Is Investing In Stocks Like Gambling?

Several times in my short career as an economics professor, I have had someone tell me that investing in the stock market is morally questionable because "it's like gambling." Certainly the unusual volatility we have seen in the stock market over the last several years has, like a lottery, enriched some and impoverished others. But is buying a share of stock like buying a lottery ticket?

Gambling and stock market investing both involve risk-taking, but this does not equate the two. Taking risk is inherent to diligent and productive work (Proverbs 22:13; Ecclesiastes 11:4). Gambling is consumption — it is done for the entertainment value of taking a risk. Stock market investing contributes to production — it is the taking on of risk as part of providing a valuable service. Because gambling is consumption, a gambler can expect to lose money, on average. An investor in the stock market can expect a considerable return, on average.

The Problem with Gambling

Gambling, reduced to its essence, is the exchange of a dollar for an expected return of somewhat less than a dollar, sometimes accompanied by blinking lights and spinning wheels. Now, we cannot say that gambling is wrong because it is entertaining, nor can we say that it is wrong because it is risky. We cannot even say that it is wrong because the gambler is likely to wind up poorer, for there are plenty of legitimate activities that cost money. A gambler is engaged in morally questionable activity because he is deriving entertainment from that which ought to have no entertainment value, like one who laughs at a car accident. A gambler takes that which is certain — a bird in the hand — and exchanges it for that which is uncertain — a less than 50-50 chance at the two in the bush. Gambling is entertainment for people who enjoy risk and uncertainty for their own sakes. The Bible encourages avoidance of risk (Ecclesiastes 11:1, 2), not reveling in it.

Why Stock Prices Change

People who believe the stock market is like gambling apparently misunderstand the source of fluctuations in stock prices. What seems like random movements or the product of mass psychology actually has a rational economic explanation.

This may be difficult to believe, given the rapid changes in the value of, say, Internet stocks in the last five or six years. First they increased at a rapid pace, even for a few firms that could not show a profit. The closely watched P/E ratios — the ratio of stock price to actual earnings — began to rise to stratospheric levels. Then, as though stockholders had suddenly and simultaneously lost their trust in these firms, the prices began to fall. Had the stock price lost all connection to a rational assessment of the firm's value? Most people seemed to think so. Yet it is not necessary to appeal to irrationality or mass psychology to explain these changes. A firm's stock price is a reflection of the firm's expected ability to produce earnings. Expectations change with new information, and with new interpretations of old information. Therefore, while the actual earnings of a firm may change only gradually, new information can appear instantaneously that causes people to re-evaluate the firm's prospects.

Stocks are generally traded for two reasons. The first is that each individual's investment goals will change over time, and each person will want to change his portfolio to reflect his tolerance for risk, need for income, or liquidity. The second reason is that the person selling the stock has a lower view of the firm's prospects than the buyer. The seller's opinion could be based on unique information he has which the buyer does not, or it could be that the two parties to the transaction simply have formed different theories about the same information. Some have said that selling stock during a boom is a matter of finding a "greater fool" to take the stock off one's hands in exchange for dollars, but this is a matter of perspective.

Market Speculators

Speculation in the stock market — buying now in anticipation of selling at higher prices later — is valuable and completely moral. Firms that discover ways of being more productive will be recognized by stock-market speculators, and their stock prices will rise to reflect the higher market value of the firm. The firm will benefit directly because its debt will fall as a percentage of its recognized market value, making it easier for the firm to borrow more if it chooses. Later, the firm may find it easier to raise capital by selling new shares of stock, perhaps for higher prices. Because of the information provided by speculation in the stock market, firms with good ideas are recognized early and rewarded with easier access to capital. Firms with poor management or other problems are denied capital. In return for performing the valuable service of identifying more productive firms, the speculator receives compensation in the form of capital gains. Though stock traders are often denigrated as not really "working" for their living, they are some of the most important individuals in society. Speculation, and the information it provides, are indispensable to wise stewardship of resources.

Does everyone who invests in the stock market have this ability to judge, this skill in evaluating the future prospects of firms? No, of course not. However, over time, those with poorer judgment tend to lose money and be discouraged from future investment. Those with exceptional abilities may "rent" their skills to others for a fee — leading to a class of professional investors who handle funds for the less capable. Yet all investors have one common trait — a willingness to put off consumption and devote resources instead to that which makes the economy grow in the long run.

As we have seen, investment in stocks provides us with valuable information — a constantly changing market assessment of the values of corporations. This should not be confused with gambling simply because of the risk involved. Instead, we should appreciate participants in this market as future-oriented contributors to long-term economic growth.