Does gambler's ruin apply to stock markets?

Question

The gambler's ruin predicts that people who speculate on future events will fail and succeed at the same rate, but a speculator with a larger initial stake will, in the long run, accumulate more money because the one with a smaller stake is likely to go broke sooner. The result of gambler's ruin is the concentration of wealth among those who possess an initial advantage in wealth.

This sounds like it applies to the stock market to me, but I've been told that it doesn't. Unfortunately, no one's explained why it doesn't apply.

I should have been more clear about how I thought gambler's ruin applied to the stock market. A large investor is able to better diversify his holdings because, I believe, stocks are usually sold in lots. So, a large investor could put a relatively small percent of his stake in each of a large number of stocks, but a small investor would have to put a higher percent of his stake in each of a smaller number of stocks. This makes it more likely for the smaller investor to go broke, and lose his stake, because each trade he makes is a proportionally larger gamble. With a mixture of large and small investors, the wealth would, eventually, be transfered to those who had a larger stake to begin with.

Answer 1

There are at least two issues to consider here, (1) game theory and (2) market structure. Let's take game theory first.

Gambling is a negative-sum game (for every dollar someone loses, there is less then one dollar someone else wins, because of the "house take", aka casino fees). The average gamble, therefore, is a small loss to the house.

The stock market, in contrast, is a positive-sum game (over the long periods of time, stocks go up, because they represent ownership of actual companies, the majority of which are value-adding concerns). So the average stock investor wins about 12% per annum in the long haul.

And now for something completely different (market structure, that is)...

There a phenomenon called "market impact"; large trades cause the market to move against the trader, so large purchases are slightly (and sometimes substantially) more expensive, while large sales are slightly (and sometimes substantially) cheaper.

Answer 2

1

Answer 3

The "gambler's ruin" I'm familiar with, is associated with the percentage of your portfolio risked in a position, as applied to the gambler.

If a gambler risks 100% of his money on each position, it doesn't matter how many times he wins, or how much money he has, he will certainly be "ruined" the first time he loses. It isn't a matter of "if" but rather "when" he will be wiped out.

So if we apply a few parameters here for trading, we can evaluate a optimum percentage to risk on each trade. Let's say you need to be able to withstand 10 losing trades in a row to keep playing the game. What is the optimum percentage of your portfolio to risk in each trade? We've already ruled out 100%.

It turns out to be somewhere around 6% or 7%. Any higher, and you run out of money before the 10th trade.

Most professional traders never risk more than 3%.

This doesn't mean you can't invest the full amount of your capital on hand, but you can only "risk" 7%. That means you either watch it real close, all day long, or you set a Protective Stop.

Answer 4

I'm not familiar with the term "gambler's ruin" - but there is definately risk involved, especially short-term, in the stock market. However, you can minimize this risk by investing in solid companies with low valuations - over the long term you will win out. Short-term investments in penny stocks and/or hype-driven stocks can be like gambling.

Answer 5

nope