Why Both Casinos and Investors Prefer Many Small Bets Over Large Ones
It’s often said that casinos prefer players to make many small bets rather than fewer large ones. In my opinion, this principle also applies to investing. Both casinos and investors thrive on a strategy of spreading risk and managing variance. This approach can work well in both worlds.
House Edge and Variance
Casinos operate with a house edge, a built-in statistical advantage that ensures they make money over the long term. Slot machines account for 60-70 percent of the casino’s earnings, where the house edge is 2% to over 10%. The more bets a player places, the more predictable the outcomes become for the casino.
- Expected outcomes: When players make many small bets, their results are more likely to align with the casino’s mathematical advantage. This helps the casino ensure consistent profits over time.
- Exposure to house edge: Each additional bet exposes the player’s bankroll to the house edge. As players make more bets, the casino has more opportunities to capitalize on this edge.
- Law of Large Numbers: This principle states that as the number of bets increases, the actual outcomes will converge with the expected statistical probabilities. For casinos, this guarantees that their built-in advantage plays out over time, minimizing short-term fluctuations and ensuring long-term profitability.
Large Bets and Variance
Although casinos hold an advantage in all games, they are more vulnerable to short-term volatility when large bets are placed.
- Higher risk: Large bets introduce more variance, meaning that while the casino may have the edge, they face the risk of significant short-term losses. A single high-stakes player could win big against the casino with a few lucky bets.
Applying the Logic to Stock Market Investments
Much like casinos, investors also benefit from spreading their risk over multiple smaller investments rather than concentrating on a few large ones.
Risk Distribution
In investing, spreading your portfolio across many smaller positions reduces the impact of any one loss. This approach aligns with the principle of diversification, a core strategy in financial management.
- Diversified risk: By dividing your investment into smaller portions across different stocks or sectors, you reduce the impact of a single underperforming stock. In contrast, putting all your money into one or two large positions exposes you to higher volatility and potential losses.
Psychological Factors
Smaller bets often come with psychological benefits for the investor.
- Frequency of wins: Making smaller good bets allows for more frequent positive outcomes, providing a sense of accomplishment and enjoyment. This is similar to the psychological boost investors get when multiple parts of their portfolio perform well.
- Stress reduction: Large, high-stakes bets can induce more stress due to the higher potential for significant losses. With smaller bets, the stakes are lower, leading to a more relaxed decision-making process.
Skill Development
Making smaller bets offers more opportunities to learn and improve.
- More learning opportunities: In the stock market, frequent, smaller trades offer chances to assess performance and make adjustments.
Time Investment
Small bets often require more time and effort to track and manage. This can be seen as either an advantage or a drawback.
- Time management: Tracking multiple smaller investments or bets can take time, but it also offers more opportunities to optimize strategies over time. For those who enjoy the process, it’s a chance to stay engaged and informed.
The Coin Flip Example
Imagine you have a two-sided coin with heads and tails, but this coin lands on heads 60% of the time while still paying out like a normal 50/50 coin flip. In this case, you would always bet heads because you have a statistical advantage. However, you would prefer to make many small bets on this coin flip rather than betting your entire bankroll on one flip. By spreading your bets, you reduce the impact of variance and increase the likelihood that your statistical edge plays out over time, just like a casino with its house edge.
Investment Strategy and Time Horizon
When it comes to investing, the principle of spreading risk plays out well over longer time horizons. Just as in casinos, where frequent small bets reduce variance, long-term investors benefit from a diversified portfolio.
- Diversification benefits: A diversified portfolio spreads investments across multiple companies and sectors, reducing risk. If one stock underperforms, others may offset the losses. You also can apply losses against gains to optimize your tax footprint.
- Performance over time: Data shows that diversified portfolios tend to deliver more consistent returns over time compared to single-stock picks. The S&P 500, for instance, has shown positive returns in 37 out of the last 50 years. In contrast, only about 20% of individual stocks outperform the market over long periods.
- Risk management: Just as a casino prefers many small bets to smooth out variance, long-term investors can better manage risk by holding a diversified portfolio. Temporary market downturns in individual stocks are often offset by gains in others.
- Cost efficiency: Investing in a diversified portfolio, such as through mutual funds, index funds or ETFs, is often more cost-effective than trading individual stocks. Frequent trading can lead to high transaction costs and tax liabilities.
Conclusion
Both casinos and investors prefer strategies that involve many small bets over fewer large ones. For casinos, this ensures long-term profitability by reducing short-term volatility. For investors, spreading investments across multiple assets reduces risk and increases the likelihood of consistent returns over time. Whether you’re gambling at a casino or investing in the stock market, the logic remains the same: spreading out risk through smaller, diversified bets leads to more predictable outcomes.