Insightful articles on the world of finance and investing

18 Dec 2011
What a Day at the Races Taught Me About Investing

Betting is a mug’s game for most punters.

At the races you see betters carefully reading their race books, looking up their research notes, following the advice of experts, betting on the favourites. Yet despite all this hard work they so often go home with less than they started with (especially when you include the price of drinks and food). Some days “their horse comes in” and they score big with a trifecta. Suddenly they are the envy of everyone as they proudly discuss their winning ways.

My view is simpler.  I know nothing about horses but I do go to the races once a year – cup week – but more to enjoy the atmosphere and excitement.

My betting strategy is simple: easy bet trifectas, low cost, no skill, the computer makes the bet, no predictive powers and fun – you don’t expect to win but can be pleasantly surprised. Well this past year at the Riccarton Cup I won $1,148 on a $6 computer generated bet.

I was lucky right? This couldn’t happen again could it? Those around me were interested in my success but mostly stuck to their own methods.

Then I won again using the exact same random computer generated bet.

I was amazed by what happened. Firstly I had to do my best to resist the urge to believe that I had “discovered” a winning system. Whereas before the wins, I made bets just to enjoy the buzz, now I began to think in my head that I was actually good at this.

But what was even more interesting was that others were now very interested in my next pick. They actually believed I had some expertise worth listening to.  Although my two wins were based completely and totally on dumb luck, there were people around me that were ready to try any suggestion I offered. In fact, some of my own friends started buying computer generated easy bets.

So it is with investing:

Investors like to follow managers and brokers with a good “track record” or winning streak and money flows in when a manager or an investing style has a couple great years in a row.

Our minds can spot a trend or a streak very easily. Fill in the blank 2…4…6…?

Intuitively and without thinking our minds go “8”. And when we see a manager or an investment style work very successfully for a few years in a row we unconsciously and automatically fill in tomorrow’s number.  And armed with a belief that we know tomorrow’s results today we place our bets… who wouldn’t?

And so my betting companions wanted to know my “system”. Heck I was enthralled with my system too. But it wasn’t a system at all. It was random.

You know, one of my favourite charts is shown below. It catalogues the top 100 managers according to Morningstar, an investing research firm. To be a top 100 manager is quite an accomplishment. There are thousands of managers vying for that top spot.  Here’s the question though? How many repeat their great performance the next year.

The answer is 13.2%. Those aren’t good odds!

And really if you look at those that do repeat it tends to be because the sector they invest in had two good years in a row. If you’re a manager that just happens to specialize in a style in favour it’s possible to have two straight great years.

So what am I getting at? Simply this, following winning streaks and investing with the herd is a horrible way to invest. Following my advice about how to bet at racetracks is probably equally as poor. A two year, three year or four year winning streak tells you almost nothing about whether an investment manager or broker is skilled or lucky.

But why let a little thing like statistical proof get in the way? Most investment managers know that investors do make decisions based on small streaks of outperformance. So they push and promote those funds that do have good records, getting rid of or absorbing the funds with poor records. Investors are left years later wondering why that “sure bet” pulled up lame.

What does matter then? Really it comes down to this. Invest at low costs with close attention to execution, stay consistent to your strategic asset allocation avoiding any temptation to drift with the crowds, and perhaps most importantly, don’t believe the media or media advertising.

In other words, don’t bet on the horse; invest in the track.

  • The track diversifies with many betters and many races;
  • The track pays close attention to costs;
  • The track stays consistent even when a few long shots beat the field;
  • The track never panics or follows the crowd;
  • The track doesn’t gamble; the track invests.

Then again you could always make $6 bets on a computer generated trifecta. And if you win you’ll certainly beat the pants off the track’s profit margin that day. And if you need advice on how to master this, contact Jacob who for a small fee will provide you the tools to generate your success. But don’t make my mistake and tell your friends it was just luck. Just tell them you’ve got a system. Trust me; you’ll be everyone’s best mate.