miercuri, 12 martie 2014

What is the difference between investment and gambling?

Few days ago I discussed with a colleague, if buying lottery tickets is an investment.
Both investment and gambling are influenced by hazard after all.
The gain from gambling is calculated as follows: the prize of the lottery * probability of your ticket to be drawn. For example if there are 1 million tickets your probability to gain is P=1/1000000. If the prize is 1000000$, your average gain is 1$=1000000$*P.
So the lottery ticket price must be <=1$ in order to have a fair game.

In investments, you don't know the prize, you don't know all the rules, neither other competitors, and sometimes you have to split the prize with your competitors.
While in gambling the probability of winning is fixed, in investment it is dependent of information.
The prize depends, how well informed other competitors are.
For example you are on an island with a surface of 1000m^2 and you  know that under the soil it is hidden a treasure chest with 1000 gold coins.
For this case the following graphic will show the evolution in time of your gain depending on information and competitors:


Without any information your investment is a gamble with probability P=1/1000.The average gain is in this case 1000 coins*P=1coin. The gamble pays of if cost of digging is bellow 1 gold coin/m^2

In time you will have more information about the treasure chest location (you find treasure map for example) so now you have a bigger probability P to gain  (1/1000
The gamble transforms into an investment because probability P of gaining is bigger than random probability 1/1000.
The ideal investment is done when probability of gaining is 1, in our case when have a treasure map and we go directly to the gold.
In time information slips to the competitors, who will arrive on island to compete with you for gold.The gain will be split betwee competitors so  your average gain shrinks 100 coins, if you have 9 competitors.

Some competitors invested too much in this enterprise, because they couldn't estimate how many competitors will be, so they will leave the island, and the gain will be split to a lower number of people, and your average gain will increase.

Conclusion:
1.Don't invest when all the people invest in the same thing. If everybody buys real estate, don't buy. If everybody buys gold or bitcoin, don't buy.
2.Exit from a market when everybody rushes in.
Joseph Kennedy said once that he started to sell his stock before the crash from 1929, when the door man started to give him advices about Stock Exchange.
3. If you information is superior to your competitors, you increase your gain probability and gain so keep your mouth shut.

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