Financial markets aren’t like casinos – but they aspire to their condition

CASINOS are a triumph of human achievement – a beacon of what financial markets hope to accomplish. No, I’m not being facetious. Consider the distinction the economist Frank Knight made between risk and uncertainty. Risk is calculable because the range of possible outcomes is known. In roulette, for example, a ball is released into a spinning wheel that contains 38 slots. The probability of correctly guessing is 1/38, and casinos will pay out odds of 35 to 1 (the difference constitutes the house advantage). Uncertainty is everything else. It is the range of possible outcomes that cannot be reduced to calculable risk. For roulette, if an Elvis impersonator jumped onto the table and stole the ball this might constitute an uncertain event. By definition it cannot be included in the payoffs, because there is no known distribution.

Both Austrian and Keynesian economists share this risk/uncertainty distinction, and while some cynical commentators like to suggest similarities between casinos and financial markets, this provides a neat way to understand the real difference between the two – casinos are temples to precisely-calculated and managed risk; financial markets exist to convert uncertainty into risk.

Casinos can also provide insight into just how hard that is. I’ve just returned from the 2012 Association of Private Enterprise Education conference, held in Las Vegas, where I set out to spend a few hundred dollars playing blackjack.

On my way to the table, I stopped off at the roulette wheel and put $10 on the number 24. It came in, winning me $350. The problem I then faced was how this win affected my plans to gamble further.

The main issue when gambling is retaining self-control. My strategy is to take out the maximum I am willing to lose in cash, and leave my credit card in my room. My problem was that now I had $550 in my pocket, and felt euphoric, so I took a moment to collect my thoughts.

One option was to “reinvest” all of the winnings, and enjoy the potential of even greater profits. But if you never cash out you are guaranteed to lose.

The second option was to split my money in two, and revise my original decision about how much to stake. I wanted to guarantee a financial profit, so I could try to ignore the $350 win and only bet with the money I was originally willing to gamble. But the problem with this is that it wasn’t time consistent. I could have gone to the blackjack table intending to spend $200, but what would my future self do in a few hours time? I would almost certainly dip into the rest of the profits.

Without a way to credibly commit to staking a fraction of the profit, I could only see two choices: walk away, or lose it all. So I cashed in the chips, went to my room and wrote this column, with fresh respect for everyone who works to turn uncertainty into risk for a living.

Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School: