What happened in Vegas....

I just got back from Vegas after celebrating bachelor party of a close friend. Need I say more? Anyways, everything that happened in Vegas has stayed in Vegas, except, an interesting thought that I could not help not bringing back – Isn’t racetrack betting very similar to investing in stocks? Now I am not saying that both are blind gambling or that the outcome in both situations could be random, what specifically caught my attention is the pari-mutuel system. The odds are not determined by betting against the house but by betting against other betters. The odds are constantly changing based on what’s being bet. The payoff in racetrack is odds and the payoff in stock market is appreciation.

Let’s discuss a little further. It’s easy to bet on the horse that has a great winning record but the payout on it is pretty low, sometimes as low as 11 to 10. Something we commonly see everyday in the stock market. Following the hottest stocks is something similar – if the investment horizon is fairly small, betting on these “winning horses” could generate a profit, but it would be a very limited profit. In case of bad horses winning, the payout is very high, sometimes 100 to 1 or more, which is understandable because the chances of a bad horse winning is typically very low. But the questions becomes, is the system so efficient that there is no chance of a mispricing? Since the odds are being determined by the betting public, I can be fairly confident that the betting is not completely efficient and the emotional element of humans must lead to infrequent mispricing.

Maybe a horse connoisseur can identify these mispricings easily, but there is still another complicating factor – the juice (or house fee) on the race track is 17% - fairly exorbitant! So in order to have a great winning bet, you need to not only be able to identify the mispricing but the mispricing should also have a margin of at least 17%.

This made me think about investing smart in the stock market – it is fairly similar. In order to generate above market returns, a canny investor must be able to (a) differentiate good horses from bad, (b) wait till the good horses are labeled as bad horses (i.e. mispriced in the market), (c) determine the level of mispricing, and (d) bet when the odds are heavily in his favor. In simple words – few bets, infrequent bets, big bets.