You may be wondering: what does horse racing have to do with investing? Charlie Munger answered this question in his famous Worldly Wisdom speech:

“The model I like — to sort of simplify the notion of what goes on in a market for common stocks — is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.”

I never bet on racehorses. Ever. The rake taken by the track is just too high for it to make any sense financially and for me the entertainment value is low. But you can learn important lessons about investing by listening to people who understand horse handicapping. I believe you can learn from just about anyone, which is why I have written blog posts on people like Bill Murray and Rza from Wu-Tang Clan. This blog has two indexes where you can see “old” posts organized by featured individual or topic. These old posts are just as up to date as the new posts. They are written to be as timeless as possible.

In the pari-mutuel  system used by racetracks, the money bet is pooled for each type of bet, the racetrack takes its percentage (the rake), and the remainder is disbursed to the winners in proportion to the amount wagered. Michael Mauboussin further explains in his book More Than You Know:

“One way to think about it is to contrast a roulette wheel with a pari-mutuel betting system. If you play a fair game of roulette, whatever prediction you make will not affect the outcome. The prediction’s outcome is independent of the prediction itself. Contrast that with a prediction at the racetrack. If you believe a particular horse is likely to do better that the odds suggest you will bet on the horse. But your bet will help shape the odds. For instance, if all bettors predict a particular horse will win, the odds will reflect that prediction, and the return on investment will be poor.

The analogy carries to the stock market. If you believe a stock is undervalued and start to buy it, you will help raise the price, this driving down prospective returns. This point underscores the importance of expected value, a central concept in any probabilistic exercise. Expected value formalizes the idea that your return on an investment is the product of the probabilities and the various outcomes and the payoff from each outcome.”

The famous Preakness horse race is being run today and on that Steven Christ has said:

“Exaggerator may provide better betting value as the 3-1 second choice than Nyquist at 3-5.”

This post will explain why professionals focus on finding the better betting value instead of predicting which horse is most likely to win the race. Nyquist can be the horse most likely to win the race and not be the best bet in terms of value. It is magnitude of success that matters in a probabilistic activity, not frequency of correctness.

Steven Crist is the editor and publisher emeritus of the Daily Racing Form, a newspaper that reports on the past performance of race horses. Crist has had a number of jobs in the horse racing industry over the years, including writing about horse racing and the gambling generally as a reporter and columnist for The New York Times from 1981 to 1990. He is the author of several books on horse racing and a 1978 graduate of Harvard. Crist fell in love with horse racing while in college: “The stats and numbers stuff is there. Plus the animals, the gambling—and the weird subculture: the racetrack is…well, like people who ran away and joined the circus.”

The idea for this blog post came from Michael Mauboussin, who I quote in this post and elsewhere extensively. His writing is an amazing resource for investors.

Here are the usual dozen quotes from this week’s featured personality Steven Crist:

 

1. “A good litmus test for someone being a liar and an idiot is if someone ever tells you, ‘I am really good at roulette,’ or ‘I win at craps,” or ‘I have a system for beating the slot machines.’ There is no such thing. These are games with fixed percentages. The casino might as well attach a leach to your forehead when you walk in the door because the longer you stay, the more you will lose, except for short-term, meaningless fluctuations.” There are zero professional roulette players. For similar reasons, I would rather pit a viper down my shirt than play a slot machine. Some people may feel cool when playing craps thinking that they are a modern day member of the rat pack, but craps in a casino is a game for suckers who are bad a math. If you really want to gamble or play cards there are games with better odds.

 

2. “The exceptions to [the previous] rule are blackjack and poker. If you count cards diligently in blackjack, you can get a 1.5 percent edge over the house. Casinos, of course, don’t get built by players having edges, so the casinos will eject you if they figure out that you’re counting cards.” There are a number of investors who counted cards at one time in their life. Card counting was invented by a group of U.S. Army Engineers known as the Four Horsemen. They published their ideas on card counting in a paper in 1957 entitled Playing Blackjack to Win. A mathematician named Ed Thorp improved on that system in his famous book Beat The Dealer. Card counting is now a well-known phenomenon. As just one example of a card counter, the actor Ben Affleck has been banned from several casinos for counting cards.  He said about one incident: “That being good at the game is against the rules at a casino should tell you something about a casino.” As just one example, Affleck has been told to never again play blackjack at the Hard Rock Hotel and Casino.

 

3. “Poker, which is always situated right next to the horse racing area. The reason that you can win at poker and horse racing is the same – you are not betting against the house; you are betting against the other players. This is such a crucial and fundamental difference, and it is lost on the general public. The house is not setting the odds. In roulette, there are 38 spaces on the wheel, and if you pick the correct one, the house will pay you off at 35-to-one, and they will keep the difference. The longer you play, the more you lose and the more the house wins. When the other players are setting the prices, it is an entirely different story because somewhere between frequently, occasionally and rarely, the public makes the wrong price.” Many successful investors also play poker. Michael Mauboussin tells this story which makes an important point about poker:

 

“Jim Rutt, who used to be the CEO of Network Solutions [talks] about playing poker when he was a young man. By day, he would learn about the different probabilities, and look for poker tells and pot odds, and all this stuff, and by night he would play. He played in progressively tougher games, and won some, lost a little. Eventually, his uncle pulled him aside and said, “Jim, it’s time to be less worried about getting better, and more worried about finding easy games.”

 

Warren Buffett put it this way in 2002: “The important thing is to keep playing, to play against weak opponents and to play for big stakes.”

Buffett’s partner Charlie Munger is another  example of someone who learned a lot from poker, including:

 

“Playing poker in the Army and as a young lawyer honed my business skills. What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often. Opportunity comes, but it doesn’t come often, so seize it when it does come.”

 

4. “The truth is that only a small number of people are 20% better than the takeout, and that just gets you even. It’s a tough, tough game to win.” I’ve have zero intention of ever betting on a horse race. Charlie Munger says he knows people who beat the odds even with this 20% “rake” by the track.  That may be true, but I’ll pass thank you very much. As I said previously, I just don’t enjoy gambling as entertainment. Some people may enjoy betting on horses or be addicted to it. If they are the former, they need to worry about the latter. Even if there is a tiny probability that I might become addicted to gambling I never want to take that chance given the magnitude of the potential harm. The odds of you seeing me playing roulette or pulling the arm of a slot machine in a casino are zero.

 

5. “The central premise of pari-mutuel wagering, is to get a better price from the other bettors than something deserves to be.” “Recognize the difference between picking horses and making wagers in which you have an edge. The only path to consistent profit is to exploit the discrepancy between the true likelihood of an outcome and the odds being offered.” “If you demand sufficient value to cover the margin of error, you should outperform the competition-your fellow horseplayers.” When Crist talks about “value necessary to cover mistakes” who does that sound like? Ben Graham and his margin of safety. Michael Mauboussin writes: “A positive expected value opportunity has an anticipated benefit that exceeds the cost, including the opportunity cost of capital. Not all such financial opportunities deliver positive returns, but, over time, a portfolio of them will…. An investment is attractive if it trades below its expected value. Expected value, in turn, is a function of potential value outcomes and the probability of each outcome coming to pass. Investing is fundamentally a probabilistic exercise. Investing is the constant search for asymmetric payoffs, where the upside opportunity exceeds the downside risk. Ben Graham described margin of safety as buying an investment for less than what it is worth. The larger the discount, the greater the margin of safety.” Bloomberg writer David Papadopoulos writes that one should seek finding “value” in a horse. He says: “You’re not necessarily looking for the most likely winner, so much as a horse whose odds are longer than they ought to be.”

Venture capital is the extreme case in that the better betting value is determined by how cheaply one can buy optionality. Optionality is sometimes mis-priced and can be bought at a bargain.Those situations tend to be in places where others are not looking and the failure rate is high. I have written two blog posts on optionality which discuss this topic in greater detail.  Jeff Bezos describes the value of mis-priced optionality here:

 

6. “What you really want to do is determine which most-likely winners are good prices and which most-likely winners are bad prices. It is a very simple equation:

 

Price X Probability = Value. 

 

The entire world of investing is that simple too. Here is what I mean. If a horse has a 33 percent chance of winning a race, and if you can get odds of 2-to-1 on him (which means tripling your money), there is no value – the horse is priced correctly. If a horse is 6-to-5 (which means you will only get back 120 percent of your bet) and he is only 33 percent to win, then he is a terrible bet. If you’re going to get 4-to-1 (quintupling your money) on a 33 percent chance winner, then it’s a great bet. People talk about value as if it is a ‘factor’ or an ‘angle’ when in fact it is the definition of success at pari-mutuel wagering.”  The math here is simple, but the many sources of emotional bias make the process fraught with potential problems. And of course determining probability is often not a simple thing and sometimes not even possible. Mauboussin writes:

“We can specify two types of probabilities: objective (or frequency) and subjective. Objective, or frequency, probabilities arise when there are specified outcomes. Coin tosses are a good example. In these cases, the probability is based on the law of averages as it assumes that the event is repeated countless times. While we still can’t make definitive statements about any specific outcome, the frequency of outcomes will reflect the probability of each outcome over time. The circumstances are totally different for events that only happen once, a valid assumption for stock investing. Here, we must rely on subjective probabilities. Subjective probabilities describe an investor’s “degree of belief” about an outcome. These probabilities are rarely static, and generally change as evidence comes along. Bayes’s Theorem is a means to continually update conditional probabilities based on new information. Bayesian analysis is a valuable means to weigh multiple possible outcomes when only one outcome will occur.”

Of course there is also what Richard Zeckhauser calls “ignorance” when you do not know the potential future states of the world and probability therefore cannot be computed.

 

7. “The point of this exercise is to illustrate that even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds. A horseplayer cannot remind himself of this simple truth too often.” Michael Mauboussin writes: “Some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.” Charlie Munger talks about the need to understand probability and statistics here:

 

“So you have to learn in a very usable way this very elementary math and use it routinely in life – just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer. If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest.”

 

8. “Do you really think this way when you’re handicapping? Or do you find horses you ‘like’ and hope for the best on price?  Most honest players will admit they follow the latter path. This is the way we all have been conditioned to think: Find the winner, then bet. Know your horses and the money will take care of itself. Stare at the past performances long enough and the winner will jump off the page. The problem is that we’re asking the wrong question. The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as ‘liking’ a horse to win a race, only an attractive discrepancy between his chances and his price. It is not enough to lose enthusiasm when the horse you liked is odds-on or to get excited if his price drifts up. You must have a clear sense of what price every horse should be, and be prepared to discard your plans and seize new opportunities depending solely on the tote board.” What the investor wants to find is a substantially mis-priced bet. The objective is not to maximize the frequency of betting on winner but to maximize the magnitude of total winning bets.  Munger:

“Playing poker in the Army and as a young lawyer honed my business skills. What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often. Opportunity comes, but it doesn’t come often, so seize it when it does come.”

“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”

“It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one.”

9. “I’m usually looking to beat favorites because that’s how you make scores, and making scores quicker than you give them back is how you come out ahead.” Investing is the search for mistakes says the famous investor Howard Marks and one big mistakes people make is following the crowd. Sometimes a mis-priced bet can be found by being contrarian. Not always but sometimes.Often the mis-priced bet is caused by a bias that impact humans.  For example, Professor Thaler has a paper on long shot bias that is worth reading (link in the Notes below). There is little “value” in just betting on favorites to win due to the rake by the track.

“The favorite-long shot bias is an observed phenomenon where on average, bettors tend to overvalue “long shots” and undervalue favorites. That is, in a horse race where one horse is given odds of 2-to-1, and another 100-to-1, the true odds might for example be 1.5-to-1 and 300-to-1”

 

10. “A lousy handicapper, who bets on hopeless horses or takes the worst of prices, has no shot. A decent handicapper who makes idiotic bets won’t do much better. A ton of players consider themselves excellent handicappers and poor bettors or money managers, but I think they may be kidding themselves by rationalizing their losses this way.” “How often have you or a fellow trackgoer opined that you’re a pretty good handicapper but you really need to work on your betting strategies or your so-called money management? This is sometimes an exercise in denial for people who are in fact bad handicappers, but it is probably true for many who can select winners as well as anyone. The problem with this line of thinking is that it suggests betting is some small component of the game, which is like pretending that putting is a minor part of championship golf. In fact, if you handicap well and bet poorly, you’ve failed. It’s as useless as crushing your tee shots while three-putting every green.” Michael Mauboussin in these three quotations elaborates on by Crist says better than I ever could:

 

“Money management is all about determining the right amount of capital to allocate to an investment opportunity, given the edge and the frequency of such opportunities.

“Position size is extremely important in determining equity portfolio returns.”

“The first rule of money management is to “live to see another day.” Say you see a 50-1 event priced as if it’s 100-1. That is an attractive opportunity, but you surely wouldn’t bet your net worth on it. Two types of investments are worth looking out for. The first is a positive expected value investment with a high probability of loss. A portfolio of these investments is attractive, but betting too much on any single idea is poor money management. The second is the one with a high probability of gain but significant downside risk. These investments are luring even though they have a negative expected value. Eventually, time assures that investors seeking these opportunities do poorly (witness Long Term Capital Management). A related concept in money management is that it is not the frequency of correctness that matters, but the magnitude. Behavioral finance emphasizes that humans like to be right. Many positive expected value investments have a high frequency of a small downside and a low frequency of large upside. Such investment opportunities may be systematically mis-priced, reflecting inherent human bias. Another rule of money management is the larger the margin of safety, the more you should invest. More attractive investments should receive a greater percentage of the funds. While most portfolio managers have legitimate constraints on how much they can invest in any single idea, too frequently their asset allocation does not distinguish sufficiently for the relative attractiveness of various stock.”

 

In managing money many investor look to the Kelly criterion, a formula used to determine the optimal size of a series of bets.  Munger has recommended a book, Fortune’s Formula by William Poundstone on the subject. The Kelly criterion or formula can be expressed as follows:

Credit http://www.pinnaclesports.com/en/betting-articles/betting-strategy/how-to-use-kelly-criterion-for-betting

The formula reveals the expected value of any bet including an investment. Robert Hagstrom points out that many investors use what is called “a fractional Kelly.”  One popular approach is a “half Kelly” in which the wager is half of the Kelly bet.

Munger at the 2006 Wesco meeting said when asked about whether he uses the Kelly criterion:

“The first time I read about that sizing system, my take was that it seemed plausible to me, but I haven’t run that formula through my head – and I won’t. You couldn’t apply it to the investment operations I’ve run [I think because of Berkshire ’s size], but the gist of it in terms of sizing your bet makes sense. Whoever developed that formula has an approach to life similar to mine.”

 

11. “The horseplayer who wants to show a profit must adopt a cold-blooded and unsentimental approach to the game that is at variance with both the ‘sporting’ impulse to be loyal to your favorite horses and the egotistical impulse to stick with your initial selection at any price. This approach requires the confidence and Zen-like temperament to endure watching victories at unacceptably low prices by such horses.” Most mistakes are psychological or emotional. For all of the reasons Munger talks about in his famous Psychology of Human Misjudgment speech people make mistakes. Munger puts it this way:

 

“Now if the human mind, on a subconscious level, can be manipulated that way and you don’t know it, I always use the phrase, “You’re like a one-legged man in an ass-kicking contest.” I mean you are really giving a lot of quarter to the external world that you can’t afford to give.”

 

12. “So many of the bad gamblers—the people who should be pulling handles on slot machines — have left racing for casinos that one of the great regrets of current horseplayers is: ‘Where did all the suckers go?’ You want to be betting against people who are betting based on colors and jockeys and hunches.” Alpha or the amount that an investor may earn above the market return is a zero-sum game. Only in Lake Woebegone can more than half of the people be above average. This is why Howard Marks says that “In order for one side of a transaction to turn out to be a major success, the other side has to have made a big mistake.” After costs alpha is a negative-sum game. As John Bogle says: “investors as a group must fall short of the market return by the amount of the costs they incur.” Beta, or the market return is not a zero-sum game. As the economy grows everyone can rise with the tide, some of course more than others and some talking a loss anyway. As more investors move to index funds, there are less mistakes and less total opportunity for outperformance. On the topic of why people make mistakes I can’t resist one final quote from Crist about people looking for clues in factors that do not matter:

 

Here’s the rest of Charlie Munger’s explanation of why investing shares attributes with horse racing from his Worldly Wisdom Speech.

 

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you’ve got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work. Given those mathematics, is it possible to beat the horses only using one’s intelligence? Intelligence should give some edge, because lots of people who don’t know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take. Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce his average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the full 17%.

I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness races…. Now, harness racing is a relatively inefficient market. You don’t have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house—which I presume was around 17%—he made a substantial living. You have to say that’s rare. However, the market was not perfectly efficient. And if it weren’t for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races. It’s efficient, yes. But it’s not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.

The stock market is the same way—except that the house handle is so much lower. If you take transaction costs—the spread between the bid and the ask plus the commissions—and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.

It is not a bit easy. And, of course, 50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner—in a relative sense—instead of a loser? Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house. They’re sending money out net after the full handle—a lot of it to Las Vegas, by the way—to people who are actually winning slightly, net, after paying the full handle. They’re that shrewd about something with as much unpredictability as horse racing. And the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced be—that they can occasionally find one.  And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.  That is a very simple concept. And to me it’s obviously right—based on experience not only from the pari-mutuel system, but everywhere else.”

Notes:

Crist on the Preakness:  http://www.drf.com/news/crist-new-factors-likely-change-little-preakness

Harvard Magazine Profile: http://harvardmagazine.com/2010/03/horseplayer-extraordinaire

Crist on Value http://www.funnyeconomist.com/CRIST%20ON%20VALUE.doc

Handicapping Lessons https://medium.com/@onehorsestable/handicapping-lessons-from-the-world-of-poker-70c71a3a0934#.3vk01ezct

Crist Column http://www.valueinvestingworld.com/2008/01/steven-crist-publisher-and-columnist.html?m=1

Mauboussin- Size Matters  http://www.pmjar.com/wp-content/uploads/2013/05/Size-Matters-Mauboussin.pdf

Mauboussin- More than You Know  http://www.amazon.com/More-Than-You-Know-Unconventional/dp/0231138709

Puggy Pearson’s Prescription  http://documents.mx/documents/puggy-pearsons-prescription.html

The Racetrack and Equity Markets http://tabbforum.com/opinions/two-pari-mutuel-environments-the-racetrack-and-equity-markets-how-different

Thaler Paper: http://faculty.chicagobooth.edu/Richard.Thaler/research/pdf/parimutual%20betting%20markets.pdf

Munger Worldly Wisdom  http://old.ycombinator.com/munger.html

Munger Psychology of Human Misjudgment http://www.rbcpa.com/Mungerspeech_june_95.pdf

• A Dozen Things I’ve Learned from Josh Kopelman about Investing and Business
• A Dozen Things I’ve Learned from Louis C.K. about Money, Investing and Business

Categories: Uncategorized