Depending on your view of the stock market, it can be easy to see as gambling. A major crisis sends stocks plummeting, and then within just a few weeks or months, stocks go soaring back even if other parts of the economy are still struggling. When there is volatility, it is very easy to turn stock picking into gambling and either win big or lose big depending on your luck. That doesn't mean you can't look to the stock market for relatively secure returns if you look for the long-term fundamentals.
A Case Study: Palantir
Palantir develops data integration and software solutions for other companies and the government. It's the type of company that works behind the scenes that you'd almost never hear about unless you just happened to work with their products in your job. Still, when the company went public, it quickly caught the attention of traders and soared 300% in a matter of weeks. Other traders said this pricing was unsustainable and began shorting the company — making a bet that its stock price would fall in the near future. With large bets on both sides, someone has to win big, but who?
Any stock trading has a certain element of gambling to it since the future is never certain, but price swings are rarely unexplainable. If you're tracking an airline and travel drops, you'd expect the stock price to fall. However, exactly how much requires predicting how much travel will continue to drop and when it will bounce back. As traders try to figure this out, you might expect the stock price to rise and fall a few points below its current levels. When traders start using options rather than direct purchases, volatility can increase even higher. If you predict an upward or downward move correctly, your returns can grow, but if you take the wrong side of an option, you could lose your entire initial investment in that option.
When a stock has extremely high volatility like Palantir, there are two common explanations. First, there is so much uncertainty that it's impossible to narrow down what will happen. Second, traders are ignoring fundamentals and are actively making a bet based on price movements. Both of these explanations seem to back the stock market being gambling in the short term.
Why Do People Gamble in the Stock Market?
Many individual investors who act as "gamblers" are influenced by social media. Take the popular reddit forum wallstreetbets. While the content is mostly memes, it contains active discussions of short-term bets. Many get tagged as YOLO, for You Only Live Once. Some people win big, but others lose everything.
When the risks are clear, why do people gamble? The answer is likely that those are the kind of posts that get attention on social media. Further, unlike other types of gambling that people are taught to stay away from, there's a legitimacy to stock market gambling because people know that investing in the stock market is part of retirement planning. Therefore, if you're only looking at social media, it's easy to fall into the gambling trap.
What's the Right Way to Approach the Stock Market?
The volatility that can make the stock market a gamble is the same thing that makes it a good investment. The S&P 500 Index has had an average annual return of about 10% for nearly a century. The index is made up of 500 of the largest and most stable companies in the United States. It's survived the Great Depression, World War II, stagflation in the 70s, Black Monday in 1987, the Dot Com Bubble Bust, 9/11, and the Great Recession.
The S&P 500 is nothing magic. Out of its hundreds of members, many have completely collapsed, and others have soared. The reason holding the S&P 500 worked is that investors spread their bets over hundreds of companies and played for the long-term instead of making short-term bets on a small handful of companies.
Does that mean the S&P 500 is the right way to invest? Not necessarily. The S&P 500 is mainly the largest stocks in the United States and today is weighted heavily in tech companies. There are also smaller stocks, different industries, and international stocks plus bonds and other asset classes. Ignoring those to focus on a single index could be seen as a similar type of gambling as sticking with individual stocks. Different asset classes often rise and fall at different times, so holding multiple asset classes can help you take advantage of natural market volatility by giving you more opportunities to buy low and sell high over time.
Of course, information is still the main difference between gambling and smart investing. If you don't know how to pick the right mix of individual stocks, stock funds, and other asset classes to build a well-diversified portfolio with a long-term outlook aligned to your goals, working with an advisor can help. Contact E1 Asset Management to learn more.