Betting vs. Investing: What We Can Learn from March Madness

At Index Funds Advisors, Inc. (IFA), we often get to see how other people are invested before they become IFA clients. If one of these prospects were to tell us that they own commodity futures as part of their investment portfolio, we would stop them dead in their tracks and inform them that a position in a commodity futures contract is a speculation (which has a zero expected return) and not an investment (which has a positive expected return). To squash any potential argument, we would ask this person if he would consider a bet on Kentucky to win the NCAA Men’s Division I Basketball Championship to be part of his investment portfolio. While there are many legitimate reasons for entering into a futures contract or filling out bracket choices in an office pool, it is important to understand and acknowledge the differences between speculating/betting and investing.

As with so many things in life, the differences can be understood by looking at the similarities, particularly with respect to the role of the market in setting prices. To determine the point spread for a particular game, the sports betting houses rely on the wisdom of the crowd by continuously adjusting the spread so that there are equal numbers of bets on both sides. Likewise, the price of a futures contract (say June delivery of soybeans) is determined such that there are equal amounts of long and short positions. The market sets the price (or the spread) and the participants decide which side of the bet they want to take. No matter which side wins, the house always collects the vig (i.e., commissions). For investors, the market sets security prices such that they can expect to be appropriately compensated for the risk they take. Most investors are best served by operating under the assumption that market prices incorporate all publicly available information (the Efficient Markets Hypothesis).

The impact of behavioral biases is keenly felt in both betting and investing. The number one behavioral issue bar none is overconfidence, or the unflinching belief that you are right even if market prices (or betting spreads) indicate otherwise. Another common behavioral issue is home bias, expressed as the tendency to bet in favor of one’s home team (or alma mater) or the tendency to buy stock in companies that have a presence in your community. Furthermore, the role of selective memory (i.e., conveniently forgetting about losing bets and ill-fated investment decisions or simply attributing them to bad luck while doing the opposite with winning bets and profitable investments) is undeniably large.

Although I am not much of a sports bettor myself, I find it fascinating to observe how some people can turn it into an exercise in active management. At the insurance company where I used to work, I recall an actuary who evaluated all the player stats in an insanely complex spreadsheet. The word “geek” would not do him justice, and while he probably did better than a know-nothing like me, he definitely was not minting money. Noting that there are some true legends in the world of sports betting such as Billy Walters who was recently profiled on 60 Minutes, the fact that we see so few of them should give pause to anyone contemplating betting beyond a recreational level.

To summarize, sports betting in moderation (especially in a March Madness office pool) is as good a place as any to unleash the active manager inside of you. If, however, you are a sports ignoramus but still wish to participate, then following the simple strategy of always picking the higher seed for each bracket will yield a very respectable result (in the 92^nd percentile of all bracket-pickers, according to ESPN). However, there will always be someone who takes a risk (like betting on the underdog) that gets rewarded. The same is true for investing. For most of us, indexing is the preferred approach, because we know that indexing will provide the market’s return at a low cost while active investors as a group receive the market’s return at a higher cost. The fact that once in awhile an active manager appears who is feted by the financial media for “beating the market” does not faze us. More often than not, we are unable to rule out luck as the explanation for outperformance, and luck, as we all know, is a double-edged sword.