THE BLOG
05/30/2012 04:21 pm ET Updated Jul 30, 2012

# Why Investing Is Always a Gamble

We all know investing is risky. People can lose a lot of money as well as gain from investing. But most people never ask, "What kind of gambling is investing?" Why is this important? When it comes to investing people often confuse the need for luck with the need for skill.

What is a stock?

A stock is "a piece of the pie." But what is that pie worth? How much is our piece of the pie worth? After an IPO takes place, it's anyone's guess how much a stock is really worth. At the end of the day, the price of a stock is set by trading (i.e., betting on whether its price will rise or drop). The more people bet that the stock's price will rise, the more it does rise, and vice versa.

Two types of gambling

Gambling games are based on two mutually exclusive principles: (1) the law of probability, or "pure luck" and (2) human intelligence.

Probability betting

The law of probability from statistics says that over time a tossed coin will come up heads 50 percent of the time and tails the other 50 percent of the time. This law dictates how high a bet to place on each choice in a game of craps. It determines the "odds" of a ball landing on each number on the roulette table or the chance of getting a particular combination of cards in a poker game.

Probability governs games found in casinos. "Casino betting" involves the manipulation of inanimate objects like coins, dice, cards or balls. Luck or "chance" brings the gambler good or bad fortune in these kinds of games.

When it comes to probability it doesn't matter whether a human being picks out the marked balls that lead to a cry of "bingo" or if a machine mixes up marked balls and spits them out for the weekly state lottery. Either way, "luck" determines the odds of an outcome.

Pari-mutuel betting

In pari-mutuel betting, on the other hand, human beings pit one person's opinion against another's to predict the outcome of an event involving living beings: e.g., horses, dogs, gamecocks, athletes, etc. Bettors' money is pooled. Those who make the best "guess(es)" about result(s) of the race or contest win.

Pari-mutuel betting refers to betting at the race track and sports betting. Pari-mutuel gambling involves human judgment, not just luck. For example, in a sport like basketball those who understand concepts like "high percentage shots" will have a significantly better chance at predicting which basketball team will win.

Hybrid gambling games

Sometimes the line between the two types of gambling gets blurred. For example, Texas hold 'em is a form of poker, a card game. Hold 'em would appear to be based on the law of probability and it is. However, it has a strong pari-mutuel component.

It matters where you sit when you play. "Players who act later have more information than players who act earlier" (Wikipedia). Hold 'em players can fake out one another. A player with cards that are worth nothing can still win the pot by "bluffing" other players' expectations.

Texas "hold 'em" poker is a "hybrid" form of gambling involving human wisdom. Poker slot machines are "casino gambling" based on pure luck.

Implications for investing

It's crucial to understand casino versus pari-mutuel gambling. Investing is neither a casino nor a hybrid game; investing is pure pari-mutuel gambling. Investing is based on "subjective probability" rather than the law of probability. In investing, the more one knows about a company, its industry and the stock market, the better chance one has of making money.

This has implications for issues such as, (1) SEC regulation, (2) broker conflict of interest, (3) proprietary trading by investment banks, (4) insider trading, (5) use of the stock market in place of Social Security, or (6) investing theories such as the Random Walk.