So how did everyone do in their March Madness pool? In the book Wise Investing Made Simple by Larry Swedroe, there is a great explanation of why stock-picking is very difficult which incorporates sports betting. I’ll try to briefly paraphrase the idea here.
Sports Betting Basics
Let’s stick with college basketball. Earlier this season, Duke played Cornell. If you were simply betting on who was to win beforehand, most people familiar with basketball would pick Duke. Duke has won national championships, has a top-ranked recruiting class, has a famous coach, has better record against stronger opponents.
But, nobody in Vegas or any sports book will take that bet. Instead, you have an adjustment called the point spread. In this case, the spread was 30 points. Now you have to either bet that Duke will beat Cornell by more or less than 30 points. This is much harder.
How was this 30 point spread determined? By the collective opinion of the other gamblers! It is a common misconception that you are betting against the casino. Nope, the point spread constantly moves so that half of all bettors are on either side of the spread. By the time the game is over, the casino doesn’t care who wins. The casinos simply take the bets, pay off the winners, and walk away with their commission. (You have to bet $11 to win $10.) Great deal, huh?
Because of this point spread and commissions, it is very difficult to make consistent money betting on sports. How many professional sports bettors do you know of? A historical study of NBA games showed that the average difference between point spreads and the actual differences in score was less than 1/4 of one point! The collective opinion of gamblers turns out to be very good.
In other words, with the handicap of the point spread, you could bet on Cornell every year and still come out the same as betting on Duke each year. (This year, Duke only won by 13.) When this is true, it is called an efficient market.
When people say “buy a company with a strong brand, a wide moat, and good growth prospects”, it is like saying one should just bet on Duke to win. It’s simply not that easy. There is a handicap, but instead of a point spread it is the price of the stock.
A good company will be priced at a premium. For example, people may love eBay, Apple, or Google and think it’s the best business company ever. But at the price you have to pay (the market price), you’re not betting that eBay will be successful, you’re betting if eBay will be more successful than the collective market participants think it will be based on all the information currently available. Again, the data shows that beating this collective prediction is very unlikely.
The argument over whether you can get better risk-adjusted returns from picking individual stocks will probably go on forever. Is it skill? Is it luck? Either way, it is important to know that very few people pull it off over the long term, and I think this analogy illustrates one major reason why. Next time you feel like stock picking, try beating the spread on 10 different sports events first. 🙂