Two Dollars to Win

Larry Sayler

PEOPLE WHO INVEST in the stock market and people who bet on horses both hope to win. I expected the efficiency and behavioral finance factors that rule the stock market to have similar effects on horse betting. Instead, I found just the opposite.

The story begins 40 years ago. A few years after we were married, I suggested to my wife that we spend a day at the fabled Saratoga Race Course in Upstate New York and watch the thoroughbreds run. At the time, we were living in nearby Schenectady. My wife was fine until I suggested we bet on each race. She was appalled, declaring, “Neither of us knows anything about horses.”

There were going to be eight races that day. I said I would put $32 in my right pocket. That would be enough for each of us to place a $2 bet on all eight races. Our bets would be simple—$2 on a single horse to win. We would put any winnings in my left pocket. Racetracks keep about 20% of what is bet and pay out 80%. If we bet $32 randomly, at the end of the day we should have $25 or $26 in my left pocket. If we had a bad day, we might have $23. If we had a good day, it could be closer to $28.

My wife asked how she should select a horse. Though I wasn’t able to clearly articulate it at the time, I believed horse betting was “efficient.” Therefore, I said it doesn’t matter—she might select based on a horse’s name or the color of the jockey’s garb, she might pick the horse with the best odds or she might opt for the long shot. It truly didn’t matter. Each race, we dutifully placed our $2 bets. That made for a more exciting day, as we cheered on our horses. As I recall, by the end, I had about $25 in my left pocket. We got a lot of enjoyment for the few dollars we lost.

What does betting on horses have to do with finance? Actually, quite a lot.

History tells us that value stocks outperform growth stocks, although this hasn’t been true recently. Behavioral finance provides a reasonable explanation for this outperformance. “Herd behavior” bias says we’re inclined to mimic what others are doing. If others like a particular stock, we tend to join the crowd and push the share price to a level beyond what’s reasonable. Conversely, if a particular sector is out of favor, we tend to shun those stocks, causing them to become undervalued.

People expect both favored horses and growth stocks to do well. Thus, favored horses should be overvalued. Meanwhile, as with value stocks, people don’t expect much from long-shot horses. Long-shot horses should be undervalued.

All of this came to mind recently when I was going through my study, trying to figure out what I could toss. I came across a paper I wrote in 2002 for a statistics class I was taking as part of my doctoral program. For the paper, I systematically examined the betting on horses to see if it was consistent with the efficient market hypothesis.

Just as the price of a stock reflects the opinion of people who have a vested interest in the outcome, the odds on a horse reflect the opinions of those who have a vested interest in the outcome. The odds are adjusted in real time as bets are placed. If more money is placed on a particular horse, the track offers less payout if that horse wins. If few people bet on a horse, the track offers a larger payout. The track doesn’t care which horse wins—it always gets its share.

I was taking my doctorate at Anderson University in Anderson, Indiana. The town is also home to a horse track, Hoosier Park. For each of the 770 races during the most recent season, I was able to find the final odds of each horse, the horse which won and the amount paid for a winning bet.

My results were the exact opposite of what I expected. For betting on horses, the best results were obtained by betting on the favorite. People had a worse outcome if they bet on the least favorite horse, the long shot.

Since a track pays out 80% of the amount bet, a $2 bet on each horse in each race will provide an average payoff of $1.60. If I had placed a $2 bet on the most favored horse in each race, meaning the horse with the smallest odds, I would have won an average of $1.70. A long-shot horse didn’t win very often, but—when it did—it paid a huge amount. But on average, a $2 bet on a long shot yielded just $1.38.

My analysis was more than 20 years ago, and I analyzed only one track and one season. Are similar results typical today? If so, perhaps horse betting is less efficient than the stock market—though making money would still be tough, given the track’s 20% take.

By the way, my wife still thinks gambling is a waste of good money.

Larry Sayler is the only person with a Wharton MBA who also graduated from Ringling Bros. and Barnum & Bailey’s Clown College. Earlier in his career, he served as CFO for three manufacturing and service organizations. For 16 years before his retirement, Larry taught accounting at a small Christian college in the Midwest. His brother Kenyon also writes for HumbleDollar. Check out Larry’s earlier articles.

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