Often, we are made to believe that picking great companies is all it takes to make it big in investing.
Buy the right companies, and sit tight - and watch your capital compound, we are told. This has in fact led to the term ‘BAAP - Buy At Any price’ becoming a big theme in recent years. However, if we look at history, this is not the case. A good business is not always a good stock, and winning investments are almost never that obvious.
And this is where the mental model of ‘pari-mutuel systems’ helps us.
A trip to the racecourse
Let's say you go to a race track to try your hand at horse race betting. You find a booklet with the details of all the horses participating in the race - how many races they have run, how many won, what were the conditions in which they won, what is their best time, who is the jockey and much more.
You spend some time exploring the booklet and with your limited understanding of the sport, conclude that one of the horses (let's call him ‘Chetak’) is the strongest contender in the race. Not sure of your analysis, you ask your friend who you believe is an expert at horse racing given the number of times he talks about horse racing, and had finally convinced you to come to today's race, as to which horse will win the race. He says, “Chetak, without a doubt. Every race I've seen Chetak participate, he has won”.
Your analysis is validated, you feel happy and confident. You have now decided to place your bet on Chetak. And once you reach the counter, you see that the odds 3 to 1 (which means that for every $ you bet, you'll get 3 if Chetak wins). You feel confident, and place your bet - Rs. 5,000 on Chetak.
It's an hour before the races start, you take your seat on the stands and start making mental notes on the kind of people who frequent this racecourse. Your seat gives you a good view of the race and the counter with the board displaying the odds. And suddenly you notice something - the odds on Chetak are now 2 to 1 (as against the 3 to 1 when you placed your bet). You wonder what's going on, but decide to not discuss it, lest you sound ignorant. The crowd begins to pour in as the race time approaches. There is now an unruly crowd at the betting counter, but you are able to get a quick glance of the display - and the odds are now 1 to 5. Which basically says that you get 20 cents to the dollar if you win. Essentially, implying that all the bettors have a consensus belief that Chetak will win 5 out of 6 races he participates in, and therefore taking away all the benefit from this obvious choice, and turning it into a certain loss. Not a great deal anymore, isn't it?
This is the pari-mutuel system - a system where the all bets are placed into a single pot and winning proceeds (after deducting the house share and taxes) are distributed to the winners in proportion to what has been bet. This, in essence, implies that the odds change based on what others bet - and not just on who wins. In such a system, while it is important to understand how the different horses (or companies, businesses or bets in general) would perform, it is even more important to understand the odds of (or payouts from winning) those bets.
As Charlie Munger, whose writings introduced this idea to me said in his speech titled ‘The Art of Stock Picking’:
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.
Respect the (G)odds!
So how do we make bets based on odds? Let’s start with a simple example -
Suppose you believe that the probability of winning for horse ‘A’ is 20% and the odds of the bet are 10 to 1, then for every $1 you bet - there is an 80% chance that you will lose the $1 and 20% chance you will get $10 - your expected value is $100.2 - $10.8 = $2. While there is another horse ‘B’ with a probability of winning at 5%, and a payout of 200 to 1, you do the same math and get an expected value of ~$9. Which bet will you make?
The above is an oversimplification, and reality is a lot messier where no clear probability of winning given to you. While everyone has the same historical information, we will need to assign our own probability of the horse winning (the the company succeeding in winning market share). You and I could very well come up with very different probabilities. However, once we form a view on these probabilities, build conviction on our judgement of these probabilities (which is, in my honest opinion, the most difficult part), we then need to look at the potential reward. If everyone feels it is an obvious winner and it is all priced in, it is a bad bet to make! More often than not, the best bets are in places where no-one is looking (at that point in time) and the the probability of winning is not so obvious.
As Munger put it:
To us, Investing is the equivalent of going out and betting against the pari-mutuel system. We look for the horse with one chance in two of winning which pays you three to one. You are looking for a mis-priced gamble. That is what investing is. And you have to know enough to know whether the gamble is mis priced. That is value investing.
Like what you read?
Kaisa lag raha hai Market? (How does the market look?)
This is probably one of the most common questions asked when someone talks about investing, despite being the most futile question from an investing perspective. Taking stock of whether the market is bullish or bearish, or discussing whether the Fed is hawkish or dovish, has absolutely no meaning when there are asymmetrical rewards in this Extremistan world of markets.
Nassim Taleb, in his exceptional book, Fooled by Randomness has illustrated this point rather well - following is a rather long excerpt from the book (I could have paraphrased it to make it shorter, but then, I would have sucked out all the sarcasm from it.)
The general press floods us with concepts like bullish and bearish as these mean to refer to the effect of higher (bullish) or lower (bearish) prices in the financial markets. But also we hear people saying “I am bullish on Johnny” or “I am bearish on that guy Nassim in the back who seems incomprehensible to me”, to denote the belief in the likelihood of someone’s rise in life. I have to say that the notion bullish or bearish are often hollow words with no application in a world of randomness – particularly if such a world, like ours, presents asymmetric outcomes. When I was in the employment of the New York office of a large investment house, I was subjected on occasions to the harrying weekly “discussion meeting”, which gathered most professionals of the New York trading room. I do not conceal that I was not fond of such gatherings, and not only because they cut into my gym time. While the meetings included traders, that is, people who are judged on their numerical performance, it was mostly a forum for salespeople (people capable of charming customers), and the category of entertainers called Wall Street “economists” or “strategists” who make pronouncements on the fate of the markets, but do not engage in any form of risk taking, thus having their success dependent on rhetoric rather than actually testable facts. During the discussion, people were supposed to present their opinions on the state of the world. To me, the meeting was pure intellectual pollution. Everyone had a story, a theory, and insights that they wanted others to share. I resent the person who, without having done much homework in libraries, thinks that he is onto something rather original and insightful on a given subject matter (and respect people with scientific minds like my friend Stan Jonas who feel compelled to spend their nights reading wholesale on a subject matter, trying to figure out what was done on the subject by others before emitting an opinion – would the reader listen to the opinion of a doctor who does not read medical papers?). I have to confess that my optimal strategy (to soothe my boredom and allergy to confident platitudes) was to speak as much as I could, while totally avoiding listening to other people’s replies by trying to solve equations in my head. Speaking too much would help me clarify my mind, and, with a little bit of luck, I would not be “invited” back (that is, forced to attend) the following week. I was once asked in one of those meetings to express my views on the stock market. I stated, not without a modicum of pomp, that I believed that the market would go slightly up over the next week with a high probability. How high? “About 70%”. Clearly, that was a very strong opinion. But then someone interjected “But, Nassim, you just boasted being short a very large quantity of SP500 futures, making a bet that the market would go down. What made you change your mind?”. “I did not change my mind! I have a lot of faith in my bet! (audience laughing). As a matter of fact I now feel like selling even more!” The other employees in the room seemed utterly confused. “Are you bullish or are you bearish?” I was asked by the strategist. I replied that I could not understand the words “bullish” and “bearish” outside of their purely zoological consideration. Just as with events A and B in the preceding example, my opinion was that the market was more likely to go up (“I would be bullish”), but that it was preferable to short it (“I would be bearish”), because, in the event of its going down, it could go down a lot. Suddenly, the few traders in the room understood my opinion and started voicing similar opinions. And I was not forced to come back to the following discussion. Let us assume that the reader shared my opinion, that the market over the next week had a 70% probability of going up and 30% probability of going down. However, let us say that it would go up by 1% on average, while it could go down by an average of 10%. What would the reader do? Is the reader bullish or is he bearish?
Accordingly, bullish or bearish are terms used by people who do not engage in practicing uncertainty, like the television commentators, or those who have no experience in handling risk. Alas, investors and businesses are not paid in probabilities, they are paid in dollars. Accordingly, it is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration. How frequent the profit is irrelevant; it is the magnitude of the outcome that counts. It is a pure accounting fact that, aside from the commentators, very few people take home a check linked to how often they are right or wrong. What they get is a profit or loss. As to the commentators, their success is linked to how often they are right or wrong. This category includes the “chief strategists” of major investment banks the public can see on T.V., who are nothing better than entertainers. They are famous, seem reasoned in their speech, plow you with numbers, but, functionally, they are there to entertain – for their predictions to have any validity they would need a statistical testing framework. Their fame is not the result of some elaborate test but rather the result of their presentation skills.
Clarifying on the similarities and differences between horse racing and stock investing
While I have used the example of horse-racing to elaborate on the mental model of pari-mutuel systems and likened it to stock market investing, there are some important differences to note.
The first one being that the purchase price is fixed when you invest in stocks, as against your odds changing even after you make your bet (based on what people do after your bet). In stocks (and all securities in general), if the odds go down (i.e. price goes up) after you place your bet, that advantage accrues to you.
Secondly, the transaction costs in horse-racing are upwards of 15%, while corresponding brokerage costs are between 0.1% - 0.5% in India when you deal with stocks.
Lastly, the taxes (in India) on horse-racing proceeds are 30% vs. the 12.5% capital gains in equities.
It is an obvious choice therefore, (unless it is for novelty and fun) to avoid horse-racing to make serious money. While there have been some (such as Bill Benter) who have cracked the code and won millions from horse-racing, the odds are stacked against you, and you are much better placed to use the platform of equities to compound your way to wealth.
In conclusion
The mental model of a pari-mutuel system is a powerful tool which helps us factor-in the impact of the actions of others on the bets that we make, and that on the odds of those bets. And if there is one thing to take-away from this long essay, it is to look for mispriced bets, rather than looking for the obviously best bets.
May the odds be with you!
What is your take on the mental model of pari-mutuel systems? Which other games can we liken to investing, and what can we take-away from them? Do share your views in the comments!
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