Gaming the System

When I was a kid I had a paper route.  One of my customers was a barber who made book on the side.  Shocking, I know.  The giveaway was the group of guys always hanging around but not getting their hair cut and the three telephones on the wall that rang a lot.  Even as a kid I could tell that something was up.

Anyway, each week the barber and I had a wager.  During the NFL season, I picked a winner of the Buffalo Bills game (the Bills were our local team) straight-up.  When I was right, I got double the subscription price, before tip.  When I was wrong, the barber got his paper free.

As it happened, I won a lot of the time – obviously aided a lot by being able to decide which side of the bet I wanted, not having to worry about the spread and (in no small measure) by the Bills being pretty lousy during that period.  One Monday after (yet another) win for me and loss for the Bills, I was feeling pretty haughty (imagine that) and started talking smack to the barber (imagine that).  Finally, my exasperated barber told me something that made a big impression at the time and which resonates still, “Do it against the spread and then we’ll talk.”

We are forward-looking creatures.  We love to make forecasts, predictions and even wagers about the future.  We just aren’t very good at it.

Sports betting is obviously very big business.  Nearly $100 million was bet legally on the Super Bowl alone and CBS reports that over $2.5 billion (with a “b”) is bet at Las Vegas sports books in a year. The sports books make money – a lot of money.  But almost nobody else does, because winning in the aggregate is extremely difficult.

Pundit Tracker compiled all the NFL picks made by the ESPN, Yahoo, and CBS Sports pundits through the 2011-2012 season.  Obviously, these people are all put forward as experts and promoted as such.  Yet if you had placed $1 on each of the pundit’s picks (based on “moneyline” odds) you ended up losing a good deal of money even after removing the sports books’ commission (the “vig”) from the odds – and these picks weren’t even against the spread. My friend Mike Silver of Yahoo Sports topped the list, but even his “bets” only “earned” an 8 percent return for the year and that’s hardly worth the risk.  Spread betting only compounds the difficulty (point spread betting relates to who wins and by how much; moneyline betting relates solely to who wins, albeit with odds factored in).  In fact, had you been relying upon the advice of the “experts” at CBS Sports to bet against the spread this season, you would have lost a lot of money (note the results here).

One major exception to the general rule is the legendary gambler Billy Walters, a crucial member of the famous “computer group,” which used a careful and computerized process to make a fortune and, as a result, to revolutionize sports betting in the 1980s.  Today, Walters uses multiple consultants – mostly mathematicians – just like a hedge fund manager uses analysts and still makes a ton of money.  Walters’s process is to create his own line largely using statistical measures of the teams and then to bet when his view of a game is significantly different from available commercial betting lines.  He’s not opposed to trying to influence betting lines either.  Walters has the power, the money and the reputation to bet on teams that he doesn’t actually favor in order to move the odds. Once that happens, he lays much larger bets on the other side, the side he wanted all along.

Walters is staggeringly rich (according to 60 Minutes, he is “worth hundreds of millions of dollars”), but he claims a lifetime winning percentage of only 57 percent, as compared to the break-even of 52.38 percent (the winning percentage sports gamblers need to hit to offset paying out a 10 percent vig on their losing bets).  Even so, while he has had losing months (randomness can overcome a good process for substantial periods of time), he has never had a losing year during this 30-year streak.

But that winning streak only started after he made a major change in his approach.  By his own account, Walters lost his shirt many times over before becoming focused, data-driven and careful to play the long game (making a profit while losing 43 percent of the time requires it, especially because the losing streaks can be very long indeed).  One key is lots of bets – whenever the data suggests a significant edge – with bet size being determined by the extent of the edge.

The betting market in Las Vegas isn’t much different from Wall Street. Fed by rumor, speculation and greed, teams, like investments, can grow hot or cold for no good reason.  Moving lines is remarkably similar to market bubbles. Walters insists that “[b]etting on a ball game is identical to betting on Wall Street.”  Walters even claims that he has lost a lot of money in the markets and thinks the Wall Street “hustle” is far more dangerous than that in Las Vegas.

It should be no surprise then that many Wall Streeters have gambling histories, most prominently Ed Thorp.   For more information, read Scott Patterson’s excellent book, The Quants.  I even know a few.

I grew up in this business in the early 90s at what was then Merrill Lynch.  My decade of legal work in and around the industry didn’t prepare me for big-time Wall Street trading.  I’d ride the train to Hoboken early in the morning, hop on a ferry across the Hudson, walk straight into the World Financial Center, enter an elevator, and press 7. Once there, I’d walk into the fixed income trading floor, a ginormous open room, two stories high, with well over 500 seats and more than twice that number of computer terminals and telephones.  When it was hopping, as it often was, especially after a big number release, it was a cacophonous center of (relatively) controlled hysteria.

It was a culture of trading, which makes sense since it was, after all, a trading floor.  And it wasn’t all that different from a sports book.  Most discussions, even trivial ones, had a trading context. One guy (and we were almost all guys) is a seller of a lunch suggestion. Another likes the fundamentals of the girl running the coffee cart. Bets were placed (of varying sorts) and fortunes were made and lost, even though customers did most of the losing because we were careful to take a spread (think “vig”) on every trade. The focus was always on what was rich and what was cheap and the what if possibilities of and from every significant event (earthquake in Russia – buy potato futures).  The objective was always to make the most money possible, the sooner the better.

One of my colleagues there was an excellent trader who traced his success to his “training” as a gambler.  While in college, in the days before the internet and relatively uniform betting lines, he would find a group of games he wanted to play (via a system not nearly as sophisticated as the one Walters used and uses) and would then place bets with bookies in the cities of the teams playing.  In each case he’d bet against the team located in the city of the applicable bookie.  Because the locals disproportionately bet on the local team, the point spread would be skewed, sometimes by a lot.  Thus he had an excellent true arbitrage situation with a chance to win both sides of the bet, which happened a lot.  He traded mortgages in much the same way.

Interestingly, value was almost never at issue on the trading floor. The idea was to exploit inefficiencies and – especially – the weaknesses of whoever was on the other side of the trade right then. Michael Lewis’s wonderful first book, Liar’s Poker, re-issued in 2010 and perhaps (finally) being made into a movie, captures this culture (in his case, at Salomon Brothers) pitch perfect.

Now that the focus of what I do has changed, I am primarily consumed with finding value through investing – which must be distinguished from trading. As Barry Ritholtz puts it, “[t]rading (as opposed to investing) is more about laying out probabilities of risk versus reward; investing is about valuations within the longer secular macro picture.” I would suggest that trading is about selling what is rich and buying what is cheap while investing is about finding, acquiring and holding on to value. That distinction is, I think, the key to why so many analysts misapprehend the market relevance of another terrific Michael Lewis book (which has been made into a movie), Moneyball.

Moneyball focuses on the 2002 season of the Oakland Athletics, a team with one of the smallest budgets in baseball.  At the time, the A’s had lost three of their star players to free agency because they could not afford to keep them.  A’s General Manager Billy Beane, armed with reams of performance and other statistical data, his interpretation of which was rejected by “traditional baseball men” (and also armed with three terrific young starting pitchers), assembled a team of seemingly undesirable players on the cheap that proceeded to win 103 games and the divisional title. If that sounds a lot like the Billy Walters approach to you, you’re right.

Unfortunately, much of the analysis of Moneyball from an investment perspective is focused upon the idea of looking for cheap assets and outwitting the opposition in trading for those assets.  Instead, the crucial lesson of Moneyball (like the Walters process) relates to finding value via underappreciated assets (some assets are cheap for good reason) by way of a disciplined, data-driven process.  Instead of looking for players based upon subjective factors (a “five-tool guy,” for example) and who perform well according to traditional statistical measures (like RBI and batting average, as opposed to on-base percentage and OPS, for example), Beane sought out players that he could obtain cheaply because their actual (statistically verifiable) value was greater than their generally perceived value. Beane sought out players in much the same way that Walters seeks out mispriced spreads.

In some cases, the value difference is relatively small.  But compounded over a longer-term time horizon, small enhancements make a huge difference.  In a financial context, over 25 years, $100,000 at 5%, compounded daily, returns $349,004.42 while it returns nearly $100,000 more ($448,113.66) at 6%.  That’s a key reason why Walters is anxious to place lots of bets.

But why are successful investors, successful prognosticators and successful betters so rare?  I have three reasons to suggest.

The first is our human foibles – the behavioral and cognitive biases that plague us so readily. These issues make us susceptible to craving the next shiny object that comes into view and our emotions make it hard for us to trade successfully and extremely difficult to invest successfully over the longer-term.  Recency bias and confirmation bias – to name just two – conspire to inhibit our analysis and subdue investment performance.  Roughly half of each year’s NFL play-off teams fail to make the play-offs the next season.  Yet our predictions (and bets) disproportionately expect last year’s (or even last week’s) successes to repeat.  Another problem is herding.  On average, bettors like to take favorites. Sports fans (and even analysts) also like “jumping on the bandwagon” and riding the coattails of perennial winners. Sports books can use these biases to shade their lines and increase their profit margins.  So can the Street.

Experts are prone to the same weaknesses all of us are, of course, as Pundit Tracker’s look at the predictions of NFL “experts” noted above so clearly demonstrates.  Philip Tetlock’s excellent Expert Political Judgment examines why experts are so often wrong in sometimes excruciating detail. Even worse, when wrong, experts are rarely held accountable and they rarely admit it. They insist that they were just off on timing (“I was right but early!”), or blindsided by an impossible-to-predict event, or almost right, or wrong for the right reasons. Tetlock even goes so far as to claim that the better known and more frequently quoted experts are, the less reliable their guesses about the future are likely to be (think Jim Cramer), largely due to overconfidence, another of our consistent problems.

We should never underestimate information asymmetry either.   Information asymmetry is the edge that high frequency traders have and why Billy Walters focuses on player injuries and their impact in addition to his models.  At a broader level, it’s why it’s so difficult to “beat the market.”  Obviously, someone is on the other side of every trade.  When you make a trade, what’s your edge vis-à-vis your counterparty?

The third reason is just plain luck.  The world is wildly random.  With so many variables, even the best process can be undermined at many points.   Pundit Tracker describes the “fundamental attribution error,” the error we make when we overweight the role of the individual and underweight the roles of chance and context when trying to explain successes and failures.

While watching SportsCenter earlier this week, where the big story remained Monday night’s controversial (to say the least – it even forced the NFL to settle its lock-out of its regular officials) touchdown call that gave the Seattle Seahawks a 14-12 victory over the Green Bay Packers, I was struck by the huge impact the last-second turnaround had on gamblers.  If Seattle’s desperation pass had correctly been ruled an interception, Green Bay – as 3½ point favorites — would have won by five, covering the spread.  Instead, the replacement officials’ call shifted the win from those who bet on the Packers to those who took the underdog Seahawks.  Remarkably, that result means that as much as $1 billion (that’s with a “b”) moved in one direction as opposed to the other.

Thus a clear win was eliminated due solely to the almost unbelievable incompetence of the replacement officials.  That’s just dumb luck for bettors, and why it can be so frustratingly difficult to wager successfully on both our favorite teams and our favorite stocks. It may seem like the system is gamed, but investing successfully is just really hard (like gambling), as Tadas Viskanta so eloquently points out and I regularly reiterate.

In all probabilistic fields, like investing and gambling, the best performers dwell on process. A great hitter focuses upon a good approach, his mechanics, being selective and hitting the ball hard. If he does that – maintains a good process – he will make outs sometimes (even when he hits the ball hard) but the hits will take care of themselves. That’s the Billy Walters process analogized to baseball. Maintaining good process is really hard to do psychologically, emotionally, and organizationally.  But it is absolutely imperative for investment success.  And for gambling success too.