Dear investors,
We have been following the case of bets in Brazil, sports betting sites that have become a craze and reached surprising proportions. In August of this year, according to a survey by BACEN, R$1.4 billion was spent on bets, considering only payments made via PIX. Of this amount, R$1.4 billion was spent by Bolsa Família beneficiaries, causing a wave of criticism of the activity, which is causing losses to a segment of the population that is already financially fragile.
Following the maxim that history does not repeat itself, but rhymes, this is just another version of an old problem that is well known to humanity. Many nations have faced times when gambling became fashionable and caused deep problems. Behind each story is something that is difficult to change: the human propensity for gambling addiction. It is not a simple psychological phenomenon. Although the rational solution is obvious: simply not to gamble, it is difficult to find a practical way to stop people from gambling.
The impulses that lead to sports betting are also well-known in the world of investments. There are people who see the harm in betting clearly, 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 another victim, what you can do is try to understand the psychology behind gambling addiction and conduct an honest self-analysis to look for possible harmful behaviors in yourself. Identifying a problem is the first step to solving it. This will be our topic.
Historical overview
In ancient Rome, gambling on dice games, gladiator fights, chariot racing, dart throwing and other sports were very popular. There is evidence of several attempts to control this through legal means, through sanctions for owners of gambling establishments, imposition of fines on practitioners and outright bans for military and government officials.
During the Chinese Ming and Qing dynasties (14th to 20th centuries), gambling was very common. Lotteries, card games, dice games, mahjong, race betting and animal fighting were all popular. The Ming government even imposed a total ban on gambling, imposing severe penalties: fines, imprisonment and corporal punishment for gamblers and operators of gambling establishments. Even so, the activity remained popular for centuries.
In 16th-19th century England, lotteries, card games, and horse racing betting were 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 court system. The law had some positive results, but also some side effects. For example, since gambling debts could not be collected 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 is no wonder that governments in different eras and cultures have tried to suppress the practice among their populations. The second point is that attempts at regulatory suppression have not been effective, even with the imposition of harsh penalties. The problem is chronic, like drug use.
Given this historical context, it is hard to imagine that Brazil will easily escape the bad 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, you must start by cultivating virtue in yourself, then order your family life, then contribute to your community and thus expand the order to ever wider circles. It is a long path and one that is unlikely to receive relevant 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 with each other to create this link with gambling schemes. The beginning is usually unpretentious, motivated by curiosity and the search for fun. By the adrenaline of betting and rooting for the desired result. By the pleasure of imagining what could be done with the prize money. When the betting begins, the traps appear.
One of them is that the human mind tends to look for patterns in historical events, without taking the time to check whether they are statistically relevant or just random accidents that give the appearance of order, similar to the possibility of seeing a cloud in the shape of an elephant. This leads bettors to theorize about methods of predicting results 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 says that Brazil always wins when he watches 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, do not 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 guesses, including situations in which no bet was made. People remember their successes much better than their mistakes, and thus create an illusion of skill based on this preponderance of positive memories. In betting, it is the memory of when they correctly guessed the outcome of football matches 3 times in a row. In the stock market, it is the case of someone who casually thinks about investing in a stock, but does not do so. Months later, they see that the stock has gone up a lot 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 they see that they “see an opportunity”.
There are also near misses. In betting, it is the game that ended 3-1 and not the 2-1 bet. In the stock market, it is the stock that was held for so long and sold only a month before rising 20%. In retrospect, everything seems more obvious and the impression arises that the method used is on the right track. With a few improvements, it should work well.
The experience of winning several times also motivates people to keep playing. Even with the negative average return that is common to gambling and speculative investments, this average is made up of several winning events amidst numerous losses. Looking back and analyzing the results obtained so far, the picture should become clear, but it is difficult to act coolly. When you are winning, you want to keep going to win more. When you are losing, you want to keep going 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 that lured sailors to their deaths at sea. The 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. Since winners tell their stories much more often than losers, many more stories of success than failure are heard, and the impression is created that the chance of success is greater than it really is.
The likelihood of falling into these traps depends on one’s personality, core values, and life situation. Those who already have a tendency toward gambling addiction, don’t care much about self-discipline, and are in a fragile situation are more likely to be seduced by the possibility of quick gains through gambling. Once they start, many find it difficult to stop.
Investors vs. gamblers
Stock exchanges and betting houses are very different environments, but some behaviors are evident in both places. In the stock market, there are two very distinct investor profiles. One is the person who analyzes each opportunity in depth and makes decisions in a rational and well-founded manner. The other is the person who buys shares based on instincts or hunches, without much pretense of knowing the business they are buying well. For the first profile, investing is not a game of chance. For the second, it is a game that is perhaps even worse than casinos. In a game of roulette, the chance of winning is about 5% lower than that of losing. In the stock market, the unsuspecting trade against several professional, competent and diligent investors.
This depiction shows both extremes, but there is a wide spectrum of possibilities between the perfectly diligent investor and the completely irresponsible one. Few people see themselves as speculators, and it is relatively common to see people acting in risky ways without being fully aware of the risk. A few simple checks can help identify potential problems.
The fundamental question to be answered when valuing a stock is whether its price is above or below the fair value for the business. Consequently, it is 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, but they are all familiar with the discounted cash flow method, which is the fundamental mathematics behind the pricing of financial assets in general. Anyone who bases their calculations solely on the stock's price history and the simplified logic of valuation multiples will be at a clear disadvantage in the market.
It is also essential to keep a reliable history of all investments made, including transaction costs, and to calculate the consolidated return on the portfolio. Ideally, over long periods. This is the only way to assess the success or failure of investments. Although it is obvious, it is quite common to see independent investors who evaluate their investments on a case-by-case basis, without consolidating the returns. They keep fond memories of the gains and try to forget the losses, without ever knowing whether the time they spend on investments is profitable work or costly entertainment.
Anyone who frequently finds themselves in the position of holding on to a stock until it returns to the price they bought it for, in order to recoup losses, or selling stocks after a small increase, in order to secure gains, should reflect on whether they are actually acting rationally and in a well-founded manner. Holding what is falling and selling what is rising is a classic cognitive bias and quite similar to the behavior of gamblers, who take more risks to try to recover losses than to seek additional gains.
One final recommendation is to be completely honest about whether your investments are being made responsibly or whether they are based on hunches and instincts. There is a myth that great investors are those who have sharp instincts and act on impulse at the right times, capturing large gains in short periods of time. The reality is much less exciting than that. Instincts are more of a hindrance than a help, and there is a great deal of analytical work involved in every decision.
Even if you invest responsibly, there is no guarantee of success, because remember that the stock market is a competitive environment. It is not enough to be right; you need to be more right than the average participant to have a superior return. The importance of being diligent and technically well-founded is due to the fact that the alternative style, investing with the attitude of a gambler, will most likely guarantee failure.
The consequences of stock market betting
Bringing the spirit of gambling to stock market investments causes the same problems. Irresponsible investments can also lead to financial ruin and the destabilization of families. We don't hear much about this because the tragic cases are not very representative compared to the total volume of capital traded on the market and because the stock market has a real function in the economy, allowing companies to access capital and providing liquidity to investors. In addition, stock market investments are less accessible. While betting allows bets starting at R$1, a standard lot of Petrobras shares currently costs around R$3,600. In other words, losing money on the stock market is a problem for the middle and upper classes, who are less likely to be labeled as victims in the news. But just talk to an honest investment advisor to see that cases like this are relatively common.
There is also a parallel between betting house operators, who take advantage of those who are prone to gambling addiction, and some financial market agents, who have the same predatory behavior of exploiting lay people. The mechanisms of exploitation range from the obvious pyramid schemes that, although already illegal and well-known, always manage to attract a number of unsuspecting people with promises of high and 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 usually even signs a term stating that he is aware of all the characteristics of the product, which exempts the financial institutions from possible problems, but almost no one reads the long and boring contracts. Only the most extreme cases appear in the media, occasionally, and are forgotten about soon after. Our warning is that each person assumes full responsibility for protecting his or her 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 (IPO and follow-on), processes that provide new capital to companies. Investing in these offerings without due analysis results in poor capital allocation and the consequent waste of the country's existing resources on unprofitable economic activities. The second is through the influence that investors exert on the executives of listed companies, who seek to please the market in the hope of contributing to the rise in the price of their shares. In both cases, the direct responsibility lies much less with individual investors than with professional managers, who move large volumes of capital. However, managers react to the desires of their clients. If they demand quick returns, the 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 very different clients, who maintain a long-term focus and a strong philosophical alignment with our fundamentalist approach. This allows us to carry out much more rational and considered management, which has been generating excellent returns for our investors for over a decade.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
