Understanding Market Efficiency Through a Sports Betting Lens
This week, from Dimensional’ s Informed Investor series, I came across the sports betting and financial markets analogy. It’s one of my favorites, with such a strong connection and valuable insight for all investors. Let me explain a bit, then give the video a listen here.
As the analogy goes, the initial “spread” comes out on the upcoming weekend’s matchup, factoring in all knowable information (weather, injuries, team strengths, coaching, etc.) in the expected outcome - how much the favored team is likely to win by. As money comes in, the spread moves, reflecting any new information available in the collective expectations of the people placing bets. Half of the money ends up on either side of the betting line, establishing an equilibrium price in the middle, in real time. In much the same way, stock prices move with the collective expectation of buyers and sellers. Enough buyers think the price is too low, so they buy, and enough sellers think the price is too high, so they sell. Multiply that by millions of millisecond transactions each day with buyers and sellers squabbling over the appropriate price, you end up with an “equilibrium” price that best represents anticipated outcomes. This happens throughout every trading day, rapidly reflecting knowable information in stock prices in a fantastically efficient way, just like Vegas does with a point spread.
Understanding this analogy helps in many ways. Like all gambling opportunities, you win some and you lose some in the short term. Vegas is fun and entertaining, but in the end those casinos don’t build themselves - we do. Day trading on perceived stock pricing inefficiencies is just as fruitless. However, in either case, the real brilliance is found in the odds. With enough volume, the casino always comes out on top. Similarly, with a well-diversified evidence-based portfolio, we investors are the “house” - we just need to stack enough days, months, years and decades of share ownership to reap the rewards!
Past performance is no guarantee of future results. The above summary is for illustration purposes only.
Dustin Smith, CFP®
Find Dustin on LinkedIn
