DRF Legend Steven Crist on Value Investing and Horse Betting by John Szramiak was originally published on Vintage Value Investing
I’m not at all a gambler.
In fact, I used to be proud to say that, thinking that gambling was only for chumps.
But after reading Crist on Value, I’m beginning to reconsider my position on the activity.
Let me explain…
Steven Crist on Value
Steven Crist is a legend in the world of horse betting.
A Harvard graduate, Steve Crist took a different approach to betting on horses than most other people, applying math, logic, and probability in making wagers, instead of simply picking the most likely horse to win the race. While by no means was this revolutionary, Steven Crist has been one of the most outspoken advocates for using this approach of finding value in wagers, and he’s used it to great success (Crist’s nickname is “King of the Pick Six” – the pick six is a wager where the bettor must select the winners of six consecutive races and is considered the most difficult type of bet).
In 1998, Steven Crist teamed up with Alpine Capital to purchase Daily Racing Form (DRF), a newspaper that has published the past performances of race horses since 1894 and is the gold standard statistical service for horse race handicappers (as one journalist put it, DRF is to horseplayers what the Wall Street Journal is to investors). While running DRF, Steve Crist also wrote a weekly column and a blog, where he often talked about his method of horse betting.
In 2001, Steven Crist wrote a chapter for the book Bet With the Best: Strategies from America’s Leading Handicappers. That chapter was simply called Crist on Value.
While Steven Crist doesn’t mention stocks, markets, the economy, companies, or investing anywhere at all in Crist on Value, the parallels between horse betting and investing are incredibly interesting. In fact, most of Crist on Value seems like it belongs in Benjamin Graham’s The Intelligent Investor, not a book on how to bet on horses!
Michael Mauboussin, a value investor and one of the sharpest thinkers in finance today, has called Crist on Value “one of the best 13 pages on investing I have ever read.”
I’d probably agree with that.
The Similarities Between Horse Race Betting and Investing
As it turns out, the connection between horse betting and investing runs pretty deep.
As a kid, Warren Buffett used to bet on horse races at Omaha’s Ak-Sar-Ben Race Track. And here’s Charlie Munger talking about horse race betting in his famous Worldly Wisdom speech:
“The model I like — to sort of simplify the notion of what goes on in a market for common stocks — is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.”
Now, before you invite me to sit next to you at the bank of slot machines at the nearest casino, remember that what we’re talking about here are pari-mutuel betting systems – gambling games like horse betting and poker where you’re betting against all the other betters – and NOT fixed-odds betting – games like roulette or craps where the odds are fixed.
Winning these fixed-odds games is pure chance and making money off of them over the long-term is impossible because the casino is setting the odds. In roulette, for example, there are 38 spaces. If you were to bet $1 on each of 1,000 spins, you would have bet a total of $1,000 – but you would only have won back a total of $936, for a total loss of $64. The longer your play, the more you lose and the more the house wins (hence the phrase “the house always wins”).
Pari-mutuel betting games, on the other hand, are an entirely different story because it’s the public – not the house – that is setting the price of the bet. And somewhere between frequently, occasionally, and rarely, the public makes the wrong price.
Michael Mauboussin expands on this point in his book More Than You Know: Finding Financial Wisdom in Unconventional Places:
“One way to think about it is to contrast a roulette wheel with a pari-mutuel betting system. If you play a fair game of roulette, whatever prediction you make will not affect the outcome. The prediction’s outcome is independent of the prediction itself. Contrast that with a prediction at the racetrack. If you believe a particular horse is likely to do better that the odds suggest you will bet on the horse. But your bet will help shape the odds. For instance, if all bettors predict a particular horse will win, the odds will reflect that prediction, and the return on investment will be poor.
The analogy carries to the stock market. If you believe a stock is undervalued and start to buy it, you will help raise the price, this driving down prospective returns. This point underscores the importance of expected value, a central concept in any probabilistic exercise. Expected value formalizes the idea that your return on an investment is the product of the probabilities and the various outcomes and the payoff from each outcome.”
This is similar to what I wrote about in Why the Stock Market is So Hard to Predict. You see, roulette and craps are “level one” chaotic systems – chaos (i.e. randomness) that does not react to predictions made about it. Everybody in the casino can bet on red 32 if they want, but the roulette wheel won’t care and it won’t affect the 1/38 chance that the ball has of landing on red 32. Likewise, the casino could care less which numbers are played – the payoff remains the same.
In contrast, pari-mutuel betting games like horse betting and poker are “level two” chaos systems – these games react to predictions made about their outcomes. While the horses don’t care who’s picking them as a favorite to win and the cards that are dealt aren’t affected by a poker player’s wager, the betting within the game itself IS affected by the actions of other bettors. In horse race betting, your bet helps shape the odds for that wager – which might be better or worse than the actual odds a certain horse has of winning the horse race. In poker, the players determine the size of the pot – which might be large or small relative to the odds your hand has of winning. And the same is true of the stock market, where investors’ predictions of a company determine the price of that company’s stock – which might be more or less than the company’s true intrinsic value.
A Quick Primer on Some Important Horse Betting Terms
Before we actually get to Crist on Value, I think it’s helpful to know some of the most important horse betting terms (so that you can understand some of the nuances of what Steven Crist is actually talking about). Here are