Investing in the stock market comes with inherent risks. In fact, one could equate investing to gambling because of the up-and-down nature of the market as a whole. However, this isn’t quite as true as it may seem. While there is risk involved in trying to increase the amount of money you have, from investing to gambling or even building a business, investing is typically done through informed analysis, while gambling, at the end of the day, is purely chance.
If you’re looking to start investing or improve on your returns, consider working with a financial advisor who can help you through the process.
Risk in Investing
Investing refers to putting money into various types of assets with the goal of increasing the value of what you own. Then, you would eventually sell them for ideally a profit. Buying stocks is one of the most common forms of investment. While many people look at the market with skepticism, it’s actually proven to be one of the best long-term investments when you approach it correctly.
Investing in the stock market doesn’t come without its own risks, especially if you have more of a short-term approach. This is more the type of message that the market gets from many mainstream media players. When the market drops suddenly, the story of when or how it could rebound gets people interested. This makes many feel like it’s a risky proposition because no matter what you invest in, the value is going to fluctuate over time.
Market risk occurs and it comes from movements in stock prices, exchange rates, prices of commodities, the rise and fall of interest rates, inflation and more. On any given day, the stock market can go up or down. If you’re investing with a gambling mindset of trying to time the market for a huge short-term win, then the risk could indeed be quite high. However, the investment that has provided the highest average rate of return has been the stock market, which makes a long-term investment strategy historically safer than others.
Risk in Gambling
When you’re gambling, you’re putting something at risk on a contingency to make something from that risk. Gambling is putting money into a game or other activity that has an uncertain outcome and relies heavily on chance. With some forms of gambling, there’s a form of risk management where the odds have the potential to fall in your favor. However, gambling games are created with a higher percentage that you lose compared to the opportunity of winning.
Gambling isn’t just about traditional games like poker or slot machines. People actually most regularly participate in sports wagering or playing the lottery. In this type of gambling, people are betting against other people because the odds and potential payouts are determined by how many people are playing. The more people that play, the more risk you have at losing, but the higher the potential payout might be.
Gambling is risky because the odds are stacked against you. The probability that you’ll lose your money is higher than the probability that you’ll earn more than the amount of money that you wager.
Investing vs. Gambling: Key Differences
Now that we understand the risk of both investing and gambling, which is the biggest difference between the two, let’s dive into the other major differences between them. The distinctions that you should be aware of include the following:
Investing Provides Ways to Mitigate Potential Losses
With investing, you’re able to simultaneously put your money in different types of investments that provide a unique level of risk. Even if you’re buying risky stocks, you can offset that risk by putting money into safer investments like government bonds, where your principal investment is protected. With gambling, you’re putting money up for a single event and you either earn on the money you risked right away, or you lose it.
You Can Make More Informed Decisions When Investing
With gambling, you’re very limited in what you can research and understand before risking your money. In fact, many games are just games of chance and there is nothing whatsoever to analyze beforehand. Professional gamblers can play games that give them a better chance of succeeding when playing the odds of cards or playing the odds of what someone else will do in the game, but it’s still very limited.
Investing in the stock market, on the other hand, brings a lot of historical data that you can use to base your decisions on. For instance, you can look at how industries have performed historically, or how the stock you’re wanting to buy has done over the past three months, one year, five years or more. You can also analyze the risk to know the likelihood of success that each investment has before risking anything.
You Can Enlist Professionals to Protect Your Investment Assets
With gambling, you’re on your own to decide what to do and how much money to do it with. However, with investing you can hire professionals, like financial advisors, who are experienced at investing in specific types of assets or using certain strategies. They understand what to invest in to help you achieve your financial goals, and can build a portfolio around building wealth for whatever your needs are. They know what funds can be successful or how to hedge your investment in a risky stock with bonds or commodities. This is a much safer way to risk your money in the hopes of gains.
Gambling Takes Less Time to Provide a Result
With gambling, you either win or you don’t, and it happens pretty instantaneously. As soon as the game or event takes place, you know if you won or lost money. That’s the complete opposite of investing in the stock market.
For investors, it typically takes years or even decades to reap the financial rewards that you’re looking for. The market may see ups and downs and you may feel like you “lost” at times, but it historically has always rebounded and provided investors with the ability to build wealth over a long period of time.
Understanding Risk-Adjusted Returns
When evaluating the potential return of anything you’re going to put your money into, it’s important to understand what the potential performance is after you’ve factored in risk. Risk is essentially the probability of loss weighted by the potential degree of that loss. In an investment, you typically have historical data to compare its expected return to its corresponding risk. This is called the risk-adjusted return.
There are multiple ways to analyze what the potential risk-adjusted return of an investment might be. The two main methods for calculating this are below:
- Treynor Ratio: This is also known as the reward-to-volatility ratio. The ratio calculates how much excess is generated for each unit of risk that your portfolio takes. It’s calculated by subtracting the risk-free rate from the portfolio return and then dividing that number by the beta of the portfolio. This helps you understand how much your portfolio earned compared to the risk it took on.
- Sharpe Ratio: This ratio is the average return earned in excess of the risk-free rate per unit of total risk, or volatility of the assets. This is calculated by subtracting the risk-free rate from the return of your portfolio and dividing that number by the standard deviation of the portfolio’s excess return.
While both of these can help an investor calculate the potential earnings even with the risk they’re taking on, it can be tough to determine on your own. Investing in the stock market enables you to enlist the help of professionals who have spent years growing other people’s investment portfolios and they can provide these calculations and potential returns for you.
Bottom Line
Overall, investing is nowhere near in the same realm as gambling. Investing actually provides ample ways to make safer and more informed decisions than gambling does. Investing in the stock market has proven, over time, to be a significantly safer place to put your money than gambling.
However, both come with their own risks that you should consider before taking part in either. Keep in mind, though, that you can hire professionals to help you along the way as you try to grow your wealth through investing.
Tips for Investing
- While investing is a great opportunity to build your wealth, it can be difficult to create a financial plan and choose the right assets. That’s where a financial advisor can help. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You can use an asset allocation calculator to see the potential portfolio breakdowns based on the risk profile that you choose. This can help you determine how to safely invest in the right assets to build wealth the way you need.
Photo credit: ©iStock.com/hidesy, ©iStock.com/Farknot_Architect, ©iStock.com/zimmytws