Bets and the stock market
Dear investors,
We've been following the case of betting in Brazil, sports betting sites that have become a craze and reached staggering proportions. In August of this year, according to a survey by the Central Bank of Brazil (BACEN), R$1,400,000 (R$21 billion) were spent on betting, considering only payments made via PIX. Of this amount, R$1,400,000 (R$3 billion) were spent by Bolsa Família beneficiaries, sparking a wave of criticism of the activity, which is causing losses for an already financially fragile segment of the population.
Following the maxim that history doesn't repeat itself, but rhymes, this is just another version of an old problem well known to humanity. Several nations have faced periods when gambling became fashionable and caused profound problems. Behind each story lies something difficult to change: the human propensity for gambling addiction. It's not a simple psychological phenomenon. While the rational solution is obvious: simply don't gamble, it's difficult to find a practical way to stop people from gambling.
The impulses that lead to sports betting are also well-known in the investment world. There are people who clearly see the harm in betting, but at the same time, act recklessly in the stock market. Like a roulette player who condemns the habit of a craps player, without realizing that his own addiction is very similar.
To avoid becoming a victim, one can seek to understand the psychology behind gambling addiction and conduct an honest self-analysis, looking for potential harmful behaviors. Identifying a problem is the first step toward solving it. This will be our focus.
Historical overview
In ancient Rome, betting on dice games, gladiatorial contests, chariot racing, dart throwing, and other sports were quite popular. There is evidence of several attempts at legal control, including sanctions against gambling establishment owners, fines for those who practiced gambling, and outright bans for military and government officials.
During the Chinese Ming and Qing dynasties (14th to 20th centuries), gambling was widespread. Lotteries, card games, dice games, mahjong, race betting, and animal fighting were commonplace. The Ming government even imposed a complete ban on gambling, imposing severe penalties: fines, imprisonment, and corporal punishment for gamblers and gambling establishment operators. Even so, the activity remained popular for centuries.
In 16th- to 19th-century England, lotteries, card games, and horse racing betting became common among both the aristocracy and the general population. In 1845, a new law called the Gambling Act attempted to suppress these activities. Gambling houses were banned, protections were created for vulnerable individuals, such as minors, and gambling debts became unenforceable through the English judicial system. The law had some positive results, but also some side effects. For example, since it was impossible to collect gambling debts legally, alternative collection methods became more common.
These historical examples make two points quite clear. The first is that gambling is harmful to society, as it leads many individuals to financial ruin, destabilizes families, and encourages criminal activity. It's no wonder that governments across different eras and cultures have attempted to suppress the practice among their populations. The second point is that attempts at regulatory suppression have been ineffective, even with the imposition of harsh penalties. The problem is chronic, like drug use.
Given this historical context, it's hard to imagine that Brazil will easily escape the dire consequences of the Bets. It seems to us that something like this could only be mitigated through the Confucian concept that, to bring order to the world, one must begin by cultivating virtue within oneself, then order one's family life, then contribute to one's community, and thus expand order to ever-widening circles. It's a long path, and one that's unlikely to receive significant attention from the government.
Despite the pessimistic prognosis, publishing this text is the contribution that is within our reach.
The psychology behind the game
The first step is to understand where the propensity for gambling addiction comes from. A series of psychological factors interact to create this link with gambling schemes. The beginning is usually unpretentious, motivated by curiosity and the search for fun. The adrenaline rush of betting and rooting for the desired outcome. The pleasure of imagining what could be done with the winnings. Once the betting begins, the pitfalls arise.
One is that the human mind tends to seek patterns in historical events, without considering whether they are statistically relevant or merely random accidents that create the appearance of order, similar to the possibility of seeing a cloud shaped like an elephant. This leads bettors to theorize about methods of predicting outcomes and create an illusion of control over what remains purely random. Sometimes, this behavior is clearly superstitious, like that person who shows up at World Cup games wearing a strange shirt and claims that Brazil always wins when they watch the game wearing it. In the most dangerous cases, a kind of pseudoscience develops, with elaborate methods, strategies, and "technical analyses" that give the appearance of something serious but are based on false premises and, consequently, don't work. In the financial market, day trading methods are a clear example of this last case.
Another perverse bias is selective memory acting on past predictions, including situations in which no bet was made. People remember their successes much better than their mistakes, thus creating an illusion of skill based on this preponderance of positive memories. In betting, it's the memory of when they correctly predicted the outcome of soccer matches three times in a row. In the stock market, it's the case of someone who casually considers investing in a stock but doesn't. Months later, they see that the stock has risen significantly and conclude that all they needed to do was act on their "knowledge" to earn a huge return. They feel foolish for not having trusted their own ability and plan to invest next time because they "see an opportunity."
Há também os quase-acertos. Nas bets, é o jogo que terminou 3×1 e não no 2×1 da aposta. Na bolsa, é aquela ação mantida por tanto tempo e vendida só um mês antes de subir 20%. Em retrospectiva, tudo parece mais óbvio e surge a impressão de que o método usado está no caminho certo. Com poucos aperfeiçoamentos, deve funcionar bem.
The experience of winning repeatedly also motivates people to keep playing. Even with the negative average return common to gambling and speculative investments, this average is composed of several winning events amid numerous losses. Looking back and analyzing the results achieved so far, the picture should become clear, but it's difficult to act coolly. When you're winning, you want to keep playing to win more. When you're losing, you want to keep playing to recover what you lost before stopping. The urge to keep playing never ends.
Even the success stories that inspire newcomers are like the mythical song of the sirens, which lured sailors to their deaths at sea. Stories of people who got rich quickly and effortlessly by investing in stocks are real, as is the case of the poker player who came up with a royal straight flush (a sequence of high cards of the same suit). Both are possible but extremely rare events. Because winners tell their stories far more often than losers, we hear far more success stories than failure stories, giving the impression that the chance of success is greater than it actually is.
Each person's propensity to fall into these traps depends on their personality, core values, and life situation. Those who already have a tendency toward gambling addiction, don't care much about self-discipline, and find themselves in a fragile situation are more likely to be seduced by the possibility of quick gains through gambling. Once started, many find it difficult to stop.
Investors vs. gamblers
Stock exchanges and betting shops are very different environments, but certain behaviors manifest themselves in both. In the stock market, there are two very distinct investor profiles. One is the person who analyzes each opportunity in depth and makes rational, informed decisions. The other is the person who buys stocks based on instinct or hunches, without much pretense of knowing the business they're buying in depth. For the first profile, investing isn't a game of chance. For the second, it's a game perhaps even worse than casinos. In a game of roulette, the chance of winning is about 5% lower than the chance of losing. In the stock market, the unsuspecting trade against several professional, competent, and diligent investors.
This representation shows both extremes, but there's a wide spectrum of possibilities between the perfectly diligent investor and the completely irresponsible one. Few people view their own actions as speculators, and it's relatively common to see people acting in risky ways without fully understanding the risks. A few simple checks can help identify potential problems.
The fundamental question to answer when valuing a stock is whether its price is above or below fair value for the business. Consequently, it's necessary to estimate what that fair value is. This task involves a series of uncertainties, and even experienced investors can make mistakes in their assessment. However, they all know the discounted cash flow method, which is the fundamental mathematics behind the pricing of financial assets in general. Anyone who relies solely on the stock's price history and the simplified logic of valuation multiples will be at a clear disadvantage in the market.
It's also essential to maintain a reliable history of all investments made, including transaction costs, and to calculate the portfolio's consolidated return. Ideally, over long periods. This is the only way to assess the success or failure of investments. While obvious, it's quite common to see independent investors who evaluate their investments on a case-by-case basis, without consolidating returns. They cherish the memories of gains and seek to forget the losses, never knowing whether the time they spend investing is profitable work or costly entertainment.
Anyone who frequently finds themselves holding onto a stock until it returns to its original price to recoup losses, or selling after a small rise to lock in gains, should consider whether they are truly acting rationally and wisely. Holding what is falling and selling what is rising is a classic cognitive bias, quite similar to the behavior of gamblers, who take more risks to try to recoup losses than to seek additional gains.
One final recommendation is pure and simple intellectual honesty when answering the question of whether one's investments are being made responsibly or whether they are based on hunches and instincts. There's a myth that great investors are those with sharp instincts and who act on impulse at the right times, capturing large gains in short periods. The reality is far less exciting than that. Instincts hinder more than they help, and there's a great deal of analytical work involved in every decision.
Even investing responsibly doesn't guarantee success, as the stock market is a competitive environment. It's not enough to be right; you need to be more right than the average participant to achieve a superior return. The importance of being diligent and technically well-founded is due to the fact that the alternative approach—investing with a gambler's attitude—is most likely guaranteed to lead to failure.
The consequences of stock market betting
Bringing the spirit of gambling to stock market investments causes the same ills. Irresponsible investments can also lead to financial ruin and family destabilization. We don't hear much about this because tragic cases are insignificant compared to the total volume of capital traded on the market and because the stock market plays a real role in the economy, allowing companies access to capital and providing liquidity to investors. Furthermore, stock market investments are less accessible. While betting sites allow bets starting at R$ 1, a standard lot of Petrobras shares currently costs around R$ 3,600. In other words, losing money in the stock market is a problem for the middle and upper classes, less likely to be labeled as victims in the news. But just talk to a sincere investment advisor to see that such cases are relatively common.
There's also a parallel between betting house operators, who prey on those prone to gambling addiction, and some financial market players, who engage in the same predatory behavior of exploiting laypeople. Exploitation mechanisms range from obvious pyramid schemes, which, despite being illegal and well-known, always manage to lure a number of unsuspecting individuals with promises of high, guaranteed returns; to more sophisticated, and perfectly legal, cases of investment products created by financial institutions and sold to their clients without full transparency about the risks. The client often even signs a statement stating they are aware of all the product's features, which exempts the financial institutions from potential problems, but almost no one reads the long, tedious contracts. Only the most extreme cases occasionally appear in the media and are quickly forgotten. Our warning is that each person should assume full responsibility for protecting their own assets.
For the country, treating the equity market as a giant casino is also not beneficial. Investors interact with the real economy in two main ways. The first is through primary offerings (IPOs and follow-ons), processes that provide new capital to companies. Investing in these offerings without proper analysis results in poor capital allocation and the consequent waste of the country's existing resources on low-profit economic activities. The second is through the influence investors exert over the executives of listed companies, who seek to please the market in the hope of contributing to their share prices' rise. In both cases, the direct responsibility lies much less with individual investors than with professional managers, who move large amounts of capital. However, managers react to their clients' desires. If they demand quick returns, their strategies become short-term and much more subject to the vagaries of chance.
While this type of behavior is becoming increasingly common in the market, we are privileged to have highly differentiated clients who maintain a long-term focus and a strong philosophical alignment with our fundamentalist approach. This allows us to execute a much more rational and thoughtful management approach, which has generated excellent returns for our investors for over a decade.
