndicated personal finance columnist in Chicago and author of "The Savage Truth on Money."

[See: 7 of the Best Dividend Stocks to Buy for 2018.]

Just as investing is not limited to financial markets, gambling is not restricted to casinos and football. The people who own teams in the National Football League have made a great investment -- but the people who "bet" on the outcome of the games every Sunday are strictly gambling. Some people buy the latest stock market craze with no understanding of the risks, and because it's a stock, they consider it "investing." The problem is "too many people think they're investing when what they're really doing is speculating or gambling," Savage says.

How can you tell them apart? "The difference between investing and gambling or speculating is taking calculated versus uncalculated risks," says Greg Woodard, managing director of portfolio strategies at Manning & Napier, an investment manager in Rochester, New York. An uncalculated risk is a random risk, such as flipping a coin or putting a chip on black. A calculated risk addresses what he considers the two main risks investors face: capital risk, or the risk of your investment losing money, and objective risk, or the risk of not achieving your investment objectives.

If you kept all of your money under your mattress, you'd have minimal capital risk because the only value you'd lose would be from inflation. Your objective risk, however, would be high because meeting your financial goals would be difficult if your money was earning nothing.

Alternatively, you could buy stock in a single company. In this case, your objective risk of not achieving your goals may be less, but your capital risk of losing money is significantly greater because that company could go out of business or fall out of market favor. Investing entails a balancing act between these two risks in pursuit of returns.

In general, long-term investors are more like the casino than the player at the table, Woodard says. "Over time, the casino or house tends to have the odds stacked in their favor." The same is true for long-term investors. The odds of positive returns are also in their favor -- especially because they don't have to deduct the costs of frequent trading, Savage adds.

In this regard, "investing is confidence in the future," says Karl Frank, a certified financial planner and president of A&I Financial Services in Englewood, Colorado. "It's confidence that over long periods of time, what has happened will happen again."

[See: 7 Utility Stocks with Powerful Dividends.]

If you're speculating, your confidence may waver. Because speculation is wishful thinking, it's not rooted in reality. It's "all about what people think is going to happen, not what has happened or is happening," Frank says.

If investing is diversifying your return over the entire stock market by purchasing a Standard & Poor's 500 index fund, speculating is trying to get large returns from a single investment you hope is right. When you base investment decisions on what you hope will happen, you're speculating, Woodard says.

Another way to determine if you are speculating is to gauge how emotionally involved you are in the process. Extreme emotions are generally a sign that you're speculating. "If you feel euphoric, you're speculating. And if you feel terrified, you're speculating," Frank says. If your investments are keeping you up at night, you're probably speculating by taking on too much risk.

Speculating and investing both require understanding the risks involved, but while an investor would have a reasonable assurance of the principal's safety for a satisfactory return, a speculator may not. Investors have a longer-term perspective for the use of their capital, which is another factor that often distinguishes a speculator from an investor, Savage adds.

Gambling and speculating are not the same thing. Risk also separates gambling from speculating, Savage says. She notes that speculation is the assumption of a risk that already exists, whereas gambling is the creation of a new risk.

For example, a farmer who grows corn and a cereal producer who makes cornflakes are each faced with certain inherent business risks. For the farmer, the risk is that a bumper crop will push corn prices lower because of the excess supply. For the cereal producer, the risk is that a poor crop will increase the price of corn, forcing him to pay more for the bushels needed to make his cornflakes.

A speculator may step between these two commercial parties and assume the risks inherent in their transaction. For example, by entering into a futures contract with a farmer, a speculator would promise to buy a specified amount of corn at a predetermined price so the farmer doesn't risk a bumper crop drastically lowering his price. The speculator would hope for a poor crop so that he can buy the corn from the farmer for the contract price and sell it elsewhere for a profit. "Speculators take on risks that others are unwilling to assume in exchange for a possible return on capital," Savage says.
These days, for speculators, those risks frequently concern interest rates and foreign exchange rates.

Gambling is speculation taken to an extreme. By picking up the dice, a gambler is creating a new risk for himself, namely the risk that the outcome is not in his favor. A gambler may hear a comment that farmers are predicting a bumper crop and decide for this reason alone to purchase a futures contract. Or he may hear a hot tip on Facebook and buy a stock with no understanding of the risks involved.

When you start gambling, your risk calculations go out the window, Woodard says. All you're thinking about is playing the game because for a gambler, the thrill is in the act of playing, not necessarily the outcome, Frank says. The win itself is never as good as playing the game.

[See: 10 Tax-Loss Stocks to Avoid in December.]

Everything in moderation. Speculation and gambling aren't inherently wrong; both can have a place in your financial universe. The key is to know when what you think is investing is actually speculating or even outright gambling, and to limit such risky bets to money you can afford to lose.

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