“What is the difference between investing in the stock market and gambling?”

This question was posed to me about a year ago by a friend of mine, and it has profoundly shaped my perception of the markets ever since.

Obviously, there are significant differences between investing and gambling, namely the fact that the stock market is not driven by randomized outcomes or subject to a house-player arrangement. The vast majority of investment managers are diligent in deploying their clients’ cash to appropriate vehicles. But to ignore the similarities between a casino and a trading floor is to risk subconsciously shifting our motivations towards a more dangerous and habit-forming investment style.

While the mechanics of these two systems may be similar, the motivations for participation are vastly different. With investing, the goal is to earn a return on cash you don’t immediately need for living expenses. With gambling, in its most innocuous state the goal is typically to have a bit of fun with a game by raising the stakes. The danger in both systems is to confuse the motivations, and the outcomes of doing so are remarkably similar. When gambling is elevated to a cash-returning avenue, many gamblers end up in financial ruin out of a desire to erase their inevitable losses with future wins. In investing, the desire to win often pushes investors further out along the risk-return curve than they would ordinarily be comfortable with, which frequently destroys investors’ long-term confidence in the market.

The difference between investing in the stock market in gambling on stocks is discipline. A disciplined investor understands their portfolio and does not stretch it beyond their risk tolerance, and this allows them to generate returns in line with their needs.

Understanding those needs is a crucial component of avoiding the pitfalls in portfolio-building. For instance, saving for retirement involves assessing what kind of lifestyle you want to have at retirement and determining what you need to do now to get there. The higher a standard of living is above your current earning power, the riskier your investments must be to achieve the necessary return to sustain that level of spending. In other words, the more you want to raise your standard of living through investing, the more you must be willing to give up in the worst-case scenario for your investment.

These assumptions indicate that it is more prudent to shape portfolios around downsides than upsides. Indeed, this is the basis of Modern Portfolio Theory, which first defines an investors’ risk and then seeks to maximize return for that level of risk. But stock markets are inherently optimistic – every participant puts money into the system because they believe they will receive a return. This optimism is easily transmutable into greed, which poisons our risk assessment by focusing on the payout rather than the danger. There is nothing wrong with seeking higher returns, but the costs of doing so must be understood and managed.

So, how do we reconcile gambling and investing? The truth of the matter is that investing has more in common with gambling than we often care to admit. But this should not dissuade us from investing; on the contrary, it makes us better investors by highlighting the dangers of chasing unsustainable returns. In order for us to justify participating in the equity markets, we must commit to discipline in our approach. Otherwise, we risk throwing away decades of wages, which are a far more effective builder of wealth than the equity markets. Let us then do our due diligence to understand our risk appetite and build our portfolios accordingly.