Diana Clement: When investing becomes gambling

I'm taking a punt on this investment.

How often have you heard this? And is it gambling or investment to "take a punt"?

The answer may be that it depends on the individual, his or her investing knowledge, risk profile, time scale and capacity to soak up financial losses.

As one website I visited pointed out the definitions of gambling and investor could be interchangeable.

One definition of gambling in my trusty Oxford Dictionary is: "Take great risks in the hope of substantial gain" and for investing it says: "Put money for profit into [stocks etc]".

Most people would consider playing the pokies, betting on the horses or visiting the casino to be gambling - although not automatically problem gambling. But what about investing in shares, residential property, derivatives and other "investments".

The line, of course, is fine. Venture capitalists take great risks and the odds are probably often against them. But are they gamblers? Probably not if they fully understand the risks and can afford them. Gamblers tend to deny the reality of what they are doing and the risks involved.

CFA president Mark Brighouse, a chartered financial analyst defines investment as "using money for profitable return", but says that gamblers often have the perception that they are doing the same.

There are times when investors put money into stocks or other investments without understanding the risks. Ask any Blue Chip or finance company investor now if they were investing or gambling and the honest ones will say the latter.

It was the same in the late 1980s, says Jeff Matthews senior financial advisor at Spicers Wealth Management, when Joe Public often had little idea what the companies they were investing in on the New Zealand Stock Exchange actually did.

"People would say they were 'having a punt' on the sharemarket," says Matthews.

And of course one man's investment might be another man's gamble. Bryan Wilshire, Executive Director Gambling Helpline, says his view is that if you can't afford the loss of the value of an investment only then does it become a gamble.

That's the same in his opinion whether it's shares, lottery or raffle ticket, horses, dogs, property speculation or pokies that you're putting your money into. "And I have probably missed a few," he says.

"For some buying a school raffle ticket for 50c with an end opportunity of a chocolate cake is not considered gambling as the world is not lost if the cake does not appear.

"Do people knowingly invest in a high risk venture in the hope of a quick high-value return? For some this will be a gamble and for some this will be an investment."

The investment circuit and problem gambling circuit in the brain may not be that far apart - especially for those investors who have high risk profiles. The investor typically benefits from his or her behaviour and the problem gambler suffers. Interestingly a variety of mental illnesses and gambling addiction are characterised by risk taking.

Brighouse just happens to be reading a book called The Drunkard's Walk-How Randomness Rules Our Lives, which discusses investment and gambling in the same tome.

In one classic 1975 study, reported in the book, male undergraduates at Yale University were asked to predict the results of coin tosses, a cliched example of a random event.

The human brain is programmed to recognise patterns, but the programming is faulty, says Brighouse. "When you apply that to the spin of the roulette wheel, you will continue to look for patterns."

In the Yale experiment many of the men believed that their performance improved through practice - they got better at calling heads or tails - and that distraction would detract from their performance, says Brighouse. They justified the wishful thinking with some sly cognitive filtering and consistently "over-remembered past successes".

It's the same for people who experience beginner's luck with their investing. They might have had some good luck or even been carried along by a bull market, and think that they've discovered a pattern thanks to their own prowess - fuelling more desire for the risk they are taking.

While few investors seemed afraid in recent years of the many companies selling investments that have since fallen over, an awful lot of New Zealanders think that investing in the stockmarket is gambling.

I raised both eyebrows when the annual RaboPlus Financial Confidence Index was released last week to find that only 23 per cent of a 1000-person sample thought that share brokers "provide good products and services" - even though you're buying a share of a company that has a track record of profits.

That perception, says Matthews, has been fuelled to some degree by the Green Party and others who accused the Government of gambling by investing the New Zealand Superannuation Fund in equities.

Another key factor was the 1987 stockmarket crash. Many baby boomers in particular had their first taste of investing in the stockmarket in the 1980s and have had it etched in their mind ever since they made losses that shares equal gambling.

Matthews says he gets clients with large superannuation pots that baulk at the idea of investing some of the money in shares - even though the money had been invested in the equity markets in order to have grown to the level it had.

It's true that equities carry risk and some are more risky than others. But more risky is putting all your money in a single equity.

The payoff from a single share is quite uncertain, says Brighouse. "Diversification of shares improves the certainty of a positive payoff in a way that repeated spins of a roulette wheel do not."

The exception to this rule is business owners who put all their money into their business. They have the added advantage of controlling the business, which investors in individual equities don't.

Matthews knows a small number of clients who have made more money by investing in fine art than they have in more traditional investment classes. They, however, fully understand the business they're in.

At the other end of the investing scale are wannabes who fancy themselves as knowledgeable, but may as well plough their money on to the roulette table. That's not just the case for equity investments.

In the last property boom it was nigh impossible to convince people that there was any risk in residential property. After all, we talk about being as safe as "bricks and mortar".

But you just need to look at the numbers of mortgagee sales affecting investors at the moment to realise many were gambling. They were buying investments that they couldn't afford to pay for, says author and property commentator Olly Newland, and when prices didn't keep rising they got into trouble.

"The gambling starts when people buy residential property knowing from day one it can't produce the income to support itself and they are hoping for capital growth within a year or two," says Newland.

A certain type of property investor in the latest boom would revalue his or her properties every few month to pull a deposit out to buy more properties.

They might have ended up owning 10, 20 or even 100 properties, with virtually no equity in them and when property values dropped, they were in negative equity. If they were also negatively geared and could no longer top up the mortgages, their empires were at risk of falling.

One of the big problems that has led residential property investors to gamble was the disconnect between the people running investment seminars and the people that attended, says NZ Property Investors Federation vice-president Andrew King.

Risk is a continuum, he adds, and where investment risk falls over the precipice into gambling differs according to individuals' own circumstances.