What does horse racing have to do with investing? Everything. The key is to think of “horses” as “stocks.”
Most gambling, like blackjack, roulette, or craps, involves betting against the House. Not so at the horse track. Instead, you bet against other bettors and your, and everyone else’s, bets on different horses (stocks) change the odds.
Not surprising, how people approach betting on horses is fairly similar to how people bet on stocks.
Steven Crist says as much in a chapter he wrote for Bet with the Best, as he explains how to bet on horses. But as I said at the top, swap out “horse” with “stock” and you’ll see the similarities with investing:
The point of this exercise is to illustrate that even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds. A horseplayer cannot remind himself of this simple truth too often, and it can be reduced to the following equation:
Value = Probability x Price
This equation applies to every type of horse and bet you will ever make. A horse with a 50 percent probability of victory is a good bet at better than even money (also known as an overlay) and a bad bet at less (a.k.a. an underlay). A 10-1 shot to whom you take a fancy is a wonderful overlay if he has a 15 percent chance of victory and a horrendous underlay if his true chance is only 5 percent. There are winning $50 exacta payoffs that are generous gifts and $50 exacta payouts where you made a terrible bet.
Now ask yourself honestly: Do you really think this way when you’re handicapping? Or do you find horses you “like” and hope for the best on price? Most honest players will admit they follow the latter path.
This is the way we all have been conditioned to think: Find the winner, then bet. Know your horses and the money will take care of itself. Stare at the past performances long enough and the winner will jump off the page.
The problem is that we’re asking the wrong question. The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory.
This may sound elementary, and many players may think they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price. It is not enough to lose enthusiasm when the horse you liked is odds-on or to get excited if his price drifts up. You must have a clear sense of what price every horse should be, and be prepared to discard your plans and seize new opportunities depending solely on the tote board…
Sticking to your guns is easier said than done, but it is the only way to win in the long run. The horseplayer who wants to show a profit must adopt a cold-blooded and unsentimental approach to the game that is at variance with both the “sporting” impulse to be loyal to your favorite horses and the egotistical impulse to stick with your initial selection at any price. This approach requires the confidence and Zen-like temperament to endure watching victories at unacceptably low prices by such horses.
In reading it, two things stand out.
First, it’s hard not to think about what Howard Marks (via Kahneman) refers to as second level thinking.
- First level thinkers think in absolutes. Second level thinkers think in probabilities.
- First level thinkers pick the likely winner. Second level thinkers pick the best value (as determined by probability and price (odds)).
- First level thinkers bet every race. Second level thinkers only bet races offering good value.
- First level thinkers are influenced by sentiment and emotion. Second level thinkers are “cold-blooded.”
- First level thinkers focus on outcome. Second level thinkers focus on process.
The second is something that investors like Buffett and Marks repeat often. Every stock can be a great buy at one price and a horrible buy at another price. The Dotcom Bubble acts as a warning on this because, at some price, the most likely outcome for a stock is a loss. All those Dotcom winners bid up to such ridiculous prices…
The first level thinkers never thought losses were possible. Second level thinkers know losses are always possible.
To take it one step further: Second level thinkers bet in a way that avoids devastating losses.
Crist on Value