Has anyone ever told you that they don’t invest because it’s no different than gambling? It’s a line I hear from time to time so I invited this week’s guest on to the show to answer this question once and for all. David Stein is the author of the new book, Money For The Rest Of Us, and hosts a podcast by the same name. Previously, for many years he managed billions of dollars for institutional investors so he knows a thing or two about the subject of investing.

Welcome to the Maple Money Show, the podcast that helps Canadians improve their personal finances to create lasting financial freedom. Have you heard the buzz about robo-advisors and would love to know how it all works? Thanks to our sponsor, Wealthsimple, you can now book a 15 minute, no obligation call with an experienced portfolio manager. Head over to maplemoney.com/wealthsimplechat to book your appointment today. Now, let’s talk about investing, speculation, and gambling with David…

Tom: Hi David, welcome to the Maple Money Show.

David: Thanks. Good to be here.

Tom: I was talking to you in person and one of the things we went into a bit was this idea of what investing, speculating and gambling was. It’s something I hear often where investing seems too much like gambling where they’re just sort of throwing their money in and hoping it does well. Can we just start diving into that a bit? Overall, how do you see the difference between these three things?

David: I got this breakdown from a gentleman named, Dr. Kingsley Jones. He’s in Australia. It was in a white paper where he was writing about binary options which clearly, in most cases, at best they’re speculating and often it’s gambling. But his distinction was that investing is something with a positive expected return. Speculation is something where there’s a disagreement between whether the return will be positive or negative. And gambling is something with a negative expected return. So what makes investing something with a positive return or expected return? Typically, it’s investing in something with income or cash flow stream. It could be dividends for stocks, interest on bonds, rent on real estate. But, you have some cash flow you can value. That, in and of itself, will generally lead to a positive expected return over time. Now, with investments, it depends on what people are willing to pay for their cash flow stream. That’s where you get volatility in the stock market. Maybe the price drops but you’re still getting that. Some investments don’t have cash flow right away. They could be some stocks that don’t pay dividends. But generally, the value of that stock is based on in its intrinsic value—what its future cash flow would be. The idea is that someday this company will generate a profit and you’ll have some cash flow from that.

Tom: With investing, when you mention dividends some people talk about how they could lose all their money on a company. But, assuming they don’t go completely bankrupt, there’s always that expectation of dividends no matter what the paper price of your stock is, right?

David: Well, it is. And most individuals shouldn’t be buying individual stocks. When I’m talking about stocks, I’m talking about buying a basket of 100 to thousands of stocks that you can get in an exchange-traded fund or an index mutual fund. You do not have to decide whether this company will do well or not. You’re just buying the entire asset class. As for a speculation—I’ll give you an example a speculation. The thing about speculation is you have to be precisely right. You buy a speculation because you believe it to go up in price. There is no cash flow. It could be antiques. It could be gold. It could be oil futures. Something where you’re hoping somebody will pay more in the future. And speculation isn’t bad. I mean, I own gold coins. I own some antiques. I own some art and other things. But I recognize that this could go in the opposite direction because there is no cash to value. So there’s no way to say this is what its worth. This is what Bitcoin is worth because there is no cash flow to value it. And so generally, I believe investors should have less than 10 percent of their net worth in speculations just because you could lose all your money. And oftentimes with speculations you should go in assuming (worst case) this is gone. And then gambling—you just do it for the entertainment value. You go to Vegas because you like to play the slot machines. But the way that gambling works is, like any type of investment or bet; you have to figure out who’s on the other side of the trade. Who am I trading with? With a casino you’re trading with the house. Well, if gambling had a positive expected return there would be no more casinos because they would go bust. But with that you know going in, you’re there for the entertainment. But the problem is people confuse and take these binary options. Most options are traded on an exchange. So there’s somebody on the other side of the trade and as a result it’s more like speculation. But some of these options you’re trading with directly with the exchange. In other words, that is who is on the other side of the trade. They’re not an intermediary. That’s just like a casino. If you’re trading with an entity—let’s say it is 4EX. You’re trading with this particular entity and they have it structured so they make money over time. Otherwise, they would go bankrupt too.

Tom: I’ve always liked the idea that if want to see who’s winning in a casino you just look at the casino. They’re in these fancy buildings and they’ve got all sorts of ways to comp people that are winning to make sure they keep them around and get that money back.

David: Exactly. Because that’s just the way the odds are. But it’s important as investors to recognize that. The question we should ask before we invest is, is this an investment? Is this a speculation or is this gambling? And understand the components of that particular investment, because oftentimes we just get too excited and don’t really research enough to figure out. Let’s say, crypto-currency. What has to happen to make money on this investment? What is the driver of that return? We should always look at what is influencing the return over time. With stocks, it’s easy. You know that over time it’s going to be that dividend cash flow, and the fact those dividends will increase over time (hopefully) as an economy grows. Then all you need to care about is what investors are paying for those dividends, or for that cash flow, or for those earnings. They’re paying a lot of money. If it were sort of in a bubble like we were back in the .com era in 1999 or 2000, you know they’re paying a lot of money for those cash flows—for those earnings. And if you pay a lot upfront that means your subsequent returns will probably be lower.

Tom: I love the Bitcoin example because I was asked this before at a talk I was giving. The question was how can we get started investing in Bitcoin? This was right at the height of everything—almost a couple of years ago now. It’s not investing, obviously. I totally agree. It’s also kind of after the fact. Much like gambling, if I knew what the lottery number was going to be ahead of time then yeah, I would put money down on that. But you just don’t know.

David: Well, you don’t. I own Bitcoin and other crypto-currencies. But I go in knowing this will work if people trust it. If they believe this will be a store of value and they trust it then Bitcoin will do fine over time because it’s limited to 21 million coins and it has a “first move” advantage. But I don’t own it any more if it goes to zero. I lose it and I’m fine with that. Most of your portfolio should be these investments where you have the cash flow; be it real estate stocks or bonds. Just because you can rely on it. You have that foundation of that income that drives a return and it’s not based on somebody else paying more down the road.

Tom: With Bitcoin, I didn’t realize you owned some. I’ve been too scared to actually have any feeling when I went to try this out, but you consider that more speculation than gambling then?

David: Yeah, it’s a speculation because, again, there’s some disagreement whether I’ll make money or not on it. With a gamble you’re guaranteed to lose money. It does have that negative returns so I consider that pure speculation. It’s no different than owning gold coins or a piece of artwork. You hope it’ll go up in value over time but you have nothing to guarantee that. And another thing, in a way, people say Bitcoin is a bubble. In order to figure out whether something’s a bubble you have to be able to say what it is worth. This is its intrinsic value. Typically, for most investments the way you determine the intrinsic value is you have this estimate of cash flow going out in the future and you discount it or take those future cash flows and put them in today’s dollars which is known as its present value. That way you can say, “Alright. I’m willing to pay this much for this potential future cash flow stream. This is what it is worth and I can decide whether it is worth more than what it’s selling for.” That’s what investor managers—hedge fund managers do. They’re always figuring out what the intrinsic value is of what they’re considering to buy. But with Bitcoin, because there is no cash flow or future cash flow, it’s just what it’s worth today. There isn’t a way to say it’s too expensive or too cheap. It just is what it is. Then when you buy it, it’s under the assumption you believe individuals will want to own this more in the future than they do today so they’ll be willing to pay more for it.

Tom: One more thing I think falls within speculating. Maybe I’m wrong because I know very little about it, is investing in commodities. I’m a very boring investor. I’ve got ETFs, a few dividend stocks. So something like commodities, I don’t really understand. Can you explain how that works? And, does that fall into speculating?

David: Commodities are definitely speculation. Let’s just focus on oil. The oil price will sell off. You live in Canada and, obviously, that’s a big component of the economy. Well, you can’t go buy a barrel of oil, right? ETFs are buying oil; they’re buying futures. The way an oil future contracts is, if you go long a futures contract you’re basically saying you’re willing to lock in a future price for oil and essentially promise to pay X amount of money in the future for this barrel of oil. Now, usually these contracts are set up where you just basically exit it at the end. You reverse the decision. But that’s what you’re saying essentially, “I believe let’s say oil is $60 a barrel,” the current price. The way future contracts typically work is let’s say it’s October’s contract (three months out) if might be $63 a barrel of oil. So that’s what the October contract is. In order to make money in oil, it isn’t enough that oil goes up in price it has to go up more than that future price that you entered into the contract at. In this case, $63. But there’s somebody on the other side of the trade that’s saying, “Alright, you know I don’t believe oil will do that,” or they’re speculating in that aspect. There’s always somebody on the other side of the trade. But it’s a zero-sum game. For every winner, there’s a loser which is another definition of a speculation because, if I make money in an oil futures contract, somebody lost money on that oil futures contract. That’s another way, when you’re thinking about this is, is it a gamble or speculation? Is it a zero-sum game? And it’s really important when it comes to commodities or 4EX or foreign exchange. A couple of months ago I was out shopping for a bed because they sponsored my podcast and I got tired of talking about a bed that I didn’t own so we went out and we bought bed. But the sales rep was way more excited about trading commodities. He was 65. He had never participated in his workplace defined contribution plan. He told me stocks were too risky. He paid $25,000 to go learn how to trade options commodities futures. And I was shocked. He said, “You have to invest in yourself,” and this was going to be his retirement. So I asked him where he paid this money at. I went to the class. I sat for four hours to figure out what it’s like. And they were very upfront. Their sales pitch to these individuals where they hadn’t saved enough, they’d say, “The only way you’re going to be able to save enough is to use leveraged asset classes,” which is basically what commodities are. A little bit of move and you can make a large amount of money. But they said they had a patent; a patent process. They didn’t share the patent but I found it and they were very upfront that the way you make money in speculations like commodities and foreign exchanges is you take advantage of naive traders; the people that don’t know what they’re doing. If you’re in a zero-sum game where there’s a winner for every loser, then you need losers that are willing to lose or that they’re not smart enough to win. And typically, that’s individuals because in most speculation markets right now who’s on the other side of the trade; it’s algorithms. It’s bots. It’s institutional bots. And that’s who you’re competing against. You can’t do that as an individual and be competitive anymore. Hedge-fund managers are leaving those. These were discretionary traders that would say they had all these networks to figure out; what the order flow was—what the supply and the demand is and who the big players are. They’re leaving because it’s all algorithms that drive it. And so as individuals we shouldn’t bother speculating in something where we’re most likely going to lose because we have no informational edge to compete with a robot that could trade way faster than we ever could.

Tom: Even with information—say you’re looking to buy a stock. Aren’t we still kind of competing against actively managed mutual funds? The managers behind those? I guess it’s not a zero-sum game because everybody can get some dividends. But at least on the on the buy, sell portion isn’t there still a loser there?

David: Yes. Although, hopefully, because of the income component the seller has made some money on it so it is. Zero-sum game means you definitely lost money having been on the other side of the trade. But you bring up a really important component when we invest in stocks. Who are we trading with there? When Benjamin Graham wrote his classic investment, book most stocks were owned by individuals. Graham was a very diligent researcher. He could figure out if a stock appeared to be mispriced. He had an informational edge so he made money because he was able to figure out that a stock was not correctly priced and that’s a key component. When you’re buying just the individual stock, you’re basically saying it’s not priced right—that the price is wrong, that the market is wrong. Because, again, what is a stock? The intrinsic value is the value today of this future cash flow stream which is driven by the expected earnings growth of a company. The other day I test drove a Tesla. I got back home thinking this is absolutely amazing. Maybe I should buy a Tesla stock. I don’t buy individual stocks but I was just tempted. But just because you think a car’s really cool or the company’s really cool, that’s a lousy reason to buy the stock. So I stepped back and said, “Alright, this company has no earnings. I have no idea how fast it will grow. But if I buy Tesla I’m saying that the market is wrong—that all these analysts that cover it and everyone else that researches it, that they’re wrong and Tesla’s going to do way better than everyone expects which is very different than to say that Tesla is going to sell a lot of more cars in the future. The stock has to do better than what everybody else thinks is going to happen. I’m not skilled to do that. And most professionals are not skilled to do that which is why most active managers underperform the market over time.

Tom: Exactly. And I guess this is where you always hear that things are already baked into the market. All this information’s already out there already so the price should be (more often than not) pretty accurate. We’re dealing with small changes often with trying to decide if that stock’s undervalued?

David: Well, no. I believe there are companies that definitely get overvalued. But as individuals, we’re not going to find them, typically. The market is interesting because in some ways it’s micro efficient. Most prices, most securities, most of time are priced correctly. But we do get bubbles. There are times where I mention the.com bubble that, for whatever reason, the market believes the growth rate of these companies are going to be very high and they’re willing to pay a bunch for that. And so you do get these asset-class bubbles. The way you know it’s a bubble is you can see what people are valuing that future cash flow at—let’s say a price-to-earnings ratio that’s way higher than what they have historically done. As an investor, I can adjust my allocation and maybe tilt away from that because I believe that is just too pricey. The market is driven by human emotion. And investors get emotional and at times they just get too exuberant. It’s easy to basically take advantage of that because you can buy an ETF or not buy an ETF. It gets harder when it comes to individual stocks because invariably there are surprises that come up. And then you’ve got to pay the fees and the trading commissions. It’s very, very difficult to do. As an investor, I like focusing on asset classes. And there are so many asset classes you can learn about. I don’t have to spend time deciding whether Tesla is priced correctly or not.

Tom: I think even with ETFs a lot of this still applies. Your president can send out a tweet and make the whole market go down.

David: Yeah, exactly.

Tom: So it all still applies maybe in a safer way. But I guess whole markets can drop too.

David: And they tend to drop significantly when the economy is slowing. In the US, the 10 of the top 12 bear markets have been doing recessions with an average loss of 40 percent. Overall, when the economy is falling apart that tends to be when markets have their biggest losses. As individuals we need to decide how much we should allocate to stocks versus cash. Can I write out a 50 to 60 percent drop in the stock market? And where am I and my life cycle in terms of how near am I to retirement? How big is my portfolio? Risk, as an individual, is not volatility. It is how much I can lose and what the personal financial harm from that loss would be. And if the personal harm is great, then you take less risk.

Tom: You mentioned riding out. I think that might be one of the biggest differences between investing and gambling is that when you gamble, you’re placing a bet whether it’s at a casino, on horses, buying a lottery ticket. Those all have a definite end and you lose 100 percent of your money. There’s just an obvious loss. But here, you can lose money on paper with investing and yes, you can ride it out. History shows that eventually you’ll end up on the plus side.

David: Yeah, but let’s say you’re two years from retirement. I’ve seen individuals go into retirement with 80 to 100 percent in stocks. If you’re a typical retiree who wants to spend four percent of the first year of your retirement—using the 4-percent rule, then you increase the amount you spend by the rate of inflation. But what if the market falls 50 percent? You’re not spending four percent anymore. Now you’re spending eight percent. Let’s say it takes five and I’d say it takes five years for the market to recover. If you run the analysis you’ll find that pool of money (even if the market recovers) will only last 25 years instead of closer to 40 years. Sometimes you don’t have enough time for the market to recover. The Japanese stock market has never recovered from its losses in the late 1980s, early 1990s. Theoretically, markets should recover because, again, it’s driven by capitalism. It’s driven by earnings growth. It’s driven by dividends. So they should recover but they don’t have to. You kind of have to play the odds as an investor. And that’s why in my opinion that cash flow is so important. Because that dividend—that interest is coming into my account. With speculation there isn’t, so you would be waiting a very long time. Now, if you bought Bitcoin at 19,000, it’s still at nine and it’s been several years. So it can take years.

Tom: Yeah, that’s tough. I guess that’s where diversification becomes so important. Not being all-in on Japan or Bitcoin.

David: No, no. We, as investors, are better to focus on asset classes. I have over a dozen different asset classes in my portfolio. Stock is just one element. But I have bonds and preferred stock. I have some speculations. I have real estate investment trust. I have land. You have public exposure, private investments because you don’t know what’s going to happen. So you want multiple return drivers—different things driving the returns. Some can be speculations but most should be investments; none should be gambles unless you want to go to Vegas and be entertained. In your investment portfolio there should be no gambles. And how does an investment become a gamble? We don’t really understand what’s driving it. If I bought Tesla stock and didn’t research the company and knew nothing about it, for me, it’s a gamble. Maybe I have a negative expect of return because I really have no idea what this particular company is or what this particular investment is.

Tom: It seems like it would always be a bit of a gamble to invest in a company that’s not making any money. There’s not much information to go on.

David: Right. And it has huge amounts of debt. Hopefully, they’ll do well. It would be interesting to see.

Tom: I hope so. If nothing else, they’re changing the car market across the board anyway so maybe you should be investing, like you said, in asset classes. Maybe you should be investing in all of these different car companies because, in their reaction to things like Tesla, they’re improving their own brands as well.

David: And they are. You’re right. And then it comes to a question of what people are valuing other car companies at? Certainly not as high as Tesla, but I’m not sure.

Tom: Yeah, but it might be those traditional companies that come out ahead in the long run. Tesla might just disappear.

David: I did an episode about a year ago on electric cars. Traditional car companies have the platform but they also have the skill in building out these plants. They know how to build cars. They know the logistics and that’s where Tesla has struggled. They have been in ramping up production for their Model 3 and building plants and that’s where these other companies thrive. Electric cars, at their core, are very simple. I was actually at the Tesla dealership and mentioned the car had two engines. And they said, no, they don’t have engines, they’re motors. Okay, it’s not an engine, it’s a motor. But yes, they’re very simple cars.

Tom: I’m hoping to rent one through Turo. That’s where you can rent people’s cars. You rent it out for a weekend and it won’t cost too much. It’s much cheaper than buying the car. Just enjoy it for a weekend.

David: Definitely.

Tom: This has been great. I think we really broke down these three different things, especially the speculating, I was a little hazy on exactly how that fell in so I appreciate this. Can you let people know about your new book that’s coming out and where they can find you online?

David: Sure. The book comes out in October 2019. It’s called, Money For The Rest Of Us—10 Questions To Master Successful Investing. Question number two asks if investing is speculating or gambling. What 10 questions should we ask and answer before we invest in anything? What I’ve found is, oftentimes we just sort of fall down into a rabbit hole. We’re going the gentlemen I mentioned in the furniture store. Suddenly he’s trading 4EX and if he were to just step back and ask these 10 questions; what is it, what is the upside, downside? Who’s on the other side of the trade? That’s one of the other questions we talked about in today’s episode. You can get more information on the book at moneyfortherestofus.com. And there is more information about me and my podcast and what I’m doing at moneyfortherestofus.com.

Tom: Perfect, thanks for being on the show.

David: Thanks for having me, Tom.

Thanks David, for helping us understand the differences between investing, speculation, and gambling. For a summary of this episode and to find out where you can preorder David’s new book, check out the show notes at maplemoney.com/davidstein. Are you enjoying the Maple Money Show on iTunes or Apple podcasts? Don’t forget to leave us a rating and review. Not only can it help the show grow, I read each and every review and value your feedback. As a reminder, please join us next week as we’ll have a special episode that was recorded live from the Podcast Movement Conference.