Detractors of the stock market often liken it to a casino. There are certainly some similarities. Many stock traders, not unlike gamblers, develop addictive personalities, are filled with greed for easy and quick riches, and often overestimate their chances of success. In addition, just like casinos, most stock markets seem to be skewed in favor of the professionals and the smart money. Under these conditions, trying to make a living by playing either the stock market or the slot machines is nothing more than a fool’s errand. They both often end in tears.
There is, however, an important sense in which the stock market is not like a casino. In casinos, the odds of winning, while quite small, are clearly defined. If one plays at the American roulette table, for example, one knows that there is a likelihood of 1/38 that one can beat the spinning wheel. Or in the game of poker, one can calculate quite accurately the probability of being given any particular winning hand. In this sense, therefore, casinos are no different from such similar games as lotteries. In all these situations, to borrow a phrase from the former defense secretary, Donald Rumsfeld, the players are facing the so-called “known unknowns.” Put differently, in casinos, gamblers are facing Risk, where the odds are given, as opposed to Uncertainty, where they are not. In addition, while gamblers collectively lose, their total loss is normally not massive, as evidenced by the limited profits of casinos or revenues of states. In short, while there may be occasional consternations on the Las Vegas Strip, the place hardly experiences widespread panic.
On Wall Street, however, the situation is quite different. The odds of beating the market are rarely clearly defined. As a result, many investors are facing Uncertainty as opposed to Risk. That is to say, the investors are faced with the “unknown unknowns.” This is simply because Wall Street rarely tells us what the future has in store for us. For example, the stock market may be reaching new highs, while at the same time the economy is tanking. Under these conditions, it is quite difficult to decide on the right time to quit the market, notwithstanding the advice given by the experts and their statistical models. The recent financial crisis provides another example of this general state of financial ignorance about the future. During the early part of the crisis, when financial trust was completely lost and there was a widespread credit freeze, many investors dropped all pretensions to their forecasting abilities and simply abandoned ship. As a result, and given that the losers far outnumbered the winners, investors managed to collectively lose a significant portion of their wealth. In fact, most “investment banking casinos” ended up bankrupts themselves. Thus, when things go wrong on Wall Street, there is more than consternation, there is panic.
The fact that the stock market is not a casino, however, is rarely acknowledged by the academia. They continue to build sophisticated probabilistic models to predict the future returns of asset prices. In addition, all of these models are based on the questionable assumption that these returns follow normal (bell-shaped) curves. As it is well known, normal curves tend to underestimate the frequency of rare events by wide margins. For example, according to these curves, the daily changes of 7 percent in the stock market should happen once every three hundred thousand years. In reality, they happen on average once every two years. Thus, normal curves can offer a false sense of security to investors.
In summary, the stock market is not a casino. It is a far more dangerous place, at least in the short run.
Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics