I come across this question or statement from my friends quite often. Trading and Investing is like Gambling. Is that a correct statement? Let’s analyze the realities and come up with an informed decision.
What is Gambling?
First, let’s look at Gambling. We go to Casinos to gamble. We play Poker, Blackjack and may be slot machines. We depend on our luck to win some money in this process. Well, I am pretty sure, this is classic gambling. However, is the house (Casino) gambling? You will be surprised to know that they are not. All the games, gaming machines and equipment are calibrated with a probability of winning slightly in favor of the house. At the end of the day, house always wins (net net). Well, you can argue that you knew that, and you go there for fun and free beer. And I won’t disagree with that.
What is Trading & Investing?
Second, let’s look at Trading and Investing in Financial Markets. We are talking about Stocks, Options, Futures, Forex and Commodities. I am not including Bitcoin or Cryptocurrencies in this list yet. Who are the typical winners and typical losers in the financial markets? Almost always, the big institutions make Billions of Dollars from Trading every year, whereas the retail investors lose money in Trading. If you google search, you will find that, over 90% of the retail traders lose money. Why is that? Why almost all large institutions make money from Trading, whereas over 90% of retail traders lose money? Is Trading same as gambling, or the way you are Trading is gambling?
Most retail traders and investors know only one strategy in the financial market. That is, buy and hold stocks and hope that the stock will go up in price and profit from it. This is not necessarily a wrong strategy. We all know that stock market is designed to go up over time. However, there are few problems in the way most retail traders do this:
- No Risk Management
- Trading driven by Emotion
- No Strategy or ineffective Strategy
- Tips from friends, neighbors and relatives
Let’s analyze each of these situations in more detail. Before we do that, I wanted to put this info on the table that, Stocks are not the only trading instrument in the market. In fact, Futures and Forex markets are several times larger than the Stock market. However, for simplicity, let us assume that you trade only Stocks.
When you buy a Stock, do you decide the following, even before buying: (a) stop loss price (b) target price (c) entry price (d) position size? Most retail traders do not. And that is the lack of basic risk management. The first number to decide before entering a position is – how much are you willing to lose in this trade? Then you need to decide the stop loss price, to avoid deep losses.
It is better to take some loss and exit a position than be in the position long term and lose all or most of it. The stop loss price, entry price and the max loss (that you are willing to take) helps you decide your position size (in terms of number of stocks / units or total $$$ to be deployed). If you have this step covered, then your loss is capped and you can sleep peacefully in the night, not worrying about losing all of your capital.
The second mistake retail traders normally make is decision based on emotion. If a stock has been going up, you may feel that you are missing out on this opportunity and you should jump on this bandwagon. FOMO – Fear Of Missing Out. The same applies on the downside as well. And sometimes, you just love a company, and you want to buy it regardless. And this decision is not based on any fundamental or technical strategy.
It is purely based on emotion. These are dangerous decisions. In trading Stocks, emotions must be removed completely. It does not matter, if you like a company, its CEO or its products.
You must remove all that bias from your decision-making process. The other dangerous emotions in Trading are Greed and Fear. Greed pushes you to buy more at higher prices, or not taking profit, when you should have. Fear does the reverse. It pushes you to sell at lower prices or take small profits and exit. Either of these emotions, without proper strategy and risk management can prove to be very expensive. And hence trading by emotion is gambling for sure, as you are depending on your guts and luck.
Trading and Investing requires a sound and proven strategy. This helps in deciding the zones, entry point, stop loss and target in a logical and scientific way. This helps to avoid emotion from trading. This helps in tracking, monitoring, and fine-tuning the strategy for higher effectiveness. The most effective strategy that I have seen is based on Supply and Demand.
There are number of technical indicators and strategies out there. However, most of them are based on past trading data, and not based on unfilled supply and demand. I would stay away from any past data based technical analysis, as they say, “Past performance is not an indication of future performance”. And you can’t predict the future price movements based on past prices alone. You need to understand where the Supply and Demand lies in the market to predict the price movement more effectively. And just to be clear, no one can ever predict all price movements 100% accurately.
If you are using fundamental analysis as your strategy, then you are again relying on the company’s past performance to extrapolate future growth. Most of these are normally factored into the Stock well in advance. So in my opinion, for short and medium term trading, fundamental analysis is not effective and often counter-productive.
Last but not the least, trading based on tips from your friends, neighbors, and relatives etc., is very risky. Please note that, almost always they don’t know much about the market and the stock. They are just providing their recommendations based on their own belief, gut feel, emotion or their current position. Either way, I wouldn’t recommend putting your hard-earned money at risk using these tips. The same goes with stock tips and picks by several companies on internet. I encourage you to search a term called “pump and dump” and let you realize what many of these companies (not all of them) actually do.
Conclusion: Is it really Gambling?
So, let’s ask ourselves this question again. Is Trading & Investing same as the Gambling? Actually, it depends on You. If you are trading with emotions and other issues listed above, then answer is Yes. If you are a professional trader and using discipline, strategy, risk management and a set process, then the answer is clearly No. So, it’s up to you, which direction you want to take your Trading & Investing.
There is a lot more to learn about Trading Strategy, common mistakes & how to avoid those. I encourage you to register for a Free Trading Workshop to learn a lot more. Click here to register now.
Author: Satya Panda