Why understanding gambling can help investors

To succeed at a casino, players must understand the odds, select the games they want to play, sharpen their instincts and make timely and measured bets. The goal is to beat the house.

Some have argued that playing the stock market is like gambling. Today’s shift toward passive investing would seem to invalidate the goal of beating the house. Or does it? In this series, we will examine how portfolio manager thinking is evolving and how the science of gambling can be applied to the stock market to an investor’s advantage.

The house always wins

Just as investors pay commissions to stockbrokers and management fees to fund companies and ETF sponsors, players pay the house for casino games. “Vig” or vigorish, the house fee for providing the facility, ranges from nearly 0% for blackjack (eight decks) to 30% for keno, according to professional gambler James Walsh.

Read: When addiction and advice mix

Casinos are closed systems: all winnings come from those who lose. Similarly, those who outperform the stock market do so at the expense of those who underperform. Like the different games at a casino, there are different approaches to portfolio construction. Factor-based methods include value, growth, small cap, low volatility and more. Professional gamblers focus on games with the lowest house advantage, like blackjack, and multiple-odds bets on the pass line as in craps. High-stakes poker may be most like the stock market because the house takes a flat fee and players compete against each other.

In pursuit of an edge

My quest to find an investing edge was ignited as a rookie on the U.S. equity trading desk for a major financial institution. I observed that portfolio managers using technical analysis saw increases in value for 66% of their trades, yet random buys over the same period would have yielded similar success. Indeed, between 1928 and 2016, the S&P 500 has risen 65 out of 88 calendar years—73.9% of the time. Like gambling, knowing how much to bet is at least as important as knowing when to bet because the range of market returns has been -43.8% to +52.6% (USD) between 1928 and 2017.

Professional gamblers tend to make many small bets (typically 1% of their bankroll or less), so if an investor had done the same, exposure to big declines would have been limited and exposure to the 73.9% up-market edge would have been maximized. By contrast, some portfolio managers—notably value investors—concentrate their holdings so as to be different than their benchmarks (read the discussion of active share in “How smart has your beta been lately?” AER May 2016). Does technical analysis add value? When markets rolled over, so did the success of those trades.

75%

The percentage of funds in Canada that underperformed their broad benchmark index over five years

Source: S&P Dow Jones Indices SPIVA

Investors and gamblers must determine:

• which strategy/game gives them the best chance to beat the market/house, and
• how to play the strategy/game successfully.

Which games are best?

Observations that value outperformed growth and that small-cap stocks outperformed large-cap stocks was the basis of Eugene Fama and Kenneth French’s three-factor model. The debate will continue because any portfolio that differs from the index will under- or outperform the market for some period. But knowing which style will outperform and when is difficult (see “Can 10 million monkeys outperform the index?,” AER October 2016).

Attracted to low volatility strategies? You are falling into the trap that fools most investors. Past performance is no indication of future performance, yet investors can’t seem to ignore historical returns. More than three-quarters of casino-goers are attracted to the motion and sound of slot machines, even though the house takes 7% on average and can legally skim 15% in Ontario.

Table 1: Largest Canadian ETFs by strategy for the 5 years ending Oct. 31, 2017

Risk-based strategies, as it turns out, outperformed most frequently according to the “10 million monkey” study mentioned earlier. And, with the caveat that comes with a short-term performance period, low volatility strategies did best in Canada over the five years ending Oct. 31, 2017, followed by value, momentum and dividend (see Table 1). It is important to understand why a strategy outperforms in order to anticipate when it might fail.

Which funds outperformed their low volatility benchmark? (See Table 2.)

Table 2: Canadian low-volatility ETF performance

Note: ZLB is among a few ETFs that don’t have benchmarks. We compared it with the S&P TSX Composite Low Volatility Index.

With few exceptions, ETFs in this and other categories underperformed their benchmarks by amounts approximating their costs. In Canada, 75% of funds, and 82.4% of funds in the U.S. underperformed their broad benchmark index over the five years ending June 30, 2017 (see S&P Down Jones Indices SPIVA).

Observations:

• All strategies outperform sometimes.
• Identifying outperformers ahead of time is almost impossible.
• In the long run, selecting a strategy’s index at low cost is a good bet.

Next time, we’ll take a deeper dive into why low volatility works and how advisors can use it.

Read: How to stick to a strategy despite market pressure

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.