Is Investing in Individual Stocks Merely Gambling?

I have a lot of fun following individual stocks in my spare time. I keep tabs on a small handful of companies that I have a personal interest in – Apple, Nintendo, Herman Miller, and Ford, namely. I watch for news articles on the company, read their annual and quarterly reports, and stay up to date on pretty much everything about the organizations.

For a short while, I owned individual shares in Apple and Herman Miller in mid-2007. I bought into Apple in late July, purchasing about 40 shares when the stock was at 140. Over the following three weeks, I watched Apple drop like a stone to below 120, then I sat there through late August and early September as it rose back up to 140. I sold immediately. Over the same rough period, I bought 50 shares of Herman Miller at 32, watched them sink and struggle to rebound, and sold the shares in late September at 29.

In the end, I didn’t lose too much money. What I did lose is a lot of sleep. The second I owned those stocks, I became obsessive over those two companies. I read every single morsel of information that came out about them, read reports, studied numbers, sweated, didn’t sleep at night, and a few times I even queued up panic sales of these stocks.

The second I finally sold all of them, I felt much better, and I walked away with a bitter taste in my mouth. Individual stocks are basically gambling pretty much sums up the way I felt and since then, I’ve barely written or even thought about individual stock investing.

But is that the right lesson to take away from the experience? Let’s dig into the idea a bit.

Individual Stock Investing 101

Information Games

Most forms of gambling that aren’t merely chance, such as blackjack and poker, are games of partial information. You know some of the information out there – the cards you hold, perhaps some of the cards the dealer holds, any revealed cards, and the “tells” that the other players have shown you. At the same time, key pieces of information are hidden – what the others are actually holding.

The same statement is true of stock investing, except the story is a bit different. Most of the information you’d really need to know – in fact, virtually all of it – is right out there for you to see. The only problem is that it’s like trying to find a water droplet at Niagara Falls – there’s so much information out there that processing it all is impossible.

As a result, stock investors often choose specific pieces to focus on. Perhaps they look at the P/E ratio for a company, or maybe they look at the backgrounds of the company leaders. I’ve read tons of books about different strategies, but most of them boil down to isolating a few key pieces of information about companies and using them as a judge about when to buy and when to sell.

The problem is that no individual metric is perfect. One can’t ever boil down the complexity of Apple’s entire business into just one factor. What would happen to Apple’s stock if tomorrow morning Steve Jobs dropped dead of a massive heart attack? Do you have any idea? Obviously, it would go down, but how far would it go down? Would Apple weather that storm? Those are both huge unknowns, but investing in Apple stock means you’re making some sort of prediction on those questions. You’re using one view of the information to make a judgement about a whole company.

The Investor Mindset

Some people respond to this glut of information and the inherent risks quite well. They focus in on specific things and just blot out everything else. They do the homework they need to do and walk away from it. Are these people gamblers?

What about others, like myself? When I was invested, I was almost driven crazy by the desire for more information. I knew that there was more to know about where my money was sitting, and I needed to know it. Am I an information addict?

Personally, the risk itself didn’t bother me so much – I was merely overwhelmed by the actual level of information in that information game. But what about a person who knows why he’s investing, but is ready to throw up after a 1% drop? I have a close friend like that – he basically can’t invest in anything that isn’t fully guaranteed. Is that person far too conservative?

It all comes down to personal makeup and psychology. Some people are predisposed to play this information-rich game; others simply aren’t. I put myself into the “not predisposed” category – I could invest if I had money that was truly “play” money, but not if anything of any importance relied on that money. It would move from being a dalliance to being an obsessive information hunt – and that’s the result of my psychological makeup, not the game itself.

Mister Market

So far, all I’ve really done is convince myself that stock investing really is gambling, but there’s one big factor that draws me back from making that leap. It’s the fact that the stock market as a whole grows in a positive direction, not a negative one.

In a typical gambling situation, the house “rakes” – meaning that the house takes some small fraction of the winnings. In stock investing, the “house” (in other words, the stock market as a whole or, for that matter, capitalism as a whole) adds to the pot over time.

How does that happen? Over time, innovations make it possible for companies to produce more and more with the same amount of resources. Think computers, for example – they’ve radically changed almost every industry. Innovation has a lot of different effects, but one of the big ones is that it constantly adds more value to the company itself in the form of increased productivity. The result is that all companies gradually become more valuable over time, simply because they can produce more with what they have – or produce the same amount they always have with less resources.

Think about a patch of farmland. Two hundred years ago, a farmer grew whatever corn he could lay his hands on, tilled a few acres with a horse drawn plow, tossed the seeds into the ground, and hoped for ten bushels of corn production per acre. Fast forward to today: tractors, fertilizer, and hybrid corn now make it possible for that same patch to produce 150 bushels of corn per acre. That means the entire farm is more valuable – and thus shares in that farm are more valuable now as well.

Over time, value is constantly added to the stock market (assuming everything else stays the same – when the market goes down, something else is changing). This addition of value is the one real difference between stock investing and traditional gambling.

My Conclusion

Individual stock investing is something like playing blackjack at a casino where, on every hand, the dealer is wagering just a little tiny bit more than you, but there are thousands of people around you shouting out suggestions. If you can concentrate enough and take the time to sift through the information overload correctly, you can potentially go on a very nice winning streak – and the odds are slightly in your favor. At the same time, though, as with any game where you don’t have all the information, you can very easily go on a losing streak.

My solution to all of this – and the solution that leaves me sleeping well at night – is to buy index funds. That’s kind of like going to that casino and playing 5,000 hands at once with earmuffs on. Because of the huge number of hands, the luck of any individual hand is negated and eventually you end up with a small overall win without the stress, time, and focus needed to win at an individual hand.

I think investing in individual stocks is a fine diversion and a potential way to earn a lot, but far from a guarantee and the work needed to get those earnings is tremendous. For the casual investor who hasn’t invested the time to really learn the game and the investment and learned how to fight through the information noise, individual stock investing might as well be gambling.

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  1. I think people, and I have done this myself, can make a mistake when they buy a stock b/c they like the product or company, as opposed to making the purchase based on whether the stock is a good buy at that price. At some point, even the best run company in the world would not be a good buy if the price was too high, and at a certain lower price point it is a bargin. Frequently, stocks in popular companies become even more popular after the stock price has risen substantially, but that is probably not the best time to buy. As you mention, I think index funds are a great way to take personal emotion out of the equation as well.

  2. Aldo says:

    Really what an investor needs is a bit of inside information. Currently illegal, but widespread (universal-spread, actually). http://en.wikipedia.org/wiki/Insider_trading#Arguments_for_legalizing_insider_trading

    Insider info is how real money is made on the stock market.

  3. The whole “information obsession” is also why I don’t mess with individual stocks. Like many others, I bought a few stocks and lost everything. When I did own them I was constantly looking for updates. I don’t think individual stocks are a sustainable investing strategy. The idea of investing in index funds – investing in a whole economy makes a lot of sense, especially if it’s just a couple broad funds.

  4. frequent reader says:

    1)Great site, good move on joining the self employed!

    2)I definitely agree with the article that funds are the way to go instead of individual stocks.

    3)I’d have to disagree with this one line -
    “Most of the information you’d really need to know – in fact, virtually all of it – is right out there for you to see.” The real info you need to invest in individual stocks (before stock prices have already changed) is locked inside the heads of those executives inside the company. It goes from there to their investment bankers who then make large movements with fund assets. Once it gets out to the public or into a government filing, it’s waaaay too late for the average investor to have any chance of reacting to avoid a huge loss or a picking up a potential bargain.
    I’m all for long term investing, but from my experience, these “news” items have a tendency to 1)wipe out years worth of gains (ie one quarter of missed earnings cuts 25% off a stock – don’t tell me that was unexpected) or 2)have a relatively huge run up in a matter of hours/minutes (ie a rumor of company x hinting at a possible acquisition of company y when y co stock price hasn’t changed in 3 years) — but this just reinforces the main point of the article, investing in individual stocks is gambling

  5. John says:

    I can’t wait until you read “The Intelligent Investor”. I haven’t finished it yet, but you just summed up a lot of the broader points. He basically says that being an “enterprising investor” can give one big gains, but unless you have some skill in it, and the time necessary to make it your profession, stay away. Be a “defensive investor” instead and invest in cheap index funds. Trying to play it half way gets you the benefits of neither and the detriments of both.

  6. Badger says:

    I think that this post is spot on. Index funds are definitely the way to go for most people, and there is no shortage of experts who say the same thing–even Warren Buffett has said so. While I’d love to play around with some individual stocks, I’ve resisted so far because I know I’d end up the way you described–obsessed by daily fluctuations and losing sleep!

  7. KC says:

    I think you took the right approach when owning individual stocks – you became obsessed. If you own indiv stocks you really should read nearly everything that comes out about them – including those dull quarterly report. And if you are diversified adequately then you would be looking at five or more stocks with this “obsessive” manner. That’s about 10 hours a week of research – most people don’t have time for this. That’s why index funds are right for most people. But if you do own individual stocks then you gotta put in the homework or you will get burned.

    Personally I’m a little of both. I have about half in index funds and the other half in a handful of well-known, strong, dividend paying stocks. I also don’t work, so I have time to pay attention “obsessively”. When I worked I owned fewer individual stocks – just didn’t have the time to pay proper attention to them.

  8. bp says:

    I think the blackjack analogy confuses some subtle issues. Unlike blackjack, for extended periods of time the market isn’t in your favor. In blackjack, its free to pull some of your chips aside, you don’t have to let it all ride on every hand. “Gambling” with stock there are transaction costs every time you buy and sell, by the time you add in these costs, inflation, and taxes, your “winnings” are not nearly what you think they are. Moreover the stock really needs to be a homerun to be worth your while because you have taken a lot of risk.

    That said, individual stock investing is gambling, it’s a gamble to think you know more than everybody else (ie the market).

  9. Credit says:

    Unfortunately, you are still primarily only invested in a few undiversified assets with the Vanguard 500. You may feel more comfortable than with the individual stocks, but you should do the same amount of research into the holdings in the index fund. Research should indicate to you that previous earnings growth rates are not sustainable and that the fund is a poor investment. You are right that investing in an index fund takes the misguided passion (excitement about products, etc.) out of the equation, which is good, but you miss the point about diversification and understanding what investments you hold.

  10. Bear says:

    Trent, you took the exact opposite approach to buying stocks that you should have. As a mildly successful day trader (I made more this month from trading than my real job), I can tell that you became emotionally invested in your particular stocks, which will only cost you money. As a trader, if I bought stock and watched it move against me, I would sell (cut my losses) and find something better. You took the approach that millions of people who invest in individual stocks take: “I really like this company, so I want to invest in it.” That is fine to do, but you should only do that if you plan on never letting go of those shares, and should hold them because you really like the company and want to own a piece of it. Don’t expect to make money when you invest with emotion!

    People who make money picking stocks do it unemotionally, by the numbers, and are not afraid to cut their losses when a position is seen to be unprofitable. Think of it like a casino analogy. The casino only has to win 51% of the time. Traders only have to be profitable 51% of the time, as well, if they are working with enough volume. Hopefully much more, but that is part of the game.

    Picking stocks is not gambling, which is why there are people that do it for a living. It is possible, but only if you are dedicated to it, and actually enjoy it. Just remember that you are competing with thousands of other traders/investors that are professionals and their income depends on thier ability to take money from the market.

    Good traders (people who do it for a living) love seeing people like you get involved in buying individual stocks, because they will take your money every time.

    If you think that the stock market only goes up over time then you are sadly mistaken. Many people thought that housing only goes up over time and I’m sure they are doing real good now. Don’t expect to see the kinds of meteoric gains that we had in the 80s-00s ever again. Many people investing in the markets for retirement are going to be very sad when they turn 60… Best of luck to you all.

  11. Bill says:

    It’s a money-losing hobby.

    No one posting here has the ability to visit a company and get the access to review it “on the ground”, as any mutual fund manager does.

  12. Frugal Dad says:

    It comes to time for me. In order to buy and hold single stocks it requires a truckload of homework (to do it right). I just honestly don’t have the time to research companies, follow their every move and react accordingly. if I were to invest in single stocks, I would limit it to 5-10% of my overall portfolio.

  13. Andy says:

    I use MSN CAPS for a lot of the research help with individual stock buying. There are thousands of players on there who do the research for you and the system works pretty well. I have a 401k and have a little bit of money in index funds, but I do individuals for fun. I think it is a healthy hobby.

  14. It is all n how you approach it. As a dividend investor, I take a long-term view and thus do not watch my stocks on a daily basis. the key is selecting fundamentally sound stocks and let it ride. As a dividend investor, i get excited when the market is down because it drives the yield up.

    That’s not to say you can’t gamble with stocks. Many do it.

    Best Wishes,
    D4L

  15. adam says:

    Looking at your investments its no surprise you were disappointed. You invested money in 2 computer/electronics companies, a cyclical, and I don’t even know where to put Herman Miller. These are all very very highly covered stocks and they move around a lot based on each bit of news. While its very good to follow the news on a company, it should only be for you to keep up on its story not to follow the price of its stock from day to day. Don’t forget this nugget of advice: ‘in the short term the market is a voting machine. in the long term its a weighing machine.’

    I’m not sure why you felt the need to sell these investments unless you didn’t believe they were fundamentally good companies anymore.

    While I like having some money in an index fund, I think its entirely possible to have 5-10 individual investments that you can keep tabs on with less than a few hours a week if you are looking to buy with a fairly long-view of things.

  16. Bill makes a good point. Its difficult to price a company without knowing the ins and outs. Microsoft had been to the Yahoo camp and knew their business before making a (though underpriced) bid.

    For example: A tech analyst for JP Morgan specializes in Apple (AAPL). This guy has working relationships with manufacturers in China, he joins Jobs on the phone for stockholder meetings. Individual investors don’t have this kind of access.

    Like Dividends, I have some long term holdings in companies that pay money every quarter. I also work with a network of investors. Together, we test investing strategies so that we all use very little capital. Being a finance major, I can’t help but test the theories my professors write about.

    But for 99% of my money, its index funds baby.

  17. Ryan says:

    Ugh, that just reminds me of when I was in school, recommending to my Investment Analysis class to buy Apple shares at $16. That was the day before iTunes dropped. My teacher said I was completely wrong on recommending Apple. And now look. Easily over $100. Too bad I didn’t have any money in college, or I would’ve bought some shares.

  18. chris says:

    You should diversify and buy for long-term (unless you are a day trader). Long-term means at least 5-7 years. Over the long term stocks give you a return above inflation.

  19. Trey Atkins says:

    I have enjoyed your web-site over the past couple of weeks and appreciate the work you put into it. However, I could not disagree more with your “buying stocks is gambling” analogy. Why? Gambling results in either a win or a total loss. Even in your example of buying at $32 and selling at $29, you have lost only a little less than 10%. Much better than the typical 100% loss associated with gambling.

    Trey

  20. Coyote says:

    I have been spending a little bit of time lately listening to and talking to professional investors. And what I have come away from it is this: For the professional, making money in the stock market (or Forex, or Real Estate, or what have you) is EASY. The trick is knowing how to minimize your losses, which will easily wipe out your gains if you don’t know what you are doing.

    The best solution I have heard for straight-up stock trading is a combination of value and growth investing. Find a company with demonstrated growth in major indexes for the last several years, research its management as best you can, and then buy it at a time when the market seems to be greatly underestimating its value.

    If a company is growing at 20% a year, its stock value WILL eventually get it right. And if you buy it at half-price, you’ve got potential for some big gains.

    Of course, estimating what its real value should be is something of a black art even for the professionals.

  21. Phil A says:

    What about bonds? Which is better-buying individual bonds or bond funds?

  22. Trent,

    Did you have an exit strategy when you invested in those stocks? (I don’t think so)

    Why didn’t you buy less number of stocks? It would have still given you the engagement with the individual stocks without loosing sleep over the dropping price.

  23. Phil A says:

    Is it gambling if you buy shares of a well established company and hold those shares for 35 years?

  24. George says:

    Trent -

    The reason you liken your stock experience to gambling is that you weren’t investing in stocks, you were trading in stocks.

  25. Gayle RN says:

    You were indeed gambling, Trent. You did not have a plan. You saw something shiny, bought it, but you didn’t really know what it was made of. Investing in individual stocks is hard work requiring discipline. When I find a likely candidate for purchase I have a formal written checklist that I have to go through. This helps to organize that mass of information. After that I run a series of calculations to figure out a purchase price. After purchase I put in a stop order to prevent massive losses from unanticipated events that I have no control over such as 9/11. Selling discipline is even more important than buying.

    For me, the work has been worth it. The more you do it the easier and faster it gets.

  26. Derek Wong says:

    Definitely think that this is a controversial post. But it is very in line with what I believe. For me personally, I don’t care to spend the amount of time to truly get invested into a company. But I will freely believe that the general stock market is on the upswing. It’s similar (but also markedly different) from roulette where you can either wager on a particular number or on black or red. However in my case, I’m betting on everything going up rather than going down rather than on a particular stock/number. Okay similar but also very different. Best analogy I could think of.

  27. alasdair says:

    “Most forms of gambling that aren’t merely chance, such as blackjack and poker, are games of partial information. You know some of the information out there – the cards you hold, perhaps some of the cards the dealer holds, any revealed cards, and the “tells” that the other players have shown you. At the same time, key pieces of information are hidden – what the others are actually holding.”

    As both a poker player and an AI researcher, I can assure you that poker is not “merely” a game of chance.

    It’s true that poker is a zero sum game, but unlike (non card counting) blackjack, it is possible to have an “edge” in poker that can translate to a greater than 50% chance of making money.

    If you have a positive “Expected Value” and play long enough, you’ll come out ahead.

    The same thought can, in theory, apply to individual stocks. With enough research (better than the aggregate), you can make money trading. It’s hardly a sure thing, however.

  28. I don’t like to see individual stock investing being called straight out gambling like that, but I understand where you’re coming from—I own only index funds except for two stocks.

    For people that are invested in over 8–10 stocks, I doubt they have the time to properly keep tabs on all of them. But still, it’s not gambling. Sure, nothing is 100% in terms of picking out winners, but nothing in life is. There is some serious money to be made on individual stocks.

  29. anonym says:

    i’m wondering why you all agree that index funds will go up in long term always.
    on the one hand there can be a really long period where they go down and it takes a lot time to get into positive range again – maybe too long for some of us.
    and second: it’s always cited “the history shows that in long term the share market gives high return”, but this misses the fact that the financial markets changed heavily during last ~10-20 years. 20 years ago stock market was done by a view traders in real trading rooms. today hedge fonds, direkt brokers, realtime charts for everyone, internet, … capital globalization have changed everything and predictions can imho not be made by looking into past.
    i’m not that negative, but a bit sceptic….

  30. George says:

    I realize everyone is going to start throwing stuff at me for saying this. . . but , frankly, the stock market is like gambling. To much speculation. And many people who give advice about brokerage accounts have a conflict because they get paid commissions every time trades are made. That being said, Google stock is down due to a decline in ad sales. Seems like with a recession, a lot of markets are dropping.

  31. Michael says:

    There is a distinction that can be made between trading (gambling) and investing (strategy). Traders are more like poker players, while investors ressemble chess players. This article might interest readers: http://www.helium.com/items/1090714-understanding-the-difference-between-investing-and-gambling

  32. Cathy Braun says:

    Count me in the “stocks are gambling” category. I was looking at options for my 401K and I just could not shake the feeling that I was gambling. I opened up a Roth IRA with CD options instead. I’m actually kind of glad that I was in debt for most of the housing boom period, so I wasn’t investing anything. All of my current assets are cash. I am going to leave it that way until there are signs of life in the US economy.

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