There is an exceptionally fine line between trading or investing and gambling. Many traders unsuspectingly and unknowingly fall into the trap of becoming gamblers - our first-of-its-kinds guide explains what you need to know.
- Trading, investing, betting and gambling are very similar activities, primarily due to their speculative nature and inherent potential to win or lose money. These activities are also alike in terms of the emotional responses they can trigger - particularly those related to the thrill of winning, the anxiety and fear of losing, and, eventually, the pain of losing.
- While investing doesn't have negative connotations, to the untrained eye, trading and gambling might not seem too different. Consider someone who puts $1,000 on red at a roulette table, buys a thousand scratch cards or opens a position for 100,000 NZD/USD. In each of these examples, this person could win money or lose money, and the outcome is somewhat binary. Specifically, the outcome of roulette could be red, black or zero; the outcome of the scratch cards is losing or winning an undetermined amount, and the price of NZD/USD will go up, down or stay the same.
- The way traders, investors, betters and gamblers approach their decisions is similar, especially the biases that influence decisions, which can push them into the realm of gambling. Similarly, professional gamblers use risk-to-reward strategies like traders approach their wagers.
- This guide, the only of its kind in New Zealand, focuses on the similarities and differences between trading & investing and betting & gambling.
- Disclaimer: MoneyHub will never be a fan of gambling; it doesn’t matter whether you’re betting on the horses or the stock market; it is not a responsible way to manage your money. We also don’t encourage investing in speculative financial products due to the high likelihood of losing your money.
Summary
- Gambling is defined as wagering money on an event with an uncertain and potentially random outcome for a potential prize.
- Whether you’re trading or investing, you must have a clear strategy to govern your decisions. If you’re opening a position without any idea of whether you’ll be profitable or under which conditions you will close the position, you’re gambling.
- Unlike gambling, trading and investing are not entirely random because the application of technical and fundamental analysis with proven techniques and strategies gives traders an edge. Additionally, the price of assets is determined by the actions of investors. For example, if there is an overwhelming demand to buy gold, the price will rise.
- Financial markets can be unpredictable because of the actions of investors. For example, if the Reserve Bank of New Zealand raises interest rates, there will be a sudden surge in demand for New Zealand dollars. If the news was not expected, it might seem like an unpredictable price movement, but the reason is clear and logical.
- Whether you’re trading shares, derivatives or investing in a company, without conducting any technical or fundamental analysis, the outcome will be entirely random; essentially, that’s gambling. Read on a Facebook group that people are buying a cannabis company share and rush in to buy? That's gambling.
- Trading psychology is a well-studied area of behavioural finance. Trading and investing require discipline. Traders need to battle dozens of biases to trade successfully.
- With products like binary options and spread betting, the boundaries of trading and gambling became increasingly blurred.
- Many gambling products, particularly those operated online (which are prohibited in New Zealand), are far from transparent. In contrast, trading platforms provided by firms licensed in New Zealand, Australia, Europe and other developed regions are scrutinised by regulators. They have to follow best execution practices and strict reporting obligations.
To help you make sense of what you need to know, our guide covers:
Before going further, we need to first define the following concepts: trading, investing, gambling and betting:
- Trading is buying and selling or opening and closing positions in financial instruments, such as stocks, currencies and derivatives;
- Investing is buying and holding assets such as stocks, property and precious metals with the expectation they will appreciate in the long term;
- Gambling is placing a wager on a game or event with a random outcome. Commonly known as games of chance, typical forms of gambling are roulette, blackjack, three-card poker and bingo. In games of chance, the dealer (or the house) usually has the edge over other players;
- Betting is placing a wager on an event, such as a rugby match or competition. The bookmaker sets odds based on demand and uses the losers' money to pay the winners. Unlike gambling, which has entirely random outcomes that cannot be predicted, technical and fundamental analysis can be used to predict the outcome of sports competitions.
From the descriptions above, you’ll notice that
betting has more in common with trading than anything else. Gambling is the outlier because it’s the least rational way to earn money, mainly because it’s impossible to be profitable in the long run because of the random nature of outcomes and the skew in favour of the house, implying that if you play for long enough, you’ll ultimately lose.
Many people who gamble should know deep down that their odds of winning are stacked against them, yet they do it anyway. The reason people gamble is reasonable and simple, but for others, it can be destructive and complex:
- On the simple side, some people gamble for the thrill and experience. Perhaps they want to enjoy a night out at the casino or make a rugby match a little more interesting by wagering a few dollars on the outcome.
- However, on the complex side of things, some people are attracted to gambling as an easy and quick way to potentially earn money, escape from other problems in their life, or are hooked on the adrenaline rush they get from winning or the thought of winning. Some people have personality traits that predispose them to problematic gambling habits.
Gambling is a vice, which is why it is illegal in many countries, highly regulated in most other countries and taboo in many organised religious and ethnic groups. In contrast, trading is a respected profession and a necessary part of the global capital markets system for creating constant liquidity. It is part and parcel of every nation's economy.
Cognitive Biases and Trading
Trading and gambling
both involve risking capital to potentially create profits. In The Colour of Money, the character Eddie says, “Money won is twice as sweet as money earned.” In reality, one dollar is the same as any other dollar, meaning they should taste equally as sweet. However, human experiences differ. Whether trading with logic and discipline, it’s foolish to discount that the desire to win (and not lose) won’t impact your behaviour.
Know This:
- Making decisions on whether to open or close positions for different trading instruments and at which price levels is complex. We take data and facts and try to process them using logic, but unfortunately, emotion and irrationality seep into our decisions.
- Whether you know it or not, biases play a huge role in making decisions. A lot of training is required to understand and manage our biases. One of the reasons algorithmic trading has proliferated in the day trading community is because it removes the emotional influences of traders and simply executes the strategy without question.
A bias is defined as a particular tendency, trend, inclination, feeling, or opinion, especially one that is preconceived or unreasoned. We explore some of the most common cognitive biases that influence trading decisions:
- Gambler’s fallacy bias is when a trader believes the probabilities will shift in their favour following a series of losses. For example, in the course of a losing streak, a trader might believe that after each losing trade, a winning trade is more likely to occur. If the market is in a bullish trend, it doesn’t matter how many short trades are placed; the chances of winning will not increase simply by placing more trades.
- Martingale bias expands the gambler's fallacy, where upon each losing trade, the trader doubles their position size to earn enough to recover the losses from the previous trade. The trader continues to double their position size upon each loss, so the next profitable trade covers the losses of all previous consecutive losing trades. The strategy only works if the trader eventually wins, but as already established, the likelihood of winning doesn’t increase based on the number of attempts.
- Hot-hand bias is when traders believe they are on a winning streak, thus enhancing their confidence and establishing a feeling they will win the next trade simply because they’re on a roll, ignoring the real reasons they're winning.
- Sunk cost fallacy is when traders double down on a losing position or investment. For example, buying 50 shares of PayPal for US$300 per share, then when the price falls to US$100, they buy more shares, essentially throwing good money after bad.
- Loss aversion bias is the tendency to avoid losing more than trying to profit. For example, a trader feeling disappointed about a $100 losing trade meanwhile earning $300 from other trades, rather than viewing it as a net profit of $200. The loss aversion bias can lead traders to avoid taking risks and not entering trades due to the fear of a negative outcome, known as status quo bias.
- Confirmation bias is when traders seek information that validates their current view while disregarding anything contradictory. The problem with confirmation bias is traders collect substantial evidence confirming their idea, leading to overconfidence.
- Recency bias is when traders assign more weight to the most recent information and consider older information less relevant. For example, they may disregard an old announcement about the company being investigated for fraud and act on recent news about its earnings rising.
- Anchoring bias is when traders fixate on the first piece of information they discovered when analysing an opportunity. Anchoring to that first piece of information, they ignore other potentially important data.
- Bandwagon bias is when traders want to follow or are reassured by the sentiment of others without necessarily understanding the basis of others' decisions.
- Hindsight bias is when traders see positive outcomes as the result of their performance while determining that negative outcomes are the result of unpredictable events.
- Contagion heuristic bias is when traders avoid a particular instrument because they previously had a negative experience. For example, if a trader lost several thousand dollars trading NZD/JPY and now feels this currency pair is somehow toxic.
- Post-Purchase Rationalisation bias is when traders overlook the shortcomings to justify their purchase.
What is the Difference Between Trading and Gambling?
Depending on who you ask, some might vehemently disagree there are any comparisons between trading financial markets and playing games of chance. In a legal sense, they are technically correct. From a behavioural perspective, they are entirely wrong, as covered above.
There are
several differences between trading and gambling. For example, differences include
market regulations,
tax implications,
ownership,
predictability and
benefits to society:
1. Regulations
In New Zealand, gambling is tightly controlled by the
Department of Internal Affairs and the industry is operated as a monopoly where competition isn’t permitted. The only company offering gambling and betting products in New Zealand is TAB. In contrast, the Financial Markets Authority (FMA) regulates trading derivatives, and stock trading isn’t a licensed activity. The FMA promotes competition in the market and encourages new participants to innovate and provide better investment products for consumers.
2. Transparency
Online brokers and investment firms licensed in New Zealand and other similarly developed nations have to prove how they arrive at prices; they can’t just make up prices from thin air. Investment companies must submit regular reports to regulatory authorities that detail the exact method used to derive prices and execute transactions. Regulated investment firms must not manipulate prices, and malicious behaviour such as intentionally slipping or spiking prices to cause losses is punishable by hefty fines, sanctions and even prison for the company's management.
3. Tax implications
In New Zealand, income from gambling winnings doesn’t need to be declared or taxed. In contrast, profits from trading need to be taxed as income. However, earnings from investments don’t need to be taxed because New Zealand does not have a
capital gains tax. The difference between income from trading and capital gains from investing is nuanced.
4. Predictability
Games of chance are intrinsically unpredictable. Whereas trading financial markets can be predictable, provided traders learn to use the abundance of tools at their disposal. There are endless well-established and time-proven technical analysis techniques using historical price data. Trading the markets requires analytical skills, patience and continual study of financial instruments' movements. It is a science and a skill.
5. Leverage
It is common for derivatives, such as forex, options and futures, to be traded using leverage provided by brokers. In contrast, it’s prohibited for credit to be provided for gambling.
6. Settlement
Any trades or investments you make will result in a variable loss. You buy an asset at one price and sell it at another price, which may be higher, lower or the same, meaning your profit or loss is variable. With gambling, the outcome is all-or-nothing, and your wins and losses are fixed.
7. Availability
Self-directed trading platforms are easy to access, as most trading platforms are supported by web browsers and iOS or Android devices. Traders can essentially trade from anywhere with internet connectivity. In New Zealand, the Gambling Act 2003 prohibits remote interactive gambling, meaning you can’t gamble online while you can trade online.
Being impulsive or treating a trading platform like a computer game where you directionlessly click to open and close positions is tantamount to gambling and rarely ends well.
Whether trading or investing, having clear strategies and objectives is essential. It is good practice to write these out and keep them as a defined list of rules to follow while trading to prevent going off course and into gambling territory.
If you find yourself behaving irrationally and feel the compulsion to trade without having a clear direction, it could be the hallmark of addictive behaviour. In which case, you should seek expert guidance to understand these compulsions better before they manifest into something more serious.
If you feel like your
trading is turning into gambling, there are several services available to help you, such as:
Frequently Asked Questions
How can I learn more about trading psychology?
Trading psychology is a topic covered by most financial blogs, but the coverage is usually superficial. To get a deep understanding of trading psychology and prevent yourself from falling into the trap of gambling, several established authors are worth exploring. We recommend the following books:
- Market Mind Games: A Radical Psychology of Investing, Trading and Risk by Denise Shull
- High-Performance Trading: 35 Practical Strategies and Techniques to Enhance Your Trading Psychology and Performance by Steve Ward
- The Disciplined Trader: Developing Winning Attitudes by Mark Douglas
Is forex trading gambling?
Forex trading is not gambling. The forex market is a necessary function of the global financial markets. Traders have learnt how the market behaves and use that knowledge to profit from price movements by buying and selling various currencies. Trading attracts more participants to the market and therefore improves efficiency and liquidity, resulting in a more competitive environment.
Just because forex trading isn’t gambling doesn’t mean you can’t trade like a gambler. Any investment can be considered a gamble if you go into a deal without rational justification that it will be a profitable transaction. Aimlessly opening and closing forex trades is essentially gambling and certainly reckless.
Are cryptocurrencies gambling?
Owning cryptocurrencies like Bitcoin isn’t gambling, providing you can justify why you have invested. However, buying unproven ICOs or tokens without conducting any research because you hope there is a chance the price might explode by thousands of per cent is gambling.
Is binary options gambling?
Binary options have rightfully earned a very bad reputation in the online trading industry. Once, retail-focused forex brokers offered binary options as an easy way to speculate on financial markets. Binary options have more in common with gambling than trading because they have a fixed-return all-or-nothing outcome. When trading binary options, you simply predict whether the price will be higher or lower when the contract expires, which can be as short as 60-seconds.
