I’m always annoyed when I hear somebody compare investing to gambling. The problem with that statement is that it implies than an investor has no control over their results.

The reality, of course, is that investors can control their results in two ways:

  • By investing in the right company
  • By investing at the right valuation

If you pick the right company it almost doesn’t matter what the initial valuation is. And if you get a good enough valuation, just about any company can be a good investment.

In my experience, people who compare the stock market to a casino are the people who do the least due diligence on their investments. They throw money at Tesla because “it keeps going up” or because they like driving their Tesla. They jump on “hot stock tips” from their friends. They throw money at stocks and hope they get lucky.

Good investing is nothing like gambling. However, good investing is a LOT like betting on sports.

Casino games

When you play something like craps or blackjack you’re playing against “the house” (usually a casino, but it could be an individual if you’re playing in a private game). For blackjack, the house has a 0.5% edge (assuming proper play and no card counting). For craps it’s 0.8% and for roulette it’s about 2.7% for single 0 variant, and 5.26% for the double 0 “American” version. The house edge is the percentage of money bet that the house will win.

For any single bet you’re going to win or lose (or tie, in some games). But if, over the course of a day, all the players in a casino played a total of $10M in blackjack hands, the casino would expect to make a profit of 0.5% * 10M = $50,000. Individual players will win or lose money (with more losing than winning), but in aggregate, they will lose, on average, $50,000 and the casino will, on average, win $50,000.

If $10M is bet on craps over the course of the night then the casino would make 0.8% * $10M = $80,000 in profit. Again, this is an average, but as the number of bets increase the actual results will get close to the predicted results.

The way that a casino makes money is by getting lots and lots of people to play these games for as long as possible. If they can get people to play a total of $100M in blackjack hands the casino makes $800k in profits. Again, individuals will win or lose, but everybody is playing against the casino and, in aggregate and on average, the players will lose $800k.

Are you with me so far?

Sports betting

Betting on sports is fundamentally different than casino games. In sports, the casino’s sports book (or your local bookie) doesn’t have an advantage in the odds. Instead, the sports book makes money by charging an additional fee when you lose a bet.

Let’s use the recent 2018 Super Bowl as an example. The Eagles played the Patriots. If you bet on the Eagles winning you’d bet $110 and, if the Eagles won the game, you’d win $100. If the Eagles lost the game you’d lose the $110. The $10 difference between the $100 you win or $110 you lose is how the casino makes their money.

The casino can guarantee a profit by having an equal amount of money bet on both teams. If a total of $110M is bet on the Eagles and $110M is bet on the Patriots, then the people who bet on the winning team will win $100M and the losers will pay $110M. The casino makes a $10M profit off the $220M bet on the game (for a 4.5% edge).

Of course, things can go terribly wrong for the casino if they DON’T have equal money on both sides of a sports bet. Imagine if there had been $220M on the Eagles and $55M on the Patriots. If the Eagles win the casino would pay out $220M to the people who bet on the Eagles but only keep $55M from the people who bet on the Patriots. The casino would have lost $220M – $55M = $165M. That’s a bad day.

It was generally accepted before the Super Bowl that the Patriots were a better team, which means that more money would be bet on the Patriots than the Eagles. But as we just discussed, casinos make money by having equal money on both sides of a bet. So how do casinos ensure they get equal money on both sides? By using point spreads.

(NOTE: I’ll just be talking about point spreads here. If you’re a gambler you know about money lines and all the rest, but we don’t need to know about any of that to make my point)

The casino might say that in order to make money on a bet on the Patriots, the Patriots actually have to win by 5.5 points. If you bet on the Patriots and the Patriots win by 4 points then you lose your bet even though the Patriots won. Conversely, if you bet on the Eagles and they lose by 4 points you still win your bet (since the Patriots needed to win by 5.5 points for a bet on the Patriots to win). So if you think the Patriots are a better team, but only 2 points better than the Eagles, then you’d actually bet on the Eagles, since you don’t think the Patriots will win by 5.5 points.

As an aside, there are obviously no 1/2 points in sports, but point spreads frequently have .5 points so there’s no way for a tie. If the point spread was Patriots -5 and the Patriots won by 5, then nobody wins the bet. The sports book just gives everybody their money back. The sports book has gone through all the work of taking the bets, paying the cashiers, publishing the line, etc. and ends up losing money.

Sports books do not like to lose money. By making the point spread Patriots -5.5 you’re guaranteeing that every bet on the game is going to either win or lose.

The line

So here’s the funny thing about lines – they move. For the 2018 Super Bowl, the line opened at Patriots -6.5 (meaning the Patriots needed to win by 7 or more points for a bet on the Patriots to pay off), then it moved down to Patriots -4.5 and eventually settled at Patriots -5.5 at the start of the Super Bowl.

Why do lines move? They move around to entice equal money on both sides of the bet. Let’s say that the line started at Patriots -99.5. That would mean that the Patriots need to win by 100 points for a bet on the Patriots to pay off. Given that the largest margin of victory in NFL history was 73 points (and that was in 1940), I think it’s fair to say that everybody would bet on the Eagles. Similarly, if the line was Eagles -99.5 then nobody would bet on the Eagles and everybody would bet on the Patriots.

Sports books set the initial line at Patriots -6.5 because they thought that would result an equal amount of money being bet on the Eagles and Patriots. When the line was Patriots -6.5 more money was being bet on the Eagles, so the sports books moved the line from Patriots -6.5 to Patriots -4.5 (meaning that instead of needing to win by 7 the Patriots only needed to win by 5). This incentivized more money to be bet on the Patriots. At some point more money was being bet on the Patriots so the line moved to Patriots -5.5 (making it slightly harder for a bet on the Patriots to win and thus incentivizing money to be bet on the Eagles).

Now listen closely, because here’s the key to this whole post:

The line isn’t set based on what the sports book thinks will happen. The line is set to get equal money on both sides of the bet. 

If the general consensus is that the Patriots are 5 points better than the Eagles then the line is set at Patriots -5. Half the people will take the Eagles, half will take the Patriots, and the sports book makes money regardless of which team wins.

That doesn’t mean that the people running the sports book think that the Patriots are 5 points better than the Eagles. It just means that the people running the sports book think the consensus is that the Patriots are 5 points better than the Eagles.

At any point in time the line tells you what the general consensus is about the relative strength of the two teams. The line is NOT a prediction of what will happen in the game.

When you’re betting on a game, you’re not betting against the casino.

When you bet on a game you’re betting against everybody else betting on that game. When you bet on a game you’re betting against the consensus. 

This is why professional sports gamblers exist – the market for sports betting is inherently inefficient. The consensus is often wrong.

Beating the market

Being a successful investor requires the same thing that being a successful sports gambler requires – identifying when the general consensus is wrong.

You don’t just need to know that the Patriots are better than the Eagles, you need to know HOW much better they are. If the consensus is that the Patriots are 10 points better than the Eagles and you think the Patriots are only 3 points better than you’ve found a market mispricing that you can profit from.

Similarly, pretty much everybody agrees that Amazon is a money-making machine that will be making more money in the future than it makes today. The question is HOW much more money it will make in the future. If the market has priced Amazon stock assuming that Amazon will make a $250B in profit in 10 years, then your decision to invest or not invest in Amazon depends on if you think Amazon will be making more or less than $250B in profit in 10 years.

This is why I don’t believe in the Efficient-market Hypothesis. I’ve just seen too many times when the market was mispricing an individual stock or even entire sectors.

Remember the Dot Com stocks in the late 90’s? The market was assigning enormous valuations to companies with no profits and no plan to ever make profits.

Or how about bank stocks in 2009? They were priced as if banking was going to cease to be a viable enterprise.

Sometimes the market is just wrong. The way to profit is to realize when everybody is suffering from some sort of mass delusion. Sometimes this means a sector is overpriced (like the Dot Com sector in the late 90’s). Sometimes this means a sector is underpriced (like bank stocks in 2009). And sometimes the entire market AND bonds are overpriced (like today).

 

Conclusion

First, you need to get past the idea that the market is efficient. It isn’t. Just because something is bought and sold for a given price doesn’t mean the price accurately reflects the value. Mispricing happens all the time. Sometimes you’re able to buy a $2M Andy Warhol sketch at a yard sale for $5.

Sometimes an asset is overpriced (for example – Tesla stock or Bitcoin). The way to benefit from this mispricing is to sell the asset and possibly even short it (although I’m not a fan of shorting stocks – there’s just too much risk involved).

Sometimes an asset is underpriced (for example, bank stocks in 2010). The way to benefit from this mispricing is to buy the asset and possibly even borrow money to buy even more of the asset (although I’m not a fan of buying investment on margin – again, too much risk).

The key is to identify when an asset is mispriced and then exploit the mispricing. This is what value investors have been doing for decades to make money in the market.