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Betting, black swans and the wisdom of crowds
By Matt | June 14, 2008
BETTING, by its very nature, asks gamblers to make a fundamental decision: do you put your money with or against the market you are betting against?
Two of the most influential business books of recent years, The Wisdom of Crowds by James Surowiecki, and Fooled by Randomness by Nassim Nicholas Taleb, throw up fundamentally contradictory views on how the cunning punter should view markets – and a synthesis of their ideas can help everyone get an edge in their betting.
I’ve thought a lot about Taleb’s work ever since I first read Fooled by Randomness. Its principal assumption is that markets are inherently unpredictable and therefore don’t indicate anything’s true underlying value.
Bull markets arise because of random events, to which humans attribute unrelated causes, creating bubbles. Something will always happen to burst the bubble – Taleb calls them ‘black swan’ events – and it is by hedging money on such events that Taleb makes his money: by betting against the crowds.
Taleb is loathed by many conventional economists; partly because he refutes their theories (which, he says, help inflate markets erroneously), and partly because of his overwhelming pomposity, but his reminder that unforeseen events will always occur has become a cornerstone of my investing (and betting and gambling) strategy.
The Sunday Times recently called him “the hottest thinker in the world”, and he can charge up to $60,000 for a speaking engagement. Betfair layers, bookies, hedge fund managers and punters who just like opposing favourites will all love his ideas.
I do too – but my thoughts were complicated a day or so ago when I read a book review of James Surowiecki’s The Wisdom of Crowds, which takes an opposite point of view.
Betting with the crowd
According to Surowiecki, favourites exist for a very good reason: because ‘the crowd’ – the largest number of punters in the market – think they will win. Crowds comprise a diverse range of people, all with different areas of knowledge and access to different sources of information, and their aggregated opinions are usually more accurate than those of experts.
Those aggregated opinions are given mathematical expression in betting markets. Such markets, of course, are nothing more than statements of a bookie’s potential liabilities: the layers don’t know who is going to win a race any more than the punters do. Crowds make favourites and – whether in the 4.30 at Hexham or on the Iowa Electronic Market, which allows trading on US politics – favourites win a significant amount of the time.
Unlike Taleb, bookies don’t need black swan events, though: the over-round they build into a market means they can profit from it even when the favourite romps home (because, if they’ve priced it up right, they should take more money in bets on the other horses than they pay out on the winner).
Cheltenham and Royal Ascot: the best markets
But, says Surowiecki, if you can identify the betting markets that exhibit four key characteristics – diversity of opinion, independence, decentralisation, and aggregation; features you only get at big race meetings like Cheltenham and Royal Ascot that appeal to a wider gambling public – you won’t go far wrong by betting on the favourites.
Some of the most successful professional gamblers bet almost exclusively on favourites at odds that most of us would find ridiculously short.
Fans of crowd wisdom, I think, are inherently backers on the betting exchanges; supporters of Taleb’s black swans will be more suited to laying. But, surely, a synthesis of the two theories that can be used to help both camps function more effectively.
Value is king in betting
Of course, it comes down to the principle of value, just as every thinking punter has known for generations.
Let’s take a topical example: the housing market. Two years ago, buying a house was seen to be buying money in the eyes of “the crowd”. Now, though, house prices are falling – as Taleb knew they would – and, far from making the fortune they expected, many house buyers are facing financial ruin.
But does that mean that “the crowd” was foolish to invest in housing? Are houses really such a bad buy?
Property and stock markets
It obviously depends on the price you pay. A house priced at £200,000 is a bargain if it can be sold for £250,000; it might even be if you can sell it for £210,000, although stamp duty, solicitors and agents fees, and the fact that you could probably make the same money in a Post Office account in the same amount of time it takes to buy and sell make that unlikely.
Similarly, in the stock market, a share that costs £2 is a bargain if it fundamentally represents £4-worth of a company, even if it is being traded in a falling market. And in the betting ring a 6/4 favourite might be good value if the horse has an even-money chance of winning; similarly, a 16/1 outsider might be a good bet if it has a one-in-ten chance.
It’s identifying value, in my book, that separates cunning punts from run-of-the-mill betting. (There are some shares that should be hoovered up at current prices, but that’s a different blog post entirely).
Taleb’s warning (borrowed from French philosopher Montaigne and ultimately from Greek mythology) should always be heeded, though. If you can get on at a good price then do it – but don’t just follow the crowd.
Blind fav backing will never turn a profit, no matter how wise the crowds are; but – with Royal Ascot round the corner – it’s still worth remembering that watching the market is always worthwhile.
Topics: Books and literature 1 Comment »
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July 16th, 2009 at 9:15 pm
[...] said that favourites generally head the betting market for very good reasons. James Surowiecki’s The Wisdom of Crowds has been mentioned before in these pages, and its precepts generally hold true for betting [...]