Friday, December 02, 2005

Sports betting in comparison to stock investing

Every once in a while, I read or hear someone compare betting sports with investing in the stock market. I have read posters in forums make this comparison more frequently in the past month. The reason they are making this comparison is due to the poor performance of many otherwise solid handicappers this NFL season. Favorites are covering at a high rate, and handicappers who have had solid years in the past are doing poorly this year (because solid handicappers have mostly taken underdogs in the past few years). Naturally, they think this is a matter of bad luck and the wins will come either in the latter part of this year or next year. For the most part, I agree with them. Many of these handicappers have solid foundations, know what they are doing, and are just overall sharp people. Bad luck can easily happen over a small sample size, like that of even a full NFL season. However, the one thing I disagree with is the comparison to stock investing.

The comparison some have been making is in what to do when the stock market takes a down turn to when there is a losing streak in sports picks. The recommendation that people have heard in the past few years in the stock market is to "stay the course" and not sell when the stock market takes a nosedive. These handicappers are using this analogy as a way to recommend to their followers to keep betting their picks, and just like in the stock market, sooner or later it will turn around. Selling off stocks and market timing is typically not profitable except for the most in-tuned professionals. When I refer to the stock market, I mean the market as a whole, not just one or two individual stocks or a specific industry. But the whole market, like an index fund. The catch phrase “stay the course” has been used in the political world too. I won’t get into that in this post, especially since I am not an expert in politics. But I don’t think sports handicappers are being too generous with their optimism about their own skills when they use that phrase for themselves. That’s because the difference between investing in the stock market and following a sports handicapper are very different.

There is a fundamental reason why stocks are expected to make positive returns in the long run. That fundamental reason is due to risk of capital. Investing in companies and stocks is risky. Compare that to investment alternatives, specifically short term Treasury bonds backed by the U.S. government. Those bonds are typically thought of as risk-free or very low risk, and that is why they pay such a low interest rate. If you are going to ask a person to invest in a company, the person knows there is risk, so there better be an adequate amount of extra reward to offset the extra risk. That’s the premium that an investor expects to achieve in order to take the extra risk. Any individual investor can make a mistake, so just because an investor puts money in a given investment, it doesn’t mean that they have positive expectancy. If an investor puts money into a real estate deal, he could be getting ripped off. The difference between those individual deals and the stock market as a whole, is that the stock market as a whole is very efficient, with millions of people putting money into it (and taking money out), and trillions of dollars involved. So for the most part, it is correct to say that the market is efficient – that the price is right, and expect for the bid/ask spread and the transaction costs one has to pay to get in and out of the market, the price is fair. This applies to the general stock market as a whole, and to most liquid stocks – most of the time.

So when one says to “stay the course”, it means that the reward expected compared to the risk in the stock market is generally high enough that it doesn’t make sense to try to time the market by getting in and getting out, because the market is efficient all of the time. Although that may not be true for some insiders and professionals, that statement serves its purpose for us individual investors.

But in sports betting, there is no fundamental extra reward for the risk that one takes. Sure, you may think someone is expected to win because they have hit 54% in the past…but that would be the same analysis as saying the stock market is expected to go up because it has gone up on average 7% a year for the last 100 years (I’m just throwing those numbers out, I don’t know if it is on target or not, but it should be close). Those aren’t fundamental reasons, but rather, those are past performance reasons. There is nothing wrong with using past performance to help predict future performance when it comes to handicapping a handicapper’s skills. But the fundamental reason of extra reward for the risk that exists in the stock market does not exist in sports betting until there are many years of actual performance data. "Many years" means 20+ years worth of data. That's just not feasible in sports betting. Even if someone did have 20+ years of data, the problem is that the game has evolved so much in the last 5 years, it's tough to use data from 15 years ago and think it is completely useful today.

With all that said, there are many handicappers out there who know their stuff and should have positive expected value in their picks going forward. The tough part is finding out who has the right stuff and who doesn’t – with limited data. Remember, there is no real fundamental reason why these guys should win, they aren’t the stock market. That doesn’t mean they won’t win or don’t have positive EV going forward. It just means one needs to analyze them in different ways.

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