Are Stocks Gambling?

[social_warfare]

A lot of women I speak to say they rather save their money in high-interest savings accounts or in GICs. When I ask them why almost all say because the stock market is like gambling to them.

Does this sound like you? If yes, read on!

What is Equity?

Stocks, or equity, is part ownership of a company. The best way to think of it as what’s left after you deduct liabilities from assets.

If we use the analogy of a house, the equity in the house is what left after you deduct the remaining mortgage from the market price.

Equity in a business works much the same way. But instead of leaving the equity locked up, the owners decided to split it into many pieces and sell them to the public. (When you hear companies go public, this is what it means)

What are Stocks?

When you buy these pieces of equity, they come in the form of shares.

In a world where you don’t buy or sell the shares, then you would only earn a bit of income periodically. As the company makes earnings from selling widgets or services, they collect a fee, after their expenses, the rest belongs to the owners.

In this case, the owners are you and all the other buyers.

Why Does the Price Go Up and Down?

If we go back to the example of the house, imagine this house was in a neighborhood that was becoming more and more desirable. Better schools are being built, lots of park space and crime was very low.

As more and more people become interested in living there, they are willing to pay more and more.

For the person who owns that house, their mortgage payment is still the mortgage payment. That doesn’t change.

As the market price of that house goes up and the mortgage remains the same, then that means the equity goes up.

Your shares also go up in price to reflect that.

Paper Money

Hold on! Something is missing. Just because the equity goes up in a house, it’s not ‘real’ because that person hasn’t sold it yet.

That is true. But now imagine if you decide you don’t want to hold the share of this house but want a share in another house.

You’d go around trying to find someone to buy this share from you.

Would you sell that share to someone else for exactly what you paid for it? Or would you want to sell it to them for the price that takes in to account the desirable neighborhood and the increase in the house price?

The second, no doubt.

This is what happens when the stock market is going up as a whole. The general economy is doing better and the conditions are good for business, like the neighborhood. The house price goes along for the ride too.

IPO

Now you might be wondering why the owner would have sold the equity of his house.

Say they wanted to build an extension or they wanted to renovate their existing house but didn’t have the money. If this was an individual, they might get a Home Line of Credit (HELOC) to do it. This is the same idea.

Why would you want to buy a share of their house? Maybe the owner rents out several rooms on Airbnb. With the money raised, more rooms can be added and renovations entice people to stay there rather than another place down the street.

As the homeowner increases the profits, they now have to share that increase with you and the other investors.

This is another reason stock prices can go up; when it’s expected that they will earn more money in the future.

How is the Share Price Determined?

Technically, the shares should reflect the value of whatever is left after all the debts are paid plus future income.

But sometimes, like houses, bidding wars start and a particular house might become overpriced. If all the houses on the street average $500K, and one particular one is selling for $800K, you’d wonder why is this house so special.

This is what’s called a peer group comparison. So all the tech stocks live on one street and all the bank stocks live on another for example.

Diversification

Isn’t betting on one house kinda risky, you ask?

Yeah, it kinda is. But if you’ve done all the steps like talked to the owner about how they are managing the Airbnb rentals and what is the maintenance schedule, got realtor reports on the neighborhood and a house inspection done, then you do take a lot of the unknowns out.

Still, there’s the risk of freak weather like flooding or maybe no one wants to rent a bedroom there, then you’re still out of luck. And that is the risk of investing in just 1 thing.

If that’s not your cup of tea, maybe you’d want to buy a bit of all the houses on the street. Or a bit of the house in the whole city. That’s what index funds and ETFs do.

They buy a bit of everything, put it in one pie and you can buy a piece of that pie.

This way if one street isn’t doing well, maybe a street on the other side of town is doing great and it all evens out.

But maybe you start worrying that this city isn’t as great as it used to be. In that case, you might want to buy bits of houses in other cities and countries… you get the idea.

Counting Cards

Gambling in stocks is different than investing. Where buying stocks do get into gambling territory is when the only reason you are buying a share is in the hopes that someone else will buy it from you for a higher price.

Generally, before 2008, we wouldn’t really buy a house without home inspections and without checking it out first.  We thought of homes as investments and so we took our time to find the right one, we did the home inspection, we did title searches and talked to neighbors about the property.

The idea of buying a house sight unseen was bonkers.

But in the run-up of housing since (at least in Canada), especially the heady days of 2017 in Toronto, people were snatching up houses, paying however much above asking and closing without conditions.  Everyone had based their purchase on the same idea: Another person will buy this house for a higher price when I’m done with it.

They were gambling on houses.

Does that sound like Bitcoin to you?

Yes the House Always Wins

This doesn’t mean that stocks are gambling and you’ll lose.  But the house does win over time.  Like a casino, there are lots of scenarios playing out, some play out and the casino loses and some play out and the casino wins.  As we have already guessed, the casino strategizes a way where they win more times than they lose.

The stock market is the same.  Over a year, you might see your digital money go up or go down.  From day-to-day, it’s nerve-wracking to watch.  But over a long term period, the stock market has “won” overall with more up days than down days.

You can see this more clearly If you zoom out and look at 5 years.  A Large dip like the one in 2008 was erased by the end of 2009.  Same with the dip we saw in Canadian stocks in 2015.  But the end of 2016, the market had gained back all that was lost and then some.

Zooming out 10 or 20 years, you see a pretty smooth line that just goes up.  This includes the tech bubble, the great recession and all the hiccups you hear along the way.  Sometimes it doesn’t even take that long.  $100 invested in the US Stock market in 2008 compounded into $10,000 by 2018.

Conclusion

Investing is never without risk.  Ideally, investing should be about buying into a company or an economy that you feel has the potential to grow.  As that country has economic success, the companies operating there have better chances because their conditions are improving.

Investing is buying into businesses.  Some times we make bad calls; like buying a couple of bitcoins at the top.  But not every company is like that.  Many companies are quietly doing their thing and sharing the profits with their owners along the way.

I hope you can relate to how equity can build your financial situation and can replace the idea that investing is like gambling.  With a bit of research, you can be an investor and leave the gambling to the casinos.

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