Tuesday, September 30, 2008

The Difference Between Gambling and Investing

The crisis in the financial markets this month is a reminder of easy it is for people to convince themselves that they know far more than they actually do. The executives in charge of Lehman Brothers, Merrill Lynch and AIG were highly compensated for their years of experience in investing and finance. Their companies made billions when the investments they made appeared to be profitable.

But, the events of the past month show that the experts running these companies had no more insight into the future than anyone else. Probably even less knowledge of the future than many people because they apparently forgot all the known principles of sound investing. Instead these executives became seduced by the lure of making quick money by gambling with the enormous sums of money entrusted to them.

The problem with gambling is that winning streaks occur frequently. It is possible to place a series of bets and come out ahead. But, suppose I walk into a casino and win five hands of blackjack in row. Does that mean I know something that the other losing players do not? Should I increase my bets? Should I give up my job and become a professional gambler?

Winning five hands in row at blackjack means nothing more than that is how the cards fell for those five hands. It does not mean that I am smart or gifted or have any special insight into the future. I certainly should not be increasing my bets or plan a career change to full-time gambling.

But, the executives running these investment firms and insurance companies had a few profitable years placing high-risk bets on real estate and concluded that they knew something others did not. Instead of being thankful for coming out ahead on bets that should not have been placed, they kept increasing their exposure to risky loans.

In my book The Two Headed Quarter I draw a distinction between gambling and risk-taking. I write:

“Gambling involves betting money on a game or contest for the purpose of winning more money. Attractions of gambling include the thrill, the entertainment value, and the possibility of wealth without work. Risk-taking involves using money to achieve broader goals that have an uncertain outcome. Anyone who pays for an education, buys a house, relocates for a new job, or starts a business, is taking a risk.”

Investing should be a risk-taking activity. The basic idea is to pool and allocate capital to grow businesses and production capacity. The end result should be economic growth resulting in more jobs, more goods and services, and a higher stand of living for all. In contrast gambling simply transfers money from losers to winners. Nothing of value is created. Imagine an economy where everyone is a full-time gambler. It would be unsustainable because nothing would be created.

But somehow the executives running firms on Wall Street convinced themselves that moving money around using complicated impossible to understand formulas was creating wealth where none existed before. They rewarded themselves handsomely for creating what amounted to a shell game. Wealth creation by subtraction does not work. You cannot keep taking out money of the pot and claim that there is more in it. No matter how complicated you make the financial formulas you cannot work around the basic facts of addition and subtraction.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy