In 2015, Michael Mauboussin wrote a great paper titled – Triple Crown Teachings, Three Takeaways from the Quest for the Elusive Feat. In the paper he discusses how the quest to win the prestigious Triple Crown provides three great lessons for investors. Here are some excerpts from the paper:
“When American Pharoah seeks to complete a sweep of the Triple Crown at Belmont Park on Saturday, racing fans will hope to see a great race and perhaps a definitive confirmation that the winner has earned a lofty place in
the sport’s history. Based on recent history, it won’t happen.”
The quest for the Triple Crown of horse racing offers three lessons for an investment organization:
- Pay attention to the results of the past
- Recognize the value of diversity
- Value = Probability x Price
The first lesson is to consider base rates in assessing future outcomes.
The second lesson is to promote cognitive diversity and thereby avoid the equivalent of inbreeding in your organization.
The final lesson is to focus on mispricing in investing.
Lesson 1: Pay attention to the results of the past. Andrew Beyer, a horse racing expert, said of American Pharoah’s chances of winning: “Based on recent history, it won’t happen.” Why the downbeat message? The answer lies in the base rate of success over time.
Lesson 2: Recognize the value of diversity. In the discussion of success rates, the year 1950 pops off the page. Why would the horses have succeeded at such a high rate prior to 1950 and at such a low rate after it?
Lesson 3: Value = Probability x Price. Notwithstanding the dismal record of horses trying to win the Triple Crown, bettors appear unfailingly optimistic about each horse’s chances. Exhibit 2 shows that the last eight contenders had probabilities of winning the Belmont in the range of 40 to 80 percent as implied by the odds.
American Pharoah is in the same range. The recent odds of 3-5 suggest a probability of winning of 63 percent. That figure is very high, representing a lofty expectation of performance. Odds are set through a parimutuel system, where the bettors express their expectations by how they allocate their dollars. More money bet on a horse drives up its probability of winning. Steven Crist, a handicapper and author, emphasizes that the attractiveness of an opportunity is a function of both the probability of the event occurring and the payoff.
Before any bettors are rewarded, there is a takeout to pay the race purses, track, and state. This means that the win pool is reduced by 15-20 percent. Assume the takeout is 20 percent. That means a $4 bet on a horse with a 50 percent chance to win pays, on average, $3.20.
Crist’s point is that the intelligent handicapper requires a combination of probability and price to yield a positive expected value. Knowing which horse is likely to win doesn’t make you money; you need to know which horse is mispriced. It takes little effort to translate this to the world of business and investing. Knowing which company is best isn’t the path to riches; knowing which company is mispriced makes you money.
Triple Crown contenders attract a lot of unsophisticated bettors. On a typical Saturday in the U.S., wagers on horses are about $50 million. For last year’s Belmont Stakes, the bets were three times that amount. You can safely assume that most of the incremental $100 million was from people caught up in the excitement of the Triple Crown. As a result, Triple Crown contenders are almost always mispriced. Probability times price yields a poor value. Perhaps for some, betting on a potential winner has excitement value that exceeds the cost of the ticket. But that doesn’t make it a good bet in monetary terms.
The final lesson is that you need to focus on mispricing in investing. Triple Crown contenders are a little like dot-com darlings from the late 1990s: Their past success draws the attention of individuals who invest without sufficient regard to the relationship between price and value.
American Pharoah may win the Triple Crown, and if he does it will be an extraordinary feat that will bring deserved excitement to the sport. But no matter the outcome, we can say that his current probability appears too high.
Incidentally, American Pharoah won the Belmont Stakes on June 6, 2015, becoming the 12th Triple Crown winner and the first since 1978, ending a “drought” of 37 years.
You can read the entire paper here: Michael Mauboussin, Triple Crown Teachings, Three Takeaways from the Quest for the Elusive Feat.
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