“Trust me,” he whispers, “Lucky Clover is going to run away with the race.”
Your gambling ‘advisor’ is disheveled and smells like musty hay. He’s hiding from the cold drizzle under the stable’s overhang. Normally you’d run. But who knows horses better than this dude?!
Ok, you tell yourself, I’m gonna listen to Hay Guy. I’m betting big on Lucky Clover.
You walk inside the track lobby and see Lucky Clover at 3-to-1 odds. If you bet $1 and Lucky wins, you get $3 in profit. You lay down $100.
You sit back, order your seltzer, and watch the betting windows for a while. Bettor after bettor—some of whom look part-equine—are pouring bets on Lucky Clover. So many bets, in fact, that Lucky’s odds start to change.
The track is running a pari-mutuel betting system. The odds on each horse change relative to how much money has been bet on all the other horses. Since Lucky Clover is getting all the bets right now, his odds are increasing quickly. Seems like Hay Guy’s secret wasn’t too secret.
This is bad for you. Unlike other betting systems, your odds aren’t “locked in” at the time of betting. Your odds get affected by all bets, even after you’ve laid your bet down.
3-to-1 turns to 2-to-1. Then even. More bets still come in. By the time the dust has settled, Lucky is showing 1-to-10 odds. Your $100 bet is only going to return $10 profit—assuming Lucky wins! Put another way: if the horses ran 11 races, the bettors believe that Lucky would win 10 times.
Can he be that Lucky? Or will he be a No Leaf Clover instead?
Can any horse be that good? Does “best horse” equate to “best bet” at any odds?
Horse Betting –> Investment Betting
Traditional investments have similarities and differences to the parimutuel betting system.
Let’s start with an important difference. In investing, your purchase price does not change after you’ve made the purchase. Duh. You pay what you pay. That’s different than pari-mutuel horse betting, where your bet’s odds aren’t finalized until after everyone’s betting is complete.
But here’s a vital similarity. When investing, your purchase price is determined by the market (of other investors). The odds in pari-mutuel betting are determined by the market (of other bettors). Everyone else’s opinions (their purchases, their bets) affect the price that’s presented to you. It’s a market.
If a stock is an “obvious winner,” then investors will buy it. As demand for that stock increases, the stock’s price will increase as well. Upward and upward. But at some point, the intelligent investor should ask themself:
“If it was an ‘obvious winner’ at the initial low price, is it still an ‘obvious winner’ at this much higher price?”
The answer is no.
The “best company” is not always the “best investment.” The “best horse” is not always the “best bet.” It all depends on the price (or the odds). And the price is set by what all the other investors (or bettors) are doing.
What’s a better car—a Honda Civic or a BMW?
What’s a better investment—a Civic for $20K or a BMW for $500K?
The “better car” is not necessarily the “better investment.” Price matters. And the price is determined by market forces (e.g. “Mr. Market“).
As Howard Marks opined, “Investment success doesn’t come from ‘buying good things,’ but rather from ‘buying things well.'”
We don’t invest in a vacuum. We invest in a market. Other investors’ actions matter.
Apple and ARKK
Apple might be the best company in the world right now. It’s trading at $175 per share (on 2/1/22), a price-to-earnings ratio of 29, and a market capitalization of $2.85 trillion. It’s a wonderful company.
Is Apple a good investment at this price? Or is it an overbought Lucky Clover bet?
I don’t know! I don’t pick stocks. But I do know that the “game” of investing involves more than finding wonderful companies to buy. It’s about finding wonderful companies at fair prices.
[For what it’s worth, the hotly debated “efficient market hypothesis” suggests that the stock market is efficiently priced—e.g. that Apple is fairly priced at $175, neither a good bet nor a bad bet.]
Last week I wrote about Cathie Wood’s ARKK fund. The more money that poured into ARKK, the more expensive it got. At some point, investors were making “Lucky Clover” bets on ARKK. Bets that were too steep to expect sufficient return. Bad bets. (I know—easy to say in hindsight).
So…Don’t Invest?
Is Jesse saying that everything is too overbought, too overbet, and too expensive to invest in right now?!?!
No. That’s not what I’m saying. I know the stock market is high. And yes – the market will crash…eventually. But investing at all-time highs remains as smart a strategy as we can muster.
I’m not predicting highs or lows, good bets or bad bets. Instead, I’m merely sharing that this is the way the market works. You’re not investing in a vacuum. Prices are set by what everyone else is doing. And “everyone else” might be euphoric or despondent. Truth (usually) lies somewhere between.
Their opinions determine your price. And your long-term success is directly correlated to that price.
I think it’s important. And I think today’s idea will help you. But maybe I’m just a (slightly) better-smelling Hay Guy in a $500K BMW.
Thank you for reading! If you enjoyed this article, join 8000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.
-Jesse
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Very interesting I thought once you placed a bet the odds were fixed… Only been to a horse race once and the entertainment and food were the main attractions for my wife and I.
Betting and the stock market do seem to have a lot in common. I guess index investing would be like owning a small part of all the horses and the racetrack.
P.S. Good music selections!
Hey Tech!
My understanding is that most betting houses – including many horse tracks – do not use pari-mutuel betting.
Non-horse sports betting, for example, works how you described. Your odds don’t change after you’ve made the bet.
And yes – indexing is kinda like owning a stake in the house itself! You’re gonna catch profits eventually!
Hope all is well.
have you ever been to the horse races? i have, and with no illusions of beating the house. however, there is a version of the daily racing form available without listing the morning line odds next to the horses. without that line creating bias a person can use the 1000’s of data available on the form and make an opinion of which horses are likely to come in the money. like you mention the morning line is meaningless in parimutuel betting anyhow. generally a legit bettor would wait until close to post time and then place the wager if she’s getting the value she determined. a decent bettor also probably would not bet on about 80% of the races on the card on a given day when she didn’t feel she was getting a good value proposition.
in the end it’s a tough game with the house taking 15% of the betting pool on win/place/show and 20% on exotic bets like exactas and trifectas. if you overpay a little for a stock at least it doesn’t likely go to zero in two minutes or less like a wagering “investment.” it’s hard to win at the track but it’s still a fun day with friends, a few beers and keeping the wagers reasonable. treat it like a day at the movies which nobody really “needs” but costs a few bucks these days.
Great point! The “rake” makes the game completely different.
Imagine paying a 15% trading fee on VTSAX? Woof. That would change the whole game.
-Jesse
Great post! Thanks for sharing the knowledge and keep up the good work.