Investing Versus Gambling | The Mathematical Difference
In this lesson, we will uncover the mathematical difference between an investment and a gamble.
Contrarian to what many people will tell you the stock market is a giant casino and everyone playing is placing wagers. Instead of ignoring that fact, perhaps the better idea is to embrace and educate individuals as to how to gamble responsibly.
Wager - an expression of certainty.
Here is investing simplified.
Value the business.
Value the wager you are placing.
Construct a plan of risk management.
Execute the plan of risk management.
Let’s assume the following:
Price of stock: $5
Value of business per share: $10
The probability we unlock the value of the business: 60%
Dollar reward: $5
Worst case business value per share: $2
The probability our risk is achieved: 40%
Dollar risk: $3
What is an investment?
Based on the above information we can determine if purchases at $5 per share are an investment or a gamble.
Here is the formula we need to use to determine if we are gambling or investing:
($ Reward x Probabilty of Reward) - ($ Risk x Probability of Risk) =
Investment = Postive Outcomes
Gamble = Negative Outcomes
Let’s insert our assumptions into the formula:
($5 x 60%) - ($3 x 40%) = $1.80
A wager on the business at $5 per share translates to investment because it has a positive expected value.
What is a gamble?
Let’s assume that the price increase to $8 and the probabilities of reward and risk remain the same. Here are the new assumptions:
Price of stock: $8
Value of business per share: $10
The probability we unlock the value of the business: 60%
Dollar reward: $2
Worst case business value per share: $2
The probability our risk is achieved: 40%
Dollar risk: $6
Let’s insert our new reward to risk profile into the formula:
($2 x 60%) - ($6 x 40%) = -$1.20
A wager on the business at $8 per share translates to a gamble because it has a negative expected value.
The Price You Pay Determines The Value
Warren Buffett famously quoted, “price is what you pay, value is what you get.” I am willing to wager this is what he was referring to.
Estimating Probability
The question I most often am asked, “how do you estimate the probability.” I use a checklist and I weigh what I feel is important in getting my money out of the business and into my pocket. If you are looking to learn more about my techniques I encourage you to purchase a copy of my investing journal which includes my investing checklist.
The Self Destruction of Over Betting
Once you calculate your edge there is a simple way to value the mathematical maximum you can wager on a potential opportunity. These people are fundamentally wrong as soon as they place their wagers. Their thinking is toxic and will prove difficult to correct the behaviors that develop from fundamentally wrong education.
If you want to learn more about allocating capital like a professional become a member and subscribe to our members-only capital allocation course.
Share With Your Friends and Other Investors
If you found this lesson useful and know someone that would appreciate an invite to follow along in this free investing course do not hesitate to share with them. Who doesn’t love investing and you never know you could be the reason they invest into the next Amazon! But wait… let’s not get excited too quickly we have a lot of lessons before I teach you how to hit your first TEN BAGGER.
Use the links below to share with your friends!
Don’t Miss Augury’s Next
BIG Trade
One of Augury’s top investors says he’s got the next BIG trade that could generate returns of +1,000%. This is the same investor who called TNDM, a stock that Augury alerted subscribers at $3.00 before it shot up to $120 per share returning an amazing 3,900%.
Get access to this stock now!