“They call gambling a disease, but it’s the only disease
where you can win a bunch of money.”
– Norm Macdonald
As November approaches, we Floridians can hope to celebrate the end of hurricane season and direct our attention toward a different obsession: football. And, as you prepare to watch your favorite teams compete each week, you may even be tempted to place a wager or two on the outcomes.
For those unfamiliar with sports gambling, betting on a football game could seem like an easy way to make money. Take, for example, a matchup in mid-September between the top-ranked Ohio State Buckeyes and their unranked in-state rivals, the Ohio Bobcats. An inexperienced gambler might have thought it was as easy as putting money on the Buckeyes and cashing in when they won. But anyone experienced in football betting knows it is not that straightforward. You cannot just bet on the favorite; you also need to find someone willing to bet on the underdog. That is where the point spread comes into play. A point spread represents the number of points an oddsmaker expects the favorite to win by, leveling the playing field for both sides of the bet. In our example, a 30-point spread was added to the Bobcat’s score to make the bet appealing for both sides. In the end, the score was 37-9 in favor of the Buckeyes. But those who bet on the Bobcats won because the point differential was less than the spread.
Beating The Spread
The same concept exists in financial markets, but instead of calling it “beating the spread,” which carries too much of a gambling connotation, economists opt for a more refined term, “equilibrium pricing.” This means you cannot beat the stock market simply by buying stocks of the best and most profitable companies. Everyone knows these are the best companies, so you must convince someone who owns those stocks to sell them to you by offering them a premium price.
For example, at the end of September Apple stock was up just 2% year-to-date while the US stock market was up 15%. Apple did not underperform the market because it is a company with low prospects; it underperformed because it was priced high at the beginning of the year and failed to beat expectations, which were equally high. In sports gambling terms, it failed to beat the spread.
Who Is On The Other Side?
Equilibrium pricing ensures that stock markets, like gambling markets, offer fair prices on both sides of a transaction. So, in order to consistently profit from active trading, you must, at the very least, be more skillful than the investors on the other side of the trade.
Is there reason to believe you have an advantage over the other side? Many people seem convinced they have special insight into the stock market (and for that matter, into the intricacies of the Cover 2 defense in football), regardless of whether they have any formal education or professional background in finance. This is problematic because equilibrium pricing ensures that the opinions of all investors (including professionals with deep expertise, better data, and faster tools) are reflected in the market price. To consistently beat the market, you have to know more than everyone else – especially the people on the other side of your trade. Before investing in your favorite stock, ask yourself who is on the other side of the trade and what could their reason be for taking the opposite position. What might they know that you do not?
Overconfidence And Unconditional Love
This investment game is already hard enough, but emotional bias makes it even more challenging to beat the market. Just like novice sports gamblers, amateur stock traders can easily fall prey to two key psychological pitfalls. The first is overconfidence. Even if your mind acknowledges that equilibrium pricing incorporates all available knowledge from all available investors, your heart (or a hunch) may still make you confident you have found a “sure thing” that the rest of the market is missing. But such certainty is rarely justified. Economist Ken French captures this perfectly: “Overconfidence is almost certainly the most important bias in behavioral finance. But most people still think I’m not talking about them.”
The second psychological hazard is familiarity bias, or what gamblers refer to as “being a homer.” Just as people fall in love with their hometown football teams or college alma maters, investors often favor the stocks of companies they know and love. But as the saying goes, love is blind. This emotional connection can cloud judgment, making it easy to overrate a company’s strengths and dismiss its weaknesses, seeing them as insignificant or temporary. Having this bias can put you at a significant disadvantage compared with the rational, unemotional investor on the other side of the trade.
Equilibrium pricing plays a key role in making markets highly efficient, which is why it is so difficult to consistently outperform the consensus view. So why do countless “experts” keep promoting strategies to beat the market? Simply put, there is a demand for it. As stock trading becomes increasingly “gamified,” the lure of quick profits and instant gratification draws in many would-be traders who cling to the idea of a sure thing.
But in the long run, these efforts are usually in vain. Just as bookmakers adjust point spreads to balance bets on both sides, financial markets constantly update prices to reflect a balance between buyers and sellers. In both cases, the price is not about predicting the future or revealing absolute truth – it is about maintaining equilibrium. Active trading, therefore, just like active gambling, is usually a losing proposition for everyone except the intermediaries who facilitate the wagers. Your best bet is to allow equilibrium pricing to work in your favor by employing a diversified, long term investment strategy and leaving the active trading to the gamblers.