New Years is for Suckers / What’s The Vig? / Make me a market / by Adam Howard

Right, fresh start this week.  No reference to last week’s Update at all.

I hope everyone had a safe and enjoyable Christmas and you are all gearing up for a large New Year’s Eve celebration.

New Year’s Eve always involves some decision making, where we are confronted with a plethora of options where we agonise over making the “best” decision. 

No pressure at all.  You’re just looking for a night out that’s potentially the best night of your life, at an interesting location, surrounded by just enough good looking people to make it fun but not so many you feel out of place, good booze and food in sufficient supply that whatever you want is always available….and all at a price that doesn’t make your eyes water.

Like I said, no pressure at all and not too much of a big ask.  Given all you are after is the above its surprising there are so many fights and arrests on the biggest night of the year….

I guess what I am saying is it’s not rational to think that you will get the above, at the same time that tens of thousands of hopeful party goers also get it.

But a lot of us bet on it every year, by paying the ticket prices, making the plans, you know….even though we suspect it’s going to be packed, take 30 minutes to get a drink and you are only allowed to buy 2 at a time and some tool knocked one of them out of your hand on the way back, and it will take 3 hours to get home.

When I put it like that it’s just dumb, but I encourage you to have a crack anyway.  Could be the best night of your life…

Now, I know I have said before that this type of decision making isn’t uncommon, and it might best be termed irrational.  Irrationality is defined as follows:

Irrationality:  an action or opinion given through inadequate use of reason, emotional distress, or cognitive deficiency.

There are two separate elements in this definition: an action, and an opinion.  Let’s focus on an opinion first.

An opinion doesn’t cost you anything in dollar terms.  Someone asks you a question and you provide your opinion.   If it’s at work you will try to provide an eloquent argument for a certain position which might result in some actions with financial ramifications, but these ramifications will often be abstract; a long way in the future and not your money.

An opinion is what Chief Economists provide.  It’s also what pundits, whether political or economic, provide when they are guests on TV or radio.

An opinion is what radio shock jocks provide, and it is what people express if they are asked about the likelihood of Tony Abbott being re-elected; whether Australia should become a republic; if gay marriage should be legalised; and who will win the 2015 AFL Premiership.

An opinion is often based on emotions, not rational judgements.  Individuals often don’t have sufficient information or insight to make a rational judgement about such matters, and in order to “answer” the question they replace the actual question with an easier one.

This, of course, happens subconsciously.

So, “Who will win the 2015 AFL Premiership?” becomes “Who would you like to win the 2015 AFL Premiership?”

Will “Tony Abbott be re-elected?” becomes “In your opinion is Tony Abbott currently doing a good job?”

Because we know the answer to the easier question we answer with some confidence.

BUT, this all changes if you ask people to put their money where their mouths are; make a bet, put some money on it.

I have discussed a chat I had with a character I called The CEO back in August.  The CEO ran a large gambling agency for a number of years and The Audiophile introduced us because The CEO had seen firsthand how decision making changed when money was on the line.

The CEO worked for gambling agency started by a family living in regional Victoria who knew the secret to running a good agency was the reliability of your statistical analysis. 

Historically, Australian licensed gambling had been limited to sports, and betting on fairly simple outcomes within sports.  Wins and places in races, and win/loss outcomes in binary events.

Timing was on the family’s side and they had a good system of data capture and analysis at the same time as online access in Australia began to grow exponentially, so they decided to use their system to open markets on anything people were interested in…well, interested enough to want to bet on the outcome.

Things like:

-          The outcome of local and Federal elections;

-          The movement of the cash rate; and

-          GDP movements.

Now, recall I have said that the Australian Bureau of Statistics (ABS) collects data on approximately 60,000 economic variables each year.  There are 7 states in Australia, each with an election every 4 years, a Federal election every 3 years. 

That’s a lot to bet on.

And the family did well.  They went to IPO and traded well until they were bought by another entity, and The CEO moved on.

Anyway, that’s just context.  A narrative to make this seem interesting.

The thing the CEO told me that grabbed me by the scruff of the neck was that the accuracy of their markets in picking the actual outcome of a future political or economic event was about 99%.  That’s right, 99 times out of 100 the market got it right.

When I say, “the market got it right” I am NOT talking about the punters.  The punters are the suckers, and the house is the market and the thing that separates them is data and analysis.

“The market” is made by the agency offering odds on the potential outcomes of an event; for our purposes here the event is a head to head contest.  A footy match, a game of cricket, an election, the movement of the RBA cash rate.  Three potential outcomes; win, lose or draw; or up, down or no change.

The CEO’s agency adopted a very mathematical approach, employing actuaries (made into a profession by the insurance industry in calculating odds of unlikely events) and quantitative analysts (maths geeks by any other name).

So, collect the data, crunch the data, calculate the odds…but how to make money?  Well, the percentage chances of the three outcomes when summed will add up to 100%.  That makes sense, doesn’t it? 

But if you are offering odds you make money by the percentage chances adding up to more than 100%, maybe 110%, and the agency makes the 10% difference….at worst.

This is called over rounding if you are from London’s East End, or The Vig if you are from Brooklyn.

So, the real odds and bookie odds of an event, say a game of AFL, might be:

 

Home Win                         

Real Percentage/Odds:                                 60% chance.  100 / 60 = $1.66

Bookie Percentage/Odds:                            64% chance.  100 / 64 = $1.56

Home Loss                                         

Real Percentage/Odds:                                38% chance.  100 / 38 = $2.63

Bookie Percentage/Odds:                            42% chance.  100 / 42 = $2.38     

Draw                                                    

Real Percentage/Odds:                                2% chance.  100 / 2 = $50

Bookie Percentage/Odds:                           4% chance.  100 / 4 = $25

Aggregation

Real Odds:                                                     60 + 38 + 2 = 100

Bookie Odds:                                                 64 + 42 + 4 = 110

Interestingly, the above odds are similar to those offered by most agencies on the 2014 AFL Grand Final between Sydney and Hawthorn.

The better the data collection and maths, the more accurate the odds, and over a large number of events and a long time, these add up.

And The CEO’s agency did well.

So, why talk about this?

There are so many reasons it’s not funny, but for today the main focus is on decision making and what it means for economics and finance, and for individuals.

Firstly, modern investment markets are nothing more than institutionalised gambling rackets.  Investors are “betting” with either their money, or someone else’s, that the value of an equity, bond, property, car, bottle of wine, artwork or whatever will either go up or down in the future.

The investors are the punters, and the seller, investment bank, stockbroking firm or similar is the house, and some houses use better maths than others.

The most obvious examples of houses with either weak maths skills, poor assumptions or limited understanding of the results of their maths are Opes Prime, Westpoint and Storm Financial in Australia, and Lehman Brothers, Bear Stearns and Merrill Lynch in the US.

If you want to see an interesting confirmation of this role in financial markets, then have a look at this Youtube video of Goldman Sachs CEO Lloyd Blankfein testifying to a Senate hearing into the GFC and Goldman’s unconscionable actions in continuing to sell investments to their customers they knew were worthless where Blankfein repeatedly refers to Goldman’s role as a “market maker.”

Senate Hearing: Lloyd Blankfein (Goldman Sachs)

Secondly, this type of analysis and decision making is now everywhere in sports, and was made famous in Michael Lewis’ book Moneyball, where Major League Baseball coach Billy Beaman used statistical analysis and probabilistic forecasting to draft players.  A hybrid version of Beaman’s approach involving some intuition and some statistics is now being used in most sports around the world, including the AFL.

This type of data collection and analysis was also used by one of my favourite’s Nate Silver, when he correctly forecasted the results in 50 of the 51 states in the US 2008 AND 2012 Presidential Elections.

And this is also the type of analysis used by Warren Buffett in making his investment decisions.  Data collection and analysis.  Formulation of a hypothesis, testing of the hypothesis and then betting on the results of the test.

But the rank and file, yours truly included, continue to make our investment, employment, and other decisions based on opinion, not on rational, data driven probabilistic judgements.

The funny thing is there is commonly conflict between our emotional opinion and our rational judgement, and the emotional opinion wins out a lot of the time.

Here’s an anecdote to add weight to what I am saying, although this story is about a time where someone knew their opinion differed from the data and their analysis, but followed the rational path anyway. 

I have to be careful here as anonymity is vital so I won’t even use a nom de guerre when telling this story.

I was talking to an old mate who is experienced and skilled in property.  Using one of his own terms, I think he is quite shrewd.

He had been active in and around a particular market for a number of years and knew it quite well and had a good system for data collection on listed properties, sold properties, time on market, prices per square metre by block size and costs to construct.

He had experience in valuations and banking, and had business associates in surveying so he had applied knowledge of the acquisition, funding, feasibility analysis, subdivision and sale of properties.

We were chatting and our talk moved to one of the properties he had bought and was planning to split up and sell as land.

I had been thinking about this idea regarding betting versus opinions for a while.  I am not a gambler but I like the idea that an individual’s financial decisions should be treated the same way a betting agency treats market making.

Collect the data, crunch the data, develop a hypothesis, test the hypothesis and then take action on the results of the test.

And then he said something I thought was surprising.  He said he didn’t think the land was worth what he knew he could sell it for.  In fact, he had said he had buyers lined up for all lots.

So, in his opinion the land wasn’t worth what he knew he could sell it for.  His emotional opinion didn’t match his rational judgement…and his judgement had won out and he placed the bet.

After that I started to think of him as a professional gambler….just not with the usual, Hollywood-driven stigma.

Once again, back to The CEO, where we were talking about professional gamblers.  Apparently many professionals had already worked out the market odds by the time the agencies released theirs, with many of their betting decisions based on finding discrepancies between their view of probability and the agencys’.

If, in their view, the market got it wrong, then large positions were taken.

Sounds a bit like investing, doesn’t it?

Food for thought….