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WHAT'S THE DIFFERENCE BETWEEN GAMBLING AND INVESTING? (Part 2)

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After last weeks discussion on portfolio theory, this week i'm going to talk about value, so lets begin

LESSON 2 – VALUE

No matter how you decide to structure your portfolio, when selecting individual positions, you should always consider what something is worth versus what you pay for it.

To quote Warren Buffett, “Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

In finance, this is emphasized most by the value investing strategy, which, in a nutshell is buying something for less than it is (hopefully) worth (or, conversely, selling something for more than what it is worth). Like the casino with its house edge on the roulette table, or the bookmakers 110% book, if you are getting more in than you are paying out, you are tilting the game in your favor, and despite not winning every bet, you increase your chances of being up in the long term.

In the financial world, analysts concentrate on determining the ‘intrinsic value’ of securities. They scrutinize the company’s financial results, their management plans, and developments within the wider operating industry in order to try and find something that hasn’t been factored into the price by the market already. They make forecasts on the sales, revenue and operating expenses of the company, and perform ‘what-if’ style scenario based analysis all with the aim of trying to determining a fair value stock today based on what they believe will play out in the future.

In reality, there is no ‘correct’ answer when determining a security’s intrinsic value. It is all a matter of opinion and as with gambling, the future is uncertain. To reflect this, the analysts will include a margin of safety and set buy and sell targets either side of their estimates. For instance, if they estimate a company’s intrinsic value to be $12 per share, they may set a buy target at $10.50 and a sell target at $13. If the market price still falls outside of this range, say at $10.28, it is a potential trade, and in this case a buy.
In the sporting world you could do the work of an analyst, do the in depth research and price up the market. If you can do a better job at this than the bookmakers and enter into mispriced gambles, again, in the long term, you should be up. Admittedly this is beyond most people, but there is many a good tipping service attempting just this. If you do fancy trying your hand at it, ‘The Definitive Guide to Betting on Football’ is an interesting read.

One slightly easier route is to try and get an edge by responding to news before others. If you can think one or two steps removed, much like the financial analyst assessing how problems at a copper company impact the downstream technology company that they supply, you start to see some great opportunities.

A common occurrence is that markets overreact to events that are happening right now, as capitalized on by swing trading strategies on in-play Tennis and NFL, but are slow to adjust prices on distant or correlated events. The evening I first drafted this, Bradford were playing Aston Villa in the Capital One Cup semi final.

The moment Bradford scored an equalizer against Villa the news was rapidly factored into the price of Bradford to qualify for the final. However, it also had a secondary effect of shortening Chelsea and, in particular, Swansea’s chances of actually winning the cup outright. These kind of long term knock-on effects can be easier to take advantage of than the frantic swings in the here-and-now markets.

Another easy source of value is related to ‘arbitrage pricing theory’ (APT), which is a grand term that suggests you shouldn’t be able to get money for nothing. Although sentiment is a strong driver of prices, particularly in financial equity markets, other markets are driven more by pure mathematics. The argument here goes that assets that have identical cash flows should be priced exactly the same. Likewise, something with a fixed future value (like a bond with known coupons every 6 months and a return of face value at the end) should be priced today such that no advantage is possible after discounting for costs of borrowing, storage, etc. If assets were mis-priced, we could take advantage of this by endlessly buying the cheaper and selling the higher.

Arbitrage opportunities in the financial markets are typically gone in milliseconds. Thankfully, the sports markets are much less efficient and leave us with many low risk opportunities. The most obvious is the straight arbitrage that can exist between the bookmakers and the exchanges. As with the financial markets, you should adjust for costs such as commission, the inconvenience of tying up your money at a bookmaker, or the opportunity cost of possibly losing your bookmaker account completely should you win on that side.

A “dutch book” is another such arbitrage opportunity where you take best price (again, think value) on all outcomes and produce the equivalent of the bookmakers over-round for yourself.

Finally, the bookmaker refund offers are also another analogy to APT. If you can manufacture a £50 refund on an event that is priced at 3/1 on the exchange for a qualifying £2 loss, then you have an arbitrage opportunity. You can ‘buy’ it low from the bookmaker and ‘sell’ it high at the exchange for an arbitrage based profit, or going back to what we discussed before, you could just treat it as a value gamble and tilt the game further in your favour in the long term.

Next time we look at the psychology of gambling

Montgomery
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Montgomery

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