Investing Is Not A Game Of Chance

Editor’s note: Today, Porter turns the Journal over to Porter & Co. analyst Martin Fridson, who through no luck of his own has compiled a list of Distressed Investing recommendations that are up 119% since March 2023, or 25.1% a year. Even more impressive, the combined Distressed Investing holdings carry a beta of 0.54 and posted a Sharpe ratio of 1.41 against the market’s 1.30. Much better than hoping for lucky sevens.

Prediction markets have been making news lately.

First off, there is convicted-and-commuted ex-Congressman George Santos, who has been banned for life from Kalshi’s prediction-market platform. Santos had bet on the proposition that he’d show up in person for President Donald Trump’s State of the Union Address this past February, suggesting in online posts that he would. The disgraced former member of Congress then raked in more than $17,000 by betting “No” and skipping the event.

The more important story was an August 28 federal court ruling that activity on prediction-market sites constitutes gambling. The Ninth Circuit U.S. Court of Appeals’ unanimous decision contradicted an earlier ruling by the Third Circuit Court. The Third Circuit upheld the industry’s position that contracts on sports events are swaps that fall under the sole jurisdiction of the Commodity Futures Trading Commission (“CFTC”).

On September 2, New Jersey Attorney General Jennifer Davenport petitioned the U.S. Supreme Court to resolve the conflict of jurisprudence. If the justices decide that companies such as Kalshi and Polymarket – the two leading online prediction markets where people buy and sell contracts based on the outcomes of future real-world events – are gambling sites, they’ll become subject to state regulation and, even more important, taxation.

Supreme Court majority opinions typically run 25-30 pages. I have no legal credentials, but if it were up to me, I wouldn’t need more than a single page to settle this question.

• If you go to a sports-betting site and wager a sum of money on which team will win the World Series, and you choose correctly, you’ll receive some multiple of the amount you wagered
• If you go to a prediction-market site and lay down a sum of money on whether an NBA player will score at least a certain number of points in a game, and you wind up being right, you’ll receive some multiple of the amount you wagered

True, the sports betting site will take a cut of your winnings, while the prediction market will instead charge you a fee. It’s a distinction without a difference. And unlike the financial instruments that their purveyors claim them to be, prediction market contracts aren’t linked to a security or a commodity, the way stock options and commodity futures are. They instead deal solely with events.

My verdict: If it looks like a duck, walks like a duck, and quacks like a duck, it’s gambling.

So if risking your money in a prediction market isn’t substantively different from gambling, let’s move the analogy over to the stock market, which has sometimes been likened to a casino. Here’s an itemized comparison of the stock market to playing the roulette wheel, where players wager that a ball on a numbered spinning wheel will fall onto a specific number:

Despite all these similarities, the most important difference is that gambling is essentially a zero-sum game. If you’re rolling dice in the back alley with some buddies, anything you win will be a loss to the other crapshooters. The aggregate wealth of those involved won’t increase, no matter how long you stay at it.

Note that I qualify that zero-sum description (“essentially”), because it’s a different story if you gamble in a casino. There, the patrons’ aggregate wealth will decrease because the house’s payout on winning bets is less than you’d receive if it were calculated according to the true odds. For example, the roulette wheel contains the numbers 1-36 plus 0 and 00, for a total of 38 possible outcomes. But if you pick the winning number with a $10 bet, you receive only $350 plus the return of your $10 stake. A full payout would be $370 plus your $10 stake, but the casino keeps the difference as vigorish of about 5%. Some casino players can come out ahead, but as a group, the average casino gambler’s net worth goes down through gambling.

In the stock market, by contrast, participants’ wealth grows over time. That’s despite temporary selloffs and even total wipeouts of some stock buyers who get carried away with the valid notion that there’s no return without taking some risk.

Notwithstanding the recessions that occur from time to time and the fact that some companies go bust along the way, aggregate corporate earnings rise over the long run. The market puts different multiples on those earnings at different times, which adds to the price volatility. But corporate America’s total value, as reflected in stock averages, marches upward over the decades.

Another difference between the stock market and gambling is that corporations use the money that people exchange for their shares to expand their operations, creating jobs and adding to the gross domestic product (“GDP”) in the process. On the other hand, the money that gamblers wager merely changes hands, over and over again. To be clear, the vig that’s siphoned off by the casinos does pay employees’ wages and some of it may get plowed back into the business, but it’s inconsequential in scale.

Here’s one final factor to consider: Although gambling regulations vary by state, some states classify only games of chance as gambling. Slot machines invariably fall into that category but in some jurisdictions, poker is deemed a game of skill and is therefore exempt from gambling regulations.

Skill definitely plays a role in investing, even though many, if not most, investors lack any. Buying the winning lottery ticket when the jackpot reaches $1 billion is pure luck. But luck can’t account for the 66% annualized return, with no losing years, of the late Jim Simons’s Medallion Fund over the period 1988 to 2018.

In short, if you manage your stock portfolio intelligently, you’re investing for your future rather than gambling.

Tell us what you think of today’s Daily Journal: porterstansberrydirect@gmail.com

Martin Fridson
New York, New York