If you’re engaged in the stock market full time, you most likely cannot help yourself but to tune into financial media, be it CNBC, MSNBC, Yahoo Finance, or others. So many talking heads, so much to love and hate. Whether you like it or not, it’s how we stay in touch with what people perceive the rest of the investing world is talking about. After all, we are professionals that should stay current and be informed about what keeps the markets and its participants occupied during our quest for investment opportunities.

It’s easy to get wrapped up in the urgency of quarterly reports, the opinions expressed by our investment heroes, and the overwhelming information flow inherent to everyday research. I believe it is worthwhile to every now and then look at our activities from a different perspective than what is presented to us on a daily basis.

This article intends to take a step back, introduce a conceptual model regarding the very nature of the stock market and the way its participants interact, and gain intuitions from winning behavior.

 

Pari-Mutuel = Bet Together

One model I use to conceptualize the market is that of the “pari-mutuel” (which means “bet together” in French.), a system of betting in which all bets are placed together in a pool, and winners divide the total amount wagered after organizers of the system deduct management expenses. If you are familiar with this concept, you also know that the odds change based on where the bets are placed and in what amounts.

A simple example of such a system is horse race betting. The critical similarities to the stock market are:

  1. All bets go into one pool so the price of any given security incorporates the opinions of market participants at a given point in time.
  2. You are competing against other participants, not the house.

So how does one win in horse betting? The answer is that those who win in horse betting bet very selectively and rely on two core principles.

The first principle is that you should not try to bet on the horse that has the highest chance of winning, but on the horse that has the best pay out ratio relative to its chance of winning. You want the horse that has a 20% chance of winning, but pays out 20 times your stake if it wins, instead of the horse that has a 50% real winning chance, but pays only 1.2 times your wager. Essentially, you are looking for mispriced bets.

Well, how do you figure out which bets are mispriced?

This links to the second principle, which is to be a contrarian. Good gamblers know that bookkeepers adjust the payout rates dependent on what amount the crowd bets on which horse. Let’s look at an example, in this case a simplified horse race without fees.

There are three horses, with the real chances of winning of, 50%, 30%, and 20%. Remember that the entire price pool is split up between the winners.

Horse A Horse B Horse C
Real Chance of Winning 50% 30% 20%
Money Wagered on each Horse by Betters * $50 $10 $30
Payoff per $1 wagered in case your Horse wins $1.8 = $90/$50 $9 = $90/$10 $3 = $90/$30
Present Value per each $1 bet on Horse $0.9 = 50% * $1.8 $2.7 = 30% * $9 $0.6 = 20% * $3

*       Total amount wagered is $90, to be split up amongst winners.

**    In this simplified example it becomes clear that horse B — paying 9 times the wager with a 30% chance of winning — is a better bet than A, or C.

***  You can calculate the present value of $1 bet on each horse by multiplying the payout with the chance of winning.

The above example shows why it makes sense to try to find a horse that is underrated given its real chance of winning; It’s really all about betting on the underdog. This exemplifies the importance of contrarian behavior, in betting as well as in investing.

If you understand these simple concepts, it is easier to confidently take the opposite side of the popular position — a position that perhaps your investment heroes explained so convincingly — and know that you are following the right principles.

Conflicts between Reality and the Model

The intuitions gained from the model are powerful, but general, and I am sure many of you are already familiar with them. But let’s take it a step further. At best, betting contrarian is merely half of the story, because the pari-mutuel betting model has short-comings when applying it to the stock market.

One important short-coming is that in our simplified horse betting model, it will be obvious and undisputed which horse won at the end of the race. In contrast, the stock market does not have a finish line, because stocks do not have a predetermined lifespan.

Let me give you an example this idea relates to. You may have been in a situation where you bought a stock that you perceived as grossly undervalued and found yourself holding the still grossly undervalued shares years later at the same price. In contrast, imagine a bet that consistently has a 30% chance of winning; In the long-run it will win roughly 30% of the time. So the conflicting question is: when and why would the real value of the stock become apparent?

Another short-coming is that in finance theory, a dollar lost is more valuable than a dollar won. Buffet expresses the intuition gained from academic insight in his number one rule “Never lose money”. Let me exemplify this with a simple mathematical example. If you lose 30%, you need a roughly 43% return in order to get back to your starting amount, not 30%. Our present value calculation ignores this aspect.

For the sake of readability, I will address and try to resolve the problems inherent to the short-comings of the model as it relates to the stock market in subsequent articles. By doing that, I hope to impart to you further useful intuitions with regards to winning behavior on a more practical basis.

This is my first article for public distribution, so I want to thank you for reading it and let you know that I welcome any and all comments!