On gambling
Many people who do not invest in stock markets (or other financial markets) compare this activity to gambling.
Finance academics defend that investing in the stock markets carries a positive risk premium, i.e., that is has a positive expected value, unlike bets, which normally have a negative or zero expected value. Playing in the lottery is the typical example. The price that one pays for a lottery ticket is higher than the expected gain, as part of the proceeds are not converted to prizes, being rather utilised for different causes. So, investing in the stock market is speculation, not gambling. Speculation is defined as "the assumption of considerable risk in obtaining commensurate gain", whilst gambling is generally regarded as "betting on an uncertain outcome".
There are two issues with this.
The first is that perhaps gambling opportunities that carry a positive risk premium can be found. Suppose that for instance one finds a bet which has an extremely likely positive outcome, but with a very small return (for instance, betting on several strong football nations to win the World Cup). If the upside is +10% and the unlikely downside is -100%, this bet might not be much different from investing in a junk bond. The distribution of returns would have the same structural characteristics: positive risk premium, negative skewness (high likelihood of small gains, low likelihood of large losses), positive kurtosis (likelihood of extreme events higher than normal). Can these opportunities be found in potentially inefficient betting markets?
The second issue regards the utility function of rational investors. We know that risk-averse investors like mean, skewness and all other odd moments of the probability distribution of returns. Moreover, they dislike variance, kurtosis and all other even moments of the return distribution. Could the preference for positive skewness be so strong to rationally offset a small negative expected value? One can see casual empirical evidence of enthusiasm for outcomes where gains are big but unlikely and losses are small but likely - large lotteries and insurance are two examples. So maybe playing the lottery is a justifiable investment after all.
Finance academics defend that investing in the stock markets carries a positive risk premium, i.e., that is has a positive expected value, unlike bets, which normally have a negative or zero expected value. Playing in the lottery is the typical example. The price that one pays for a lottery ticket is higher than the expected gain, as part of the proceeds are not converted to prizes, being rather utilised for different causes. So, investing in the stock market is speculation, not gambling. Speculation is defined as "the assumption of considerable risk in obtaining commensurate gain", whilst gambling is generally regarded as "betting on an uncertain outcome".
There are two issues with this.
The first is that perhaps gambling opportunities that carry a positive risk premium can be found. Suppose that for instance one finds a bet which has an extremely likely positive outcome, but with a very small return (for instance, betting on several strong football nations to win the World Cup). If the upside is +10% and the unlikely downside is -100%, this bet might not be much different from investing in a junk bond. The distribution of returns would have the same structural characteristics: positive risk premium, negative skewness (high likelihood of small gains, low likelihood of large losses), positive kurtosis (likelihood of extreme events higher than normal). Can these opportunities be found in potentially inefficient betting markets?
The second issue regards the utility function of rational investors. We know that risk-averse investors like mean, skewness and all other odd moments of the probability distribution of returns. Moreover, they dislike variance, kurtosis and all other even moments of the return distribution. Could the preference for positive skewness be so strong to rationally offset a small negative expected value? One can see casual empirical evidence of enthusiasm for outcomes where gains are big but unlikely and losses are small but likely - large lotteries and insurance are two examples. So maybe playing the lottery is a justifiable investment after all.
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