Gaining an Edge from Gambling

Updated: May 17

I never gamble. Not because I think it is a stupid thing to do - though it certainly can be - I just don’t have the time or inclination. Furthermore, I get enough uncertainty in my job. As a professional investor, I seek to forecast the future direction of markets and stocks. The professional gambler, on the other hand, seeks to forecast the winner of the 1:50 at Haydock. Wait a minute! Is there really a fundamental difference?

"There is no difference between the tools used by the successful gambler and those used by the successful investor"

When I talk about gambling, I am talking about skill games in which human beings play each other, rather than luck games where you play against ‘the house’. The latter includes games in which the odds are both fixed and stacked against you. You may have a lucky streak now and again, but it is just that - luck.

In essence, gambling involves two people disagreeing about the likelihood of the outcome of an event where the probabilities of the various outcomes are objectively unknowable. Imagine two twitchers sitting over a pint in January, disagreeing as to when the first house martins will be seen in the UK this year. Twitcher A says March, which is a little earlier than usual; twitcher B says April. Is it possible that A has some sort of edge over B? Absolutely! There are all sorts of things that A could know that B does not. He could be the world’s leading authority on house martins, he could be a leading weather forecaster, or he could know that B is a fool, something that B, being a fool, is ignorant of. All these constitute some sort of edge.

It was. Bell Laboratories scientist John L Kelly Jr who, in 1956, set out a scientific framework for gambling and how most efficiently to convert edge into profit. His formula, known as the Kelly criterion, is beautifully simple, and says that the percentage of your purse that you should bet in order to maximise your winnings over time is equal to your edge divided by the market odds.

Take a coin that you know is likely to land heads 60% of the time. You play toss with an opponent who is unaware of the coin’s bias. What percentage of your purse should you bet in order to maximise your profits? If you bet your entire purse, there is a 40% chance you will lose everything. If you bet nothing, you waste your edge, namely your inside knowledge that the coin is biased. The optimal bet size must therefore be somewhere between zero and 100%.

Now let us look at the aforementioned formula. Edge can be measured as the difference between what you know or think and what the market, i.e. your opponent, knows or thinks. In this instance you know that the probability is 60%. Your opponent, on the other hand, thinks it’s 50%, so your edge is 10% - 60% minus 50%.

What about the denominator in the formula, the market odds? We know this is 50%, which is what the opponent thinks is the probability of the coin landing heads. Edge 10% divided by odds 50% equals 20%. It is a mathematical fact that if you bet 20% of your purse each toss, you will overtime get richer than with any other bet size, say 19% or 21%.

Things, of course, in the real world, whether with respect to investing or gambling are not so simple. While the odds or market probabilities will generally be available, gauging your edge is hard. This is why truly successful gamblers and investors are rare beasts, primarily because they know that most of the time, they do not have an edge. Or at least not a sufficiently large one, and so should not place a bet or establish a position in a portfolio.

It was driven into me as a young fund manager that investing is not the same as gambling and that suggesting so was foolish indeed - unless, that is, you wanted to lose clients quickly. However, there is no fundamental difference between the tools and principles used by the successful gambler and those used by the successful investor.

In my next piece, I will argue that the misunderstanding of the simple point lies at the heart of what is wrong with the entire investment industry.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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