Gambling nation

The U.S. is currently experiencing a rise both in retail trading in the stock market and in all types of gambling including sports betting. Here’s a recent article in Bloomberg:[1]

We’re living in a new age of finance. It’s never been easier to bet your money—anytime, anywhere—and meme-stock craziness is here to stay. A wave of technological advancements has coincided with new apps and platforms to create a thriving ecosystem where everyday people can trade stocks with the ease of swiping for dates on Tinder.

… At the same time, sports betting has exploded, with Americans wagering more than $220 billion in the past five years, according to the American Gaming Association … “Trading has become interchangeable with the same kind of online betting that we’re seeing for games and in the sports world,” says Peter Atwater, an economics professor at William & Mary. “It’s part of a gambling zeitgeist.”

Warren Buffett agrees. Here’s his latest Berkshire Hathaway shareholder letter:[2]

For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.

How should we understand the fact that both market gambling and regular gambling have risen in tandem? Are we living in a degraded age where American morality has been corrupted by casino culture? In this post, I review the connection between gambling and asset markets. I ask the following questions:

• Why do we see an increase in both stock market gambling and regular gambling?
• Why do people gamble?
• Why do people trade stocks?
• What’s the connection between gambling and trading stocks?
• Is stock market gambling bad?

Explaining the increase in gambling

Substitutes vs. complements

Let’s start with the microeconomic framework of describing products as either substitutes or complements. Jelly and peanut butter are complements, because people consume them together in the form of PB&Js. If demand for PB&Js rises, demand for both PB and for J go up. In contrast, beer and wine are substitutes; people generally don’t consume both at the same time.

One implication is that if the price of PB goes down, that drives up demand for J, since the total cost of a PB&J has fallen and so people consume more. In contrast, for substitutes like beer and wine, a price fall for one will lead to lower demand for the other.  An extreme example comes from government prohibition. If wine is outlawed, beer demand will go up, because the price of wine has become infinite.

Now we are ready to consider market gambling vs. regular gambling. Are they complements or substitutes? They are substitutes; the time and money you spend at the casino cannot be spent on the stock market.

Preferences vs. prices

So how can it be that the quantity of both activities has risen? Shouldn’t the higher regular gambling replace the stock market gambling, or vice versa?

Well, let’s go back to beer and wine. There are two situations in which the quantity consumed of both would simultaneously rise. First, there might be correlated demand, due to a general rise in demand for alcohol. In fact, we observe higher sales of both beer and wine in December due to holiday consumption. I will call this explanation “correlated preference shocks”.

This story does not require that the same individual consumes both products. That is, maybe on New Year’s Eve, I sip Pinot Grigio while Aunt Kiki guzzles down Bud Lite; total demand for both beer and wine has risen even though no individual consumes both products simultaneously.

It is worth noting that correlated preference shocks have social origins. Why do I drink more alcohol in December? Because Aunt Kiki is also drinking alcohol with me. So the true driving force is endogenous social coordination in consuming alcohol (unlike, say, the demand for snow shovels, which reflects exogenous seasonality). 

Second, if the price of beer and wine both fall, we’d expect both beer and wine consumption to increase. I will call this explanation “simultaneous price fall.” Consider a social event featuring a cash bar vs. an open bar. The event with an open bar surely has greater consumption of both beer and wine (that’s assuming the open bar does not offer Chateau Lafite but instead the beer and wine have the same approximate dollar cost).

So, which of these two stories explains the simultaneous rise of market gambling and regular gambling? Probably both. Let’s start with correlated preference shocks.

Here’s a brief cultural history of the U.S. In 1620, the Pilgrims arrived and brought with them religious beliefs that were both anti-market and anti-gambling. The Puritans who arrived later were also strongly anti-fun; in 1631, the Massachusetts Bay Colony banned the possession of playing cards and dice. In the intervening four centuries, we’ve gradually been abandoning Puritan beliefs and dismantling Puritan restrictions. We’ve experienced an anti-Puritan preference shock that increases demand for all activities that Puritans deemed ungodly.

Thus the recent embrace of market gambling and regular gambling is the logical progression of anti-Puritanical preference trends. This trend is reflected in legalization of different types of gambling, including the 2018 Supreme Court decision which allowed legal sports betting.

Second, the cost of both market gambling and regular gambling has fallen. Technology, especially cell phones, has made all types of gambling easier and more fun. And thanks to the elimination of commissions by most retail brokerages in late 2019, stock market gambling seems free to retail investors.

Here's Keynes in The General Theory:

It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.

In the U.S., in recent years we’ve gone in the opposite direction, implementing the anti-Keynesian (and anti-Puritan) policy of making both stock exchanges and casinos more accessible and less expensive.

Why do people gamble?

There are two explanations for why people gamble:

1. Overconfidence: They wrongly expect that they will win.
2. Fun: They enjoy gambling.

Here’s Adam Smith in The Wealth of Nations discussing overconfidence:

The overweening conceit which the greater part of men have of their own abilities is an ancient evil remarked by the philosophers and moralists of all ages. Their absurd presumption in their own good fortune has been less taken notice of. It is, however, if possible, still more universal. There is no man living who, when in tolerable health and spirits, has not some share of it. The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.

That the chance of gain is naturally overvalued, we may learn from the universal success of lotteries. The world neither ever saw, nor ever will see, a perfectly fair lottery; or one in which the whole gain compensated the whole loss; because the undertaker could make nothing by it … There is not, however, a more certain proposition in mathematics than that the more tickets you adventure upon, the more likely you are to be a loser. Adventure upon all the tickets in the lottery, and you lose for certain; and the greater the number of your tickets the nearer you approach to this certainty.

But instead of framing gambling as driven by an “absurd presumption in their own good fortune,” we can frame it as a fun activity pursued by totally rational individuals. What I call “fun” has three components:

(2a) Lottery preferences. While the expected dollar value of buying a lottery ticket is negative, the expected utility might be positive.

(2b) Sensation-seeking. Gambling is a thrill, similar to riding a roller coaster.

(2c) Social enjoyment. As with roller coasters, part of the fun is shared experiences.

According to the fun view, the fact that people systematically lose money from gambling is neither here nor there. People also systematically lose money riding roller coasters, but we call this spending “consumption” and not “absurd presumption.” Of course, if roller coaster addiction became a major problem, we’d want to discourage roller coasters (perhaps via taxes or a “you must be this tall” sign that is seven feet high).

Why do people trade stocks?

Motives for trade

There are many possible explanations for retail trading behavior, but the two main ones are exactly the same as for gambling: overconfidence and fun.

First, here is Keynes in The General Theory discussing the fun of sensation-seeking:

… human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. 

Here is Shiller (1984) discussing the fun of social enjoyment:

Investing in speculative assets is a social activity. Investors spend a substantial part of their leisure time discussing investments, reading about investments, or gossiping about others’ success or failures in investing.

Liu, Peng, Xiong, and Xiong (2022) study Chinese investors using a dataset including survey responses and actual trading behavior. They conclude the main drivers of retail trading are overconfidence (in the form of perceived informational advantage) and gambling preferences (“When I trade stocks, I aim to select those stocks whose price would rise sharply in a short period of time so that I can make a lot of money quickly”).

Retail investor performance

Retail trading may be fun, but it is not free. As with casinos and lotteries, stock market gambling has costs, reflected in the fact that retail traders on average lose money. First, on average retail investors destroy their own wealth via trading. Second, the more they trade, the more wealth they destroy (as Smith says, “There is not, however, a more certain proposition in mathematics than that the more tickets you adventure upon, the more likely you are to be a loser.”).

Here’s one startling statistic from Barber, Lee, Liu, and Odean (2009):

Individual investor trading results in systematic and economically large losses. Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individuals suffers an annual performance penalty of 3.8 percentage points. Individual investor losses are equivalent to 2.2% of Taiwan’s gross domestic product or 2.8% of the total personal income. Virtually all individual trading losses can be traced to their aggressive orders. In contrast, institutions enjoy an annual performance boost of 1.5 percentage points, and both the aggressive and passive trades of institutions are profitable.

So retail traders are the casino customers who lose on average, while institutional investors are the casino owners who ultimately win. If retail investors lose from trading, it must be that somebody somewhere is winning. Another potential winner is issuing firms, who repurchase shares from retail investors when shares are cheap and issue shares when shares are expensive.

The connection between regular gambling and stock market gambling

History

Historically, gambling and financial markets have been tightly connected. As described in Chancellor (2000), the rise of gambling and lotteries in Europe was intertwined with the development of stock, bond, and insurance markets. The intertwining took place both on a personal level (gamblers became financial speculators) and a theoretical level (the development of mathematical probability theory).

Both the South Sea Bubble in Britain and the Mississippi Bubble in France (both occurring around 1720) involved former gamblers. John Blunt, a central figure in the South Sea Bubble, had previously operated “The Two Million Adventure,” a state-sponsored lottery.

John Law was a professional gambler (as well as adulterer, convicted murder, and fugitive from justice) before starting his project to transform France’s financial system, resulting in the Mississippi Bubble. In a few short years, Law introduced amazing innovations in a mad scheme that almost worked. Imagine all the absurd claims made by crypto enthusiasts (a monetary system, a credit system, a massive reduction in financial frictions) being implemented in 1720.

In the 1700s and 1800s, there was less distinction between lotteries and normal financial activity. Both private companies and governments issued bonds that had lottery-like features where random chance determined which bondholders received payments. Lottery bonds are still issued today in the U.K. (“Premium Bonds”) and Sweden (see Green and Rydqvist (1997)).

Substitution

When regular gambling is impossible, stock market gambling offers a substitute. We see this fact in countries where gambling is illegal (such as mainland China) and at times where gambling is temporarily suspended (such as during the pandemic).

Perhaps no individual is more emblematic of the connection between gambling and pandemic-era retail stock trading than Dave Portnoy of Barstool Sports, a sports betting media company. Here’s Bloomberg describing the situation in 2020: [3]

Barstool Sports’ Dave Portnoy had bought just one stock in his life before the quarantine hit. When the country shut down in March, canceling sports and sports betting, the founder of the brash media empire considered sexist by some dusted off his old E*Trade account and started day trading.

“With the volatility, it is kind of like watching a sports game,” said Portnoy, 43, who started live streaming as “Davey Day Trader Global” to his 1.5 million Twitter followers with the caveat: “I’m not a financial advisor. Don’t trust anything I say about stocks.”

Portnoy and his ilk have been part of one of the greatest rallies in history, adopting as a mantra the online slogan of “stocks only go up!” Market watchers are being forced to ask to what degree retail interest has become a self-fulfilling prophecy in many parts of the market -- and what dangers it poses for its sustainability…

… Stuck at home with plenty of free time, government stimulus checks, no sports to bet on and, for better or worse, a figure like Portnoy turning investing into entertainment, more and more young people are wading in for the first time.

Prior to the pandemic, another natural experiment was the introduction of legal gambling in Taiwan. Here is Barber, and Odean (2013):

Barber et al. (2009) find that trading in Taiwan dropped by about 25% when a legal lottery was introduced on the island in April 2002. As in Dorn, Dorn, and Sengmueller (2007), Gao and Lin (2011) further explore this substitution effect by analyzing the volume of individual investor trading in Taiwan around lotteries with unusually large jackpots. They document trading by individual investors declines during periods with unusually large lottery jackpots; moreover, the effects are greatest in stocks with high levels of individual investors participation and skewed returns.

Barber et al (2009) compare the amount of money lost to retail investors via day trading to the amount lost from playing the lottery, and ask the following question: if you introduce a lottery, do people end up losing less money on net? Does the total amount of wealth destruction go up or down? They find:

a 25% reduction in the trading activity would correspond to a reduction in annual trading losses of about $NT 46.75 billion. Thus, the approximate aggregate annual net cost of playing the lottery ($NT 32.9 billion) was somewhat less than the approximate aggregate annual reduction in trading losses subsequent to the introduction of the lottery ($NT 46.75 billion). If, indeed, the Taiwanese derived the same utility of gambling from the lottery that they had previously derived from additional trading, they did so at a lower cost.

Traditionally in the U.S., gambling was illegal and stock markets were legal. But the above calculations suggest that if your only goal was to provide maximum fun while minimizing the cost to the average citizen, the stock market should be banned and gambling should be legal.

More generally, looking across countries, we see two facts. First, in countries with more legal restrictions on gambling, stock markets look more speculative. Second, when the pandemic hit, stock market gambling went up, but it went up less in countries where gambling was already mostly illegal. Here’s Kumar, Ngyuyen, Putnins (2021):

… stock markets serve as a substitute or an alternative to “traditional” gambling venues such as casinos, lotteries, sports betting, gaming machines, and other forms of gambling.

When a country restricts traditional gambling, for example, by banning casinos or restricting them to a state-owned monopoly, a significant volume of gambling activity spills over into the stock market. …Our evidence indicates that the substitution effect holds more broadly for a range of gambling forms and in a global sample. This evidence also supports the conjecture that the surge in retail investor trading during the COVID-19 pandemic is, at least in part, driven by an increase in gambling activities.

So the overall evidence suggest that widespread legal U.S. gambling makes the U.S. stock market less speculative because it lures gamblers into other venues.

Is stock market gambling bad?

My own view is that if people want to gamble, they should be allowed to gamble. Similarly, if people want to smoke tobacco, they should be allowed to smoke tobacco. Both these activities impose costs, but as long as these costs are voluntarily accepted by consenting adults who are fully informed, it is fine with me.

So, if you accept my view that gambling in general should be allowed, we must ask whether stock market gambling is more or less desirable than regular gambling. The answer is not clear. Let me break this into two pieces. First, is stock market gambling bad for the retail investors who engage in it? Second, is stock market gambling bad for society as a whole?

First, does stock market gambling hurt retail investors? The Taiwan results suggest that stock market gambling results in greater wealth destruction compared to lottery tickets. On the other hand, Roaring Kitty and his followers have all sorts of regular gambling available to them, and yet they prefer to gamble in the stock market. So they must prefer stock market gambling for some reason. You can say they are overconfident, and you’d be correct, but they certainly seem to be enjoying themselves for now, and that’s not nothing.

Second, is stock market gambling bad for society? Does it make stock markets more dysfunctional? Here, the impact could be good, could be bad, or could be neutral.

First, let’s take the neutral case. If retail investors cancel each other out, then they will not impact stock prices but they will enjoy all the fun of gambling. Similarly, if two individuals wager on a football game, that does not impact the outcome of the game (assuming these individuals are not crooked NFL players).

Second, let’s take the case where stock market gambling is good. I’ve previously described what a well-functioning stock market looks like:

In a healthy market, we need some smart active investors … We also need some non-smart non-passive investors for the smart people to trade with; such traders appear plentiful. 

The retail investors who gamble in the stock market provide a valuable service to society. They allow smart people to make money. Gamblers provide liquidity, and their losses are the grease that lubricates the market. As described in Barber et al (2009), retail investors in Taiwan lose money, allowing the institutional investors to make money.

This lubrication process is the solution to the paradox of Grossman and Stiglitz (1980): how can markets be efficient? What are the incentives of informed traders to gather information? The answer is that markets are not perfectly efficient, allowing informed traders to profit from trading, and giving them the incentive to gather information that gets impounded into prices.

So in this lubrication case, the gamblers do impact prices, but only a little bit, and eventually the smart non-gamblers push prices back towards fundamentals.

Third, let’s take the case where stock market gambling is bad. Here, we have gamblers who all trade in the same direction (perhaps following the lead of Roaring Kitty or Dave Portnoy). Now, you are probably familiar with Milton Friedman’s famous argument that speculation is inherently stabilizing: speculators stabilize prices because speculators on average make money. But since retail investors systematically lose money, they do not stabilize prices. And one can imagine scenarios under which crazy gambling drives out the rational traders.

Friedman (2017) argues that even destabilizing speculation can be good since it provides gamblers with a valuable service in countries where gambling is otherwise illegal. Fair point, but here in the U.S. in 2024, we are living in a libertarian Utopia of widely available legal gambling.

So, is stock market gambling bad? I don’t think all stock market gambling is bad, but as I’ve previously argued, recent market nihilism has gone too far.

America has many fine athletic events, casinos, lottery tickets, and other gambling opportunities. My message to retail investors is: if you must gamble, why not try one of these delightful gambling venues? Unlike the stock market, at Vegas they serve cocktails and you could catch a show.