Roll of the dice

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What are the differences between investing and gambling?

Only invest in what you know and understand. It's long-standing and reasonable enough advice except for the fact many people likely know more about the Bombers or the Kardashians than about the contents of their RRSPs.

You can even put your money where your opinion is these days on everything from sports, celebrities and elections to the probability of NASA discovering E.T. before the end of the year.

Bookies and oddsmakers are nothing new.

But prediction markets -- where traders can buy and sell shares valued on world events -- are a relatively new development over the last decade that further blur the lines between investing and gambling.

One of the better-known websites -- Intrade: the Prediction Market -- provides an exchange for users to buy and sell shares that pay out at zero or $10.

For example, you can buy shares -- trading at about $3 to $4 and change a share -- that Mitt Romney will win Nov. 6.

"You've got some expectation whether the shares are going to go up or down and you trade accordingly," said Carl Wolfenden, operations manager with the Dublin-based website.

If your pick ends up being correct, your shares pay out at $10. If you're wrong, you lose your investment.

Originally developed by London currency traders in the late '90s, the trading mechanism is similar to those used for currencies and commodities, only Intrade is built to trade anything, Wolfenden says.

Clearly, this kind of trading is gambling. Except rather than bookmakers creating the odds, it's a market of gamblers.

Although prediction markets bear some similarity to actual financial markets in how they function -- matching buyers with sellers -- that's where the comparison stops, says Alok Kumar, a professor of finance and behavioural economics at the University of Miami's School of Business Administration.

"In the case of investing, the risk and reward can be broadly predicted or known," he says. "Investors also have some idea about the correlations among the assets or asset classes."

In contrast, this type of data is usually unavailable for the contracts that trade on Intrade or other prediction markets because these trades are very specialized and one-time-only contracts, he says.

Yet, more broadly, investing and gambling do often share a number of similarities -- even though the industry itself may be loath to admit it, says Frank Murtha, a New York-based behavioural psychologist who consults with investment advisers.

"I would say that gambling and investing are not different so much in kind as they are in terms of degree," says Murtha, whose consultant firm is called Market Psych.com.

Gambling, first and foremost, means you have to risk something in order to get something back -- a description that also fits investing rather well.

"Another feature is there has to be at least some element of luck," Murtha says. "And I would say there's luck involved in the outcomes of the market, especially over the short term."

With gambling, individuals can also avoid incurring losses by not participating in the activity, and it's often a zero-sum game: Either you win or lose.

"I believe investing conforms to all of that," he says. "I think the effort to portray that the two are distinct and totally different exercises is understandable, but it really has a lot more in common with gambling than most people would like to think."

In fact, the investment world has its own euphemism for gambling: speculation.

Of course, investing should require informed decision-making based on up-to-date financial data.

Yet professional gamblers also often use tried-and-true strategies to increase their odds of favourable outcomes, says Michael Ellery, a professor of psychology at the University of Manitoba who has studied professional gamblers.

"Poker is about making good decisions, and a great deal of strategy, mathematics and knowledge is used by many professional poker players to make good decisions," he says.

Successful pros wager their money when the odds are in their favour.

In that respect, investing is much the same. Yet like gamblers, investors are prone to making cognitive errors leading to poor decisions. Anyone who's invested in the stock market can attest to that. That said, unavoidable conditions such as the collapse of the global banking system and the European debt crisis hurt even the most prudent investors. But losses incurred through uncontrollable events are often compounded by emotionally driven errors.

For example, even the normally sage advice to invest in what you know and understand can lead to mishaps because of a cognitive error called familiarity bias, Kumar says.

"They (investors) believe they have superior information," he says. "Therefore, they may perceive them (investments) to be even less risky and therefore may trade more aggressively and lose more money."

Many investors also run into problems when they draw correlations between unrelated events that may appear connected.

This well-known cognitive error is even named gambler's fallacy, Murtha says.

"It's essentially this: Not recognizing how individual, discreet events are not interdependent."

So while the TSX Composite Index may be down for two consecutive days, its recent performance can have little bearing on whether it will be up or down the following day.

"The problem with the gambler's fallacy is it doesn't appreciate just how long-term the nature of regression to the mean is," he says. "It's basically thinking that because the market did something yesterday or last week, therefore, it's going to do something different this week."

Another frequent error is confirmation bias.

"There are very few people who will say, 'Boy, I got lucky with this stock pick,' " Murtha says. "They will say 'I was right,' but if their pick goes wrong, and they can cite some sort of plausible evidence that they were really right and something wrong happened to change the outcome, they will ignore that."

Yet Kumar says most investors still make one critical distinction between gambling and investing that keeps them out of trouble. With gambling -- such as buying a lottery ticket -- most people expect a negative outcome with a small chance of winning, whereas with investing, we expect a long-term positive return.

"The reason people still gamble is because there is a tiny chance of a very large payoff."

Most will wager accordingly -- very little -- and they often will get into trouble if they don't.

It's much the same with investing.

"When people just focus on the potential of a huge payoff and ignore -- or pay less attention -- to the fact that they are likely to lose money on average, they are moving from the territory of investing to gambling," Kumar says.

When it comes to shrewd investing, the best advice is to keep emotions in check -- not so easy when money is on the line, Murtha says. Invest with the big picture in mind, such as retirement, and ensure odds are in your favour. Don't put all your money on one horse, and the longer the timeline to get the sought-after result, the better.

"Investing is about an ongoing series of events where you get the benefit of the odds being in your favour."

Think like a casino, not like a gambler.

"Casinos make money because the odds are in their favour," he says. "A casino can lose money on occasion, but they can't lose money over the long term."

Quick facts:

The wisdom of the crowd

Prediction markets are known for forecasting the outcome of events more accurately than other forecasting instruments, such as polls.

A 2004 article by American economists Justin Wolfers and Eric Zitzewitz published in the Journal of Economic Perspectives found prediction markets call election outcomes and other events such as the Oscars more precisely than polls and expert panels.

The first experimental prediction market was created at the University of Iowa in 1988, and it has a long record of correctly calling election outcomes with more accuracy than polls, Wolfers later wrote in a Wall Street Journal article. The professor at both the University of Pennsylvania's Wharton School and Princeton University further stated economic historians have found oddsmakers for elections from more than 100 years ago also have an "impressive forecasting record."

Intrade spokesman Carl Wolfenden has a theory why.

"Polls will generally call you up and ask who you're going to vote for, whereas Intrade asks who you think will win," he says.

A poll might find Obama leading Romney by two per cent of the popular vote.

"That's a close race, but on Intrade is zero-sum -- win or lose -- so whether Obama wins by 100 votes or a million votes, the outcome is the same." A market system forces people to think about their bottom line. "When your cash is at risk, you have to be a little more rational about it and go with your head rather than your heart," he says. "You could be a rabid Romney supporter, but if you don't think he's actually going to win, you're not going to buy his shares to win."

Prediction markets aren't just for gamblers

Increasingly large organizations are using similar systems to measure risk. Some firms, such as Lumenogic, offer market-prediction systems to help companies and government organizations manage risk. The U.S. Defence Department even contemplated this kind of forecast modelling a decade ago.

"Proposed contracts were based on indices of economic health, civil stability, military disposition, conflict indicators and potentially even specific events," wrote Wolfers and Zitzewitz in their 2004 article. But the project was quickly dropped after critics dubbed it "terrorism futures," arguing government could spend its money better elsewhere.

A look at a couple of prediction markets and their trades

Intrade: This prediction market is based in Dublin and is among the longest-running and largest of its kind. Its most popular trades right now deal with the U.S. presidential election, but here's one of its stranger trades: NASA to announce discovery of extraterrestrial life before midnight (EST) Dec. 31, 2013. Price: $1.55 or 15 per cent likelihood, as of Oct. 16.

-- HSX: The Hollywood Stock Exchange allows users to trade stock on movie stars and films' projected box-office earnings. You can even buy "movie funds" that are portfolios of movies and stars performing in those films. No money actually is exchanged. The site is considered a web-based, multi-player game using simulated money. One of its top trades is Taken 2, a Liam Neeson action film in which he kicks butt to free his ex-wife from Albanian criminals. As of Oct. 16, its stock was trading at $112.16, which is a prediction it will earn $112 million at the box office within four weeks of release.

Republished from the Winnipeg Free Press print edition October 20, 2012 B12