Advantage Gambling

Sports gambling is a hot topic right now.  On May 14, by a 6-3 decision, the Supreme Court overturned a federal law that effectively outlawed most sports gambling.  The law included a few exceptions, the broadest being granted to Nevada.

New Jersey, the home of Atlantic City, challenged the law on multiple grounds.  The Supreme Court agreed with the challenger and decided that Congress has the power to regulate sports betting at the Federal level, but if it does not do so then the states cannot be prohibited from regulating sports betting themselves.

Congress may act to regulate sports betting nationwide, or even to prohibit it entirely.  If not, then it is still unclear how quickly, and how permissively, states may legalize it.  In the wake of the Supreme Court decision, there is a flurry of speculation around what the decision could mean for sports leagues and bookmakers (gambling companies).  Sports leagues have traditionally viewed gambling as a danger to match integrity and as competition for fans’ money.  Gambling proponents note that betting increases interest in sports.  Currently, the only three cities who tune in for the second half of an Alabama vs. Vanderbilt football game are Tuscaloosa, Nashville, and Las Vegas.

For bookmakers, an enormous new market could soon appear.  Despite all the unknowns about what happens next for Congress and the states, incumbent and startup bookmakers are already jostling for position in what they hope will be a huge new market.  A U.K. bookmaker is expected to buy a U.S. company that provides technology for fantasy sports leagues. Casino stocks also rose the day of the Supreme Court decision, although it’s not completely clear that the decision will ultimately be good for them.  After all, their legal monopoly is now subject to challenge from all sides.  Simply from a business perspective, it will be interesting to see what happens from here.

The subject piques my interest because, while investing and gambling are two different things, they also share a lot of similarities.  Some investors would scoff at that comparison, but they either don’t know or simply won’t admit how many parallels there are between the two pursuits.

It can be interesting to see what works or doesn’t work in the gambling world and try to apply those insights to investing.  Bloomberg recently published The Gambler Who Cracked the Horse-Racing Code by Kit Chellel, profiling a gambler named Bill Benter.  An Eagle Scout, Benter dropped out of college in 1979 to move to Las Vegas to play blackjack using the card counting system developed by math professor Ed Thorp.  Card counting was not cheating, but it flipped the odds in favor of the gambler.  This is called advantage gambling, and there are very few documented cases of it actually working.  Card counting is one such exception.

Casinos have changed their rules to prevent card counters from beating the house, but it was still possible back in the early 1980s, and it drove casinos nuts.  Benter worked at 7-Eleven during the day and played blackjack for small profits, before joining a team that played for bigger stakes and greatly magnified his ability to make money.  After four years, the casinos sniffed him out and blacklisted him from Las Vegas.  Then Benter decided to focus his attention on horse racing in the hopes of recreating what Ed Thorp had done with blackjack: turn the house advantage into a player’s advantage.  He would first teach himself statistics, then he built models to predict race outcomes.  He tested his models by coding historical race data from the library archives into a computer, and finally he moved to the horse racing capital of the world, Hong Kong.  It would take him a few attempts and a few years to earn regular profits, but he eventually succeeded.  Since then, he has won nearly a billion dollars.

On its face, this would seem impossible because horse racing odds are much worse than blackjack odds in the first place.  A blackjack player only needs to overcome a small house advantage.  The Bloomberg article estimates the house edge in horse racing as 17%.  That is a lot to overcome!  However, horse racing allows the player to pick and choose which races they will participate in or stay out of.

I’ll point out that stock-picking provides the best of both worlds—a positive player edge (stocks tend to go up over time), as well as the freedom to decide when to play and when to sit out.  Good thing too, because if I had to make a living as a gambler I don’t think I could compete against the likes of Bill Benter.  I’ll have to stick to saving and investing.  I’ll take every advantage I can get.

Another example of gambling informing investing is one of the most prominent risk control strategies in the investing world, a mathematical expression called the Kelly Criterion.  It was invented by physicist John Kelly Jr., and it expresses the optimal size of a wager as a function of potential upside, downside, and the likelihood of a positive versus negative outcome.  I first learned about the Kelly Criterion from an investing book, and I had no idea until very recently that his original paper presented the idea using horse betting as an example of how the formula applied in the real world.

One last example of gambling informing investing is the lesson of the Martingale betting strategy.  For investors, this is a cautionary tale.  Originally a gambling formula, a Martingale strategy seeks to earn consistent, small profits from a game that is stacked against the player.  However, it comes with the risk of rare, enormous losses.  Over a long enough horizon, enormous losses are certain.  Many brilliant-looking investors have ultimately been revealed as frauds whose seeming success depended on a variant of the Martingale strategy.  There are lots of clever variants, and they all look great until they totally blow up.  For investors, the best defense against a Martingale-style fraud is to understand in detail what the manager is doing.  Be very wary of “secret sauce” investment strategies. Investors should also be suspicious of results that look too consistent. Consistency feels like safety but may ultimately cause ruin.  Gamblers know the pitfalls of Martingale traps, but investors keep falling into them.  Don’t be one of them.

Miles Putnam, CFA