So, you’re 23 and fresh out of college. You landed your first job and got a healthy paycheque. What’s next?
Maybe you want to invest. After all, your friend made big money when the GameStop stock skyrocketed. Plus, you watched Wolf of Wall Street (spoiler alert), and cushy jail time isn’t enough of a deterrent to make you want to avoid trading single stocks.
Or you could take your money to Vegas and try to win big. The odds of that happening are slim, and there’s the risk you lose it all. The highs of gambling look dreamy, and the lows could empty your bank account. But wait.
Why are we talking about gambling at all? Well, on a neurochemical level, gambling, day trading and speculation are not very different at all. To understand why this happens, first, we need to understand the basics of why we do anything: motivation, drive, and reward.
Why Does it Feel So Good When Our Stocks Go Up?
Let’s start at the level of a single molecule: a neurotransmitter.
Neurotransmitters are your body’s chemical messengers. They are responsible for all sorts of functions, and important to investing, they are an integral part of driving our behaviour.
Dopamine is a neurotransmitter that plays a role in your reward center by driving “pleasurable reward and motivation” according to Cleveland Clinic.
Dopamine also triggers your adrenal glands which produce adrenaline. Adrenaline is a hormone that is responsible for that “rush” feeling you get when you gamble. So, even though it may feel like this is going to be your big break, you’re actually not rolling a fair pair of dice.
Like addictive substances, when you gamble, your brain’s reward center lights up. The highs feel higher because of this large amount of dopamine flooding your system. Gambling has a special addictive quality to it.
“Gambling, unlike any other addiction, is associated with cognitive distortions,” says UCLA Health. “People say, if I keep gambling then eventually, I’ll win […]. The cognitive distortion often takes place within people who have lost large amounts of money or other assets due to gambling. Sometimes their pride, ego or sense of despair drives them to gamble more, in hopes of making back what they lost.”
Why Does Day Trading Feel Like Gambling?
What does this have to do with investing?
On a neurochemical level gambling, day trading and speculation are not very different. Behavioural economist Sarah Newcomb says “there are certainly legitimate reasons for the occasional trade. Some trading is the result of long-term planning and the execution of a solid strategy. However, repeated studies, including Morningstar’s annual Mind the Gap report, demonstrate that investors who actively trade tend to underperform the market”.
Let’s take a step back. What is the difference between trading and speculation?
Morningstar’s John Rekenthaler cites the Cambridge Dictionary definition of speculation as “buying something hoping that its value will increase and then selling at this higher price in order to make a profit.”
Rekenthaler then cites Investopedia saying speculation is “conducting a financial transaction that has substantial risk of losing value but also holds the expectation of a significant gain.”
How about just trading single stocks? “Stock trading is the act of buying and selling shares of a public company’s stock in the open market”, according to our very own Investing Glossary.
The definition goes on further to state that “investors can profit from stock trading by purchasing stocks at a low price and selling them later at a higher price. There are a variety of different strategies for stock trading. Some investors may purchase stocks in hopes they increase in price over the long term. Others may buy and sell stocks throughout the day to capture short-term growth (day trading).”
Why Do We Speculate in Stocks When it’s so Risky?
So, why would we trade or speculate when it’s risky? It’s not much different than why gamblers gamble. Newcomb points to four key factors: fear, greed, overconfidence, and sensation-seeking.
“When faced with the pain of significant loss, some investors are willing to deviate from their long-term strategy in order to reduce uncertainty in the moment,” she says.
“In the long run, this is generally a bad idea given that markets historically have rebounded and rewarded investors for staying the course. In the moment, the feeling of power from taking action, and certainty from reducing risk exposure can feel more valuable than the abstract possibility of future rebounds”.
When you take action, make a risky move, and deviate from your long-term strategies, dopamine lights up that reward center in your brain, and you feel pleasure from the chance of a potential big win, even if it hurts your long-term performance.
Overconfidence is also important to speculation. According to Newcomb: “overconfidence is the degree to which an investor overestimates their ability to generate returns”. You have to believe you can beat the odds or you wouldn’t try. This is a gambler’s mindset. “The irony is that overconfidence leads to frequent trading, and frequent trading leads to underperformance.”
Can I Speculate ‘Safely’?
So is there a safe way to speculate? “We hear a lot about the irrational behaviour of investors, and much of the time it’s attributed to heady things like overconfidence and other cognitive biases,” says Newcomb.
“But what about good old-fashioned greed and the thrill of the game?”
Three Tips to ‘Play Responsibly’ With Your Portfolio
Here’s what Newcomb has to say about ‘playing responsibly.’ Most importantly, don’t gamble with money you can’t afford to lose.
She also offers some tips:
1. Set aside an amount of money that you can part with and use that for speculation. This keeps the game going without turning the downside into losses that can ruin you. You can still potentially make a lot of money this way, but you won’t lose your life or livelihood in the process.
2. Do not gamble with money that isn’t yours to lose. If you share finances or manage money for others, make sure you keep your speculation separate from these funds. The only exception would be if you have the informed consent of the other party.
3. NEVER speculate on the margin. In other words, don’t borrow money to gamble in the market. Borrowing in order to gamble makes financial ruin more likely in the long run. Leverage is best used when you have all the information and time necessary to reduce your risk exposure.
Because let’s face it. Vegas can be exciting. Investing shouldn’t be.
