Discusses parimutuel betting and its similarities to stock-market investing.
Draws on two examples, those of Bill Benter and Edward Thorp, to illuminate similarities between gambling and investing.
Presents a justification for treating investing as a branch of gambling while recommending a systematic approach.
Last May, Kit Chellel wrote a very interesting article for Bloomberg News about Bill Benter, who won $900 million betting on horse races. The races he bet on were run on a parimutuel system, where odds are updated in proportion to how bettors bet, with the house simply skimming a commission of the top.
One passage in the article leaped out at me:
Buried in stacks of periodicals and manuscripts, [Benter] found what he was looking for—an academic paper titled “Searching for Positive Returns at the Track: A Multinomial Logit Model for Handicapping Horse Races.” Benter sat down to read it, and when he was done he read it again.
The paper argued that a horse’s success or failure was the result of factors that could be quantified probabilistically. Take variables—straight-line speed, size, winning record, the skill of the jockey—weight them, and presto! Out comes a prediction of the horse’s chances. More variables, better variables, and finer weightings improve the predictions.
It struck me that that’s exactly what I’m doing when I trade.
The stock market is a bit like a parimutuel system. In parimutuel betting, all bets are placed in a pool, taxes and the house take are skimmed off the top, and the pool is shared by the winning bettors.
Let me give an example. Let’s say five horses are racing, and right before the race is run, all bets have been placed. $100 has been placed on horse #1, $200 has been placed on horse #2, $300 on horse #3, and so on. Altogether, $1500 has been bet. Let’s say the taxes and the take amount to 10%, leaving $1350 in the pool. If horse #5 wins, then those who bet on that horse will take home $1350 divided by $500, or a payout ratio of 2.7 to 1. If horse #1 wins, on the other hand, those who bet on that horse will take home $1350 divided by $100, or 13.5 to 1.
How is this like the stock market? Because in both cases, prices are set purely by the bidders, the traders, the buyers and sellers. The key to winning in a parimutuel betting system—just like the key to winning in the stock market—is to wield an advantage over other bettors/investors through better information/data and/or a better strategy.
Just like Bill Benter did, a wise investor can take factors that can be quantified, weight them, and come up with a prediction of a stock’s chances. The more and better variables, the better the predictions.
This has been my practice: to use as many and good variables as possible, to weight them well, and to look at every decision I make in probabilistic terms. I’m betting on twenty-seven stocks right now, stocks that I think will be winners not only because they’re primed to beat other stocks, but because I’m using formulas that few other investors use. I’m interested not only in the future performance of the companies I invest in but in the behaviors of other investors in those companies, just as Benter was interested not only in the performance of the horse he bet on, but in the betting behavior of his competitors.
The relationship between gambling and investing is made explicit in the abstract to the 1986 paper that Bill Benter read: “This paper investigates fundamental investment strategies to detect and exploit the public’s systematic errors in horse race wager markets” (emphases added).
At some point, gambling and investing can become interchangeable. Bill Benter was a gambler. But what about Edward O. Thorp, one of the greatest investors in history? Fundamentally, he was a gambler too.
Thorp started out playing blackjack. He proved, mathematically, that the odds could be in his favor if he counted cards, and in his 1966 book Beat the Dealer he was the first to show exactly how it could be done. When Thorp placed his bets at a blackjack table using his method, was he gambling or investing?
“The overlap of interest between gambling and the stock market is very high,” Thorp once said. “It’s an amazing phenomenon. But there are so many similarities and so much one can teach you about the other. Actually, gambling can teach you more about the stock market than the other way around. Gambling provides an analytically simpler world, and you can see principles and test theories.”
Thorp went on to derive the Black-and-Scholes options pricing model a few years before Black and Scholes (he decided to keep it secret in order to make money on it). Between 1969 and 1988 his Princeton Newton Partners firm made 19.1% annually, with a positive performance in 227 out of 230 months. Frederik Vanhaverbeke, in his book Excess Returns, points out that the probability of getting this kind of performance by pure chance is smaller than the probability that one would find a specific atom by looking in a random place on earth. Over twenty-nine years, Thorp’s compound annual return was almost 20%.
Now a lot of gambling has nothing to do with investing, and a lot of investing has nothing to do with gambling. Gambling based on odds set by a money maker rather than by other gamblers (as in most sports betting these days), gambling on slot machines, gambling on lottery tickets—these have little in common with investing. Dividend investing and fixed-income investing have little in common with gambling.
But I would argue that the point when successful gambling and successful investing become interchangeable comes when your aim is to beat the market, you take a purely systematic approach, you never let your emotions get in the way, and you let the data do the work.
If you take a rigorous probabilistic approach and put in lots of practice and hard work, it’s not that difficult to beat the house.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.