I read an article some years ago in which Charlie Munger (the Vice Chairman of Berkshire Hathaway) likened the stock market to a parimutuel betting system (referred to in some countries as a totalizer betting system).
This aroused my interest and the more I thought about it, the more I thought that Munger was absolutely correct.
A parimutuel or totalizer betting system is where people wishing to bet on a particular event (let’s say a horse race or a sporting event) place their bet with an organisation that pools all the money wagered and then sets the odds for each outcome based on the amount of money bet (after taking a set percentage off the top, I believe the percentage is around 17% in the US).
For example, Team A is playing Team B in some sporting event. Those betting on the outcome of this event have bet $800,000 in total. Of this $800,000, $600,000 has been bet on Team A and $200,000 has been bet on Team B.
The organisation running the parimutuel system will take off the top a certain amount, let’s say 17%. Therefore, $136,000 of the amount wagered goes straight to the betting organisation. So $664,000 is left to distribute in winnings.
Because $600,000 was wagered on Team A and those making that bet can only be paid $664,000, the payment for a $1 bet is close to $1.11 ($664,000/$600,000). The payout for Team B is $3.32 ($664,000/$200,000). We are assuming that a draw cannot happen in this example (and yes, I have simplified the calculations).
The organisation running the parimutuel system doesn’t care who actually wins or loses – they take their cut right up front. In the parimutuel system, bets on opposite sides of a wager are competing against each other and the odds are set based on how much each side is prepared to bet on a particular outcome. The winners share the entire pool of money and the losers get nothing.
In the betting world, all of the really large horse racing syndicates operate in Hong Kong because it has the largest betting market in the world.
These syndicates use extremely sophisticated software to calculate odds. This software usually cost upwards of $1 million to develop and many of the people involved in these syndicates come from an actuarial background.
It can be highly lucrative. The late Alan Woods (an Australian) died in 2008 with an estimated fortune of $670 million, all of which was derived from gambling.
Now, as Charlie Munger observed, the stock market is very similar to the parimutuel system. Individuals in the stock market submit buy and sell orders (rather than bets) and market prices (like the odds) are determined by the number of buyers and sellers on each side.
In the stock market, the buyer of company XYZ’s shares is in effect “betting” against the seller of company XYZ’s shares that company XYZ’s share price will rise.
A really good horse will have low odds in a race and a really good company will generally sell at a high price in the market.
As Munger has stated, the two huge advantages that the stock market has over the parimutuel system are:
1. The stock broker takes far less off the top than the betting organisation;
2. Prices of shares can occasionally completely disengage from the fundamentals. This is far less likely to happen when setting the odds in a parimutuel system.
Obviously the share market is not a zero sum game like the parimutuel system (that’s if we exclude derivatives). It’s highly unlikely that you will lose all your money in the stock market if you have a sufficiently diversified portfolio. But just like the parimutuel system, if you don’t really know what you are doing, you will lose some money overtime, it’s just a slower process in the share market.
So what implications do Munger’s observations have?
1. It’s extremely important to keep brokers’ costs as low as possible to maximise the potential gain. This is one of the reasons why sophisticated share market investors rarely use full service brokers;
2. Research pays off. Just like those syndicates in Hong Kong, use of statistics and research can aid in finding an incorrectly priced “bet”. But remember, this research is not always the kind of thing that you can just find out from a broker or read in a newspaper;
3. Professional gamblers only bet when the odds are incorrectly set in their favour (based on significant research). Most of the time the odds will in fact be accurate, just like the prices of shares in the stock market will be and when this is the case the professional will not “bet”. Fortunately however, this is not always the case – bear markets and bull markets offer real rewards to the patient investor;
4. Most novices would not seriously think that they could make money betting on horses but many share market novices think they can beat the market (I’m sure that 2008 probably changed that attitude for many of these people).
Just to pick up on that last point - you may be an average investor with a small portfolio and limited knowledge, the person on the other side of your buy or sell order may have vast knowledge and may have made millions in the market. You are unlikely to outsmart such people, just as novices won’t outsmart professional gamblers or bookmakers.
It worries me when I see people who know almost nothing about share market investing jumping into the market (sometimes with borrowed money). These people need to educate themselves before making any investments – read, read and then read more. If someone wants to invest in the market but doesn’t want to bother with research, they can always buy a good quality listed investment company (this will be the subject of an upcoming post).
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