After our experiment with turkeys last week, Cora wanted to know the difference between gambling and investing. After all, when we invest in high-risk properties, we're essentially placing bets, right? The odds against a profit are high, and the payout is just as high if we are successful. So, what is the difference between a coin toss and a stock purchase?

These questions are difficult to answer. Even more so when our teen reads that our chances at market profitability are the same whether we conduct diligent research or just toss a dart at a list of stock options. In fact, based on the probability methods below, the differences between gambling and investing are very slim. The only difference, actually, is the time frame involved between gambling and long-term investing. You're not convinced? Let's see how this works?

There are only two numbers that define probability, and these are 0 and 1. The chances of shaking hands with the real Abraham Lincoln are 0. The chances that the sun will set tonight are 1. The outcome of any event can be explained with these two numbers, because a probability of 0 means the event is impossible, and the probability of 1 means the event is certain (even if we don't see the sun set because of low clouds and snow, it will happen). Now that we know the saying, "Nothing is impossible, only highly improbable" is false, let's see how one of these three methods (or all three combined) will help determine the outcome of any event (this information can be found in most high school or college math textbooks):

1. Theoretical Probability - this type of probability is based on a model where all outcomes are equally likely. This is determined by dividing the number of ways an event can occur by the total number of possible outcomes. In other words, if a two-sided coin is tossed one time, the coin is not flawed, and we pick heads, our chances are 1/2 (0.50), or one in two that the coin will land heads up. Basically, this probability is based on a theory of how the coin will behave when tossed. When a coin is "flawed," this means that the coin is tossed with mitigating factors (one side of the coin is heavier, a person rather than a calibrated machine tosses the coin, etc.). If we apply this theoretical method to the stock market, we gamble that a stock will move one of three ways - up, down, or sideways - during a specified time frame. This means our chances are 1/3 (0.33), or one in three that the stock will move one of three ways. Notice the probability that a stock will move up or down is decreased, because it can also move sideways within a specified time frame.
   
   
2. Empirical Probability - this method of probability is based on observations or experiment, so it is grounded in the relative frequency of the event. If we toss a coin 100 times and the coin lands heads up 75 times, we create the formula of 75/100 (0.75), which is much higher than the theoretical probability of 1/2 (0.50). This means our experiment proved the coin is flawed in this event of 100 tosses. If we apply empirical knowledge to the stock market, we find the market is flawed, as it will never do what it's supposed to do in theory. However, we also know that the market historically and, on the average, increases in value over time (see last week's article on market valuation between 1926 and 1999).
   
   
3. Subjective Probability - this is an estimate based on either experience or intuition. Since we already know the results of the theoretical and empirical coin toss experiments, we might gamble that the next coin toss will land heads up 65 times out of 100, or 65/100 (0.65). Weather forecasting is based on subjective probability because, no matter how educated our meteorologist is, the weather is dictated by no one. Similarly, we can purchase stock on recommendation, rather than from our own experience. We often believe meteorologists and fee-based financial planners will help us, because they have more skills and experience than we do in their respective fields. However, we now know they're not to blame if their predictions are incorrect because, although some events are impossible and others are certain, every other event carries a percentage of probability.

Probability methods are complicated by language, because there are several different ways to express the idea of probability. We've used the words "chance" and "estimate," and the other word is "odds." Strictly speaking, "odds" are not probability, because odds are the ratio of a probability. In gambling, the term "odds" expresses how much a bet will pay if we win.

For example, if we bet on a horse, we might bet against the odds. If one horse's odds are given as 5 to 1 and we bet $10, we gain $5 for every $1 we bet if we win. A $10 bet is equivalent to ten $1 bets, so we gain $5 x 10 = $50. We will also see our original ten dollars, so we will receive $60 when we collect our winnings. Similarly, if we place odds on our portfolios, we'll probably come close to "winning" if we base our odds on historic percentage increases for equities. However, we will probably bet against ourselves on this gamble, because most gamblers won't stick around for a number of years to find out if they've won or lost this bet.

Essentially, what makes probability in gambling different than probability in investments is the time frame. A coin toss and a horse race - like a day trade - are a series of one-time events. Day trading, it seems, is more of a gamble than a long-term investment when seen in this perspective. When we add our knowledge and skills to our diversified long-term portfolio choices, then we are not gamblers?we're smart investors.

Until Next Week,
Linda Goin

The securities markets are subject to the risks of fluctuating prices and the uncertainty of rates of return and yields inherent in investing and past performance is no guarantee of future results.