Sunday 6, February 2022

Investing and horse racing

A very long time ago, someone said to me that most people just didn’t understand gambling. He gave the example of a horse race. He explained that a lot of people just ask themselves the question “Which horse is most likely to win?” and put their money on that specific nag. He pointed out that this was equivalent to just sending money direct to the bookmakers benevolent fund. The point is that nobody knows who is going to win the race, but the bookie has an idea, based on the volume of bets which have already been placed. In fact, the bookie has a very good idea of who will win, but it really doesn’t make any difference to him, since he just adjusts the odds so that whichever horse wins, he’ll have enough funds to pay out. So, the key to winning, as a punter, is to find the horse that is most underpriced. In other words, the horse whose ‘real’ odds of winning are furthest from the odds implied by the bookie’s odds. If you know that the favorite is not going to run, or that the jockey has been nobbled, then you could well win. But it’s the mis-pricing of risk that is key, just as in the stockmarket.

(It’s possible that a very large bet on a long-odds horse would actually cause the bookie to lose money. In this case, he’ll probably refuse the bet, or lay off the risk with another bookie. It’s exactly the same as an insurance underwriter re-insuring a policy.)

This excellent piece takes this analysis to the next level, and incidentally has the first explanation of Soros’s concept of ‘reflexivity’ that I’ve been able to understand. To continue the horse-racing analogy, the stock market is a race where the starting pistol is actually fired. It doesn’t really matter if the stock makes real profits. Benjamin Graham famously said that in the short run the stock market is a voting machine, but in the long run it’s a weighing machine. Which means that short term stock price moves are driven by demand but ultimate returns are driven by dividends and underlying economics. But as Keynes said, in the long run we are all dead. So the behaviour of the voters becomes critical for predicting where a stock price will end up.

The stock market, the price of an individual stock, has many possible outcomes, and these all reflect different narratives. Tesla may end up driving all traditional auto-makers out of business and end up with a global monopoly. Or Volkswagen may master the art of producing battery cars and with its greater economies of scale and superior distribution channels crush this pesky startup into the dust. I have no idea which of these is correct, but by looking at these outcomes, and understanding which groups are aligned with the different narratives, it is possible to anticipate moves in $TSLA share price better than trying to understand whether the accounts receivables line is correctly reported.

It’s not just individual stocks. Read the article, several times, because it has some profound ideas. I’ll leave you with this quote:

George Soros was the first to discover this truth. He wrote that “Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued.” This means that the act of valuing a stock, bond, or currency, actually affects the underlying fundamentals on which they are valued, thus changing participants’ perceptions of what their prices should be. A process that plays out in a never-ending loop…

This is why Soros says that “Financial markets, far from accurately reflecting all the available knowledge, always provides a distorted view of reality.” And that the level of distortion is “sometimes quite insignificant, and at other times quite pronounced.”

This means that markets are efficient most of the time except for some of the times when they become wildly not so.