What makes gambling different from investing? If pushed for an answer, we would say that one of the key differences is “diversification.”
In other words, the former is primarily about rolling the dice on one hoped-for outcome, based mainly on chance. The latter, however, involves spreading your money out across many different asset types and classes which you reasonably expect to grow.
Images can sometimes present investing in a way which makes it look like gambling. Many of us are familiar with the hectic scenes of traders shouting and running around on the floors of the stock exchanges, buying and selling manically.
Prudent investing, however, is far removed from this image. Rather than putting all of your money into the fate of one company (such as Facebook or Amazon) and hoping it grows, you minimise your risk by putting your money into many different investments.
This way, if one or even several of your investments fail, your other investments should help carry you through and minimise your losses.
An example of diversification in action
When you look at different countries, you may notice that certain countries seem to be more vulnerable to economic shocks than others. This is partly because, like investors who do not spread out their investments, these countries are putting their “economic eggs” in one basket.
For instance, many countries hinge their economies on an important resource which they can produce and trade – such as oil, or coffee. When these commodities do well, their economies boom. When demand for the commodity falls, however, it can cause a huge deficit.
This is one reason why countries often seek to diversify their economies, so they are not reliant on one particular commodity, product or service in order to grow (e.g. manufacturing). Similarly, a wise investor will recognise that by diversifying their investments, they protect themselves from investment “shocks” whilst continuing to benefit from positive performance from other assets.
For instance, suppose you have two investors. Investor A has an investment portfolio (i.e. a set of investments) comprising 100% stocks (i.e. shares in various companies). Investor B, however, has a portfolio comprising 50% stocks and 50% bonds (we’ll come onto this later).
When the stock market experiences a dip or shock, which investor should fare better throughout the storm? Investor B should lose less money than investor A, because his/her bond investments should continue to deliver an investment return even as his/her stocks decline.
Different asset types
Another analogy sometimes used for diversification is the modern military.
Advanced military nations such as the USA, UK, France and Russia all have a range of defence assets at their disposal including infantry, mechanised vehicles (e.g. tanks), air power, naval units and cyber warfare technology.
These different military “assets” exist not just to counter different threats on the battlefield within a theatre of war. Each asset also exists in order to support the other. For instance, armoured vehicles and airpower assets are used to protect infantry during assaults.
Investing can also be conceived in a somewhat similar way. Just as military assets support one another, investment assets can “cover” and “carry through” other assets which might struggle on their own within particular market contexts. For instance, when your commodity investments are declining in value it might be your stocks which keep your investment portfolio moving forward.
Let’s take a quick look at some important asset classes you can include in your portfolio…
One of the most familiar types of investments, cash investments, are usually seen as lower risk but also tend to carry a lower investment return.
For instance, up to £85,000 of your cash in recognised UK Building Societies and Banks will be protected by the Financial Services Compensation Scheme.
However, many cash investments deliver a poor investment return due to low interest rates, which are largely eclipsed by inflation.
Sometimes these are called “equities”, and they refer to the stake(s) you have in one or more companies. For instance, you could invest directly in the shares of one company (which is very high risk). Or, you could put your money into an “investment fund” (e.g. a Unit Trust) together with a range of other investors. This fund would then invest this money into a collection of select companies. This is lower risk, because if one company in the fund declines or fails the others should help to keep the overall value of the fund growing.
Many of us are familiar with the idea of house “flipping” – which involves buying a house and later selling it at a profit (often after a period of household improvements).
However, other lower-risk investment opportunities exist when it comes to property. For instance, you might invest in property funds – which are similar to the “share” funds described above, except in this case the investment money is put into residential or commercial property.
Property can be a great investment, but it does carry risk and you also face the issue of your money not being easily accessible once it is invested into property. If you need the money quickly, you might need to wait a lot longer than you would have otherwise liked.
When you need money from the bank you can sometimes get a loan. This involves the bank giving you money provided you pay it back over time, with interest (so they make a profit).
In a similar way, you can “lend” your own money to companies and governments through bonds. So, if you buy a UK government bond you are effectively loaning money to them.
The idea is that, over time, you get the principle back as well as interest payments. These investments are generally seen as lower risk (particularly UK government bonds because they have a reputation for paying people back). However, the more reliable the bond-issuer the lower the investment return tends to be, because the risk is lower.
Bonds are usually a vital part of an investment portfolio, because they provide a solid investment foundation and “buffer” in the event that your other investments fall in value.