No, this isn’t my second-grade teacher’s description of me on my report card, though it’s close. (She actually referred to me as “lazy” and “distracted.”) It’s the name of the thoroughbred that won the Kentucky Derby in early May. Although I didn’t attend the Derby itself, I was lucky enough to visit Churchill Downs, the home of the Kentucky Derby, last fall when I visited my niece, who attends the University of Louisville.
We sat in the surprisingly dusty bleachers watching race after race. As a financial planner from Memphis, I wasn’t interested in actually betting, but I was fascinated by the process — the odds of every race, how they were calculated, and what they implied.
Horse races use a pari-mutuel betting system, which determines the “odds” of each horse. The odds represent both the probability of winning and the potential payout, based on how much confidence the gamblers themselves have expressed in each horse’s likelihood of winning. The more likely the horse is to win, the better the odds — and the lower the payout.
Implied in the betting odds is the recognition that not every gambler gets every bet right but in aggregate they are pretty good at knowing which horse will finish “in the money.”
Always Dreaming was the odds-on favorite and won by 2 ½ lengths.
What does this have to do with investing? The answer is a lot. Markets price securities in a very similar fashion to the pari-mutuel betting system used in horse races.
Stocks and bonds don’t race against each other to a finish line, but each security is, in effect, racing against the ideal version of itself. Implied in every security’s price is some model version of the future. For a bond, this means no default. For a stock, this implies executing the company’s business model to perfection. But in every case, the probability of this ideal outcome is less than 100 percent. In many cases, it’s significantly lower.
Investors in aggregate set the price of the security to reflect the probabilities of different potential outcomes. When the probabilities of the desired outcome are high, prices get bid up and, in turn, the expected future return on the investment may be lower. In horse racing, that equates to better odds of winning and a lower payout.
The opposite is also true. When the probability of the desired outcome is low, prices tend to reflect this uncertainty, which leads to a higher potential return if the desired outcome is reached. The horse-racing equivalent is betting on the long shot that has poor odds of winning but the potential of a significant payout.
This is easy to see in the bond market, where higher risks of default translate directly into higher yields. It’s a little harder to perceive in the stock market, but it does exist. Stable businesses that have competitive advantages and sustainable growth rates tend to trade at higher valuations. Implied in these higher valuations is a lower expected future return. Businesses that have the opposite characteristics and a broader range of possible outcomes — some good and some bad — tend to have lower valuations. This implies that the owners expect to be compensated for the risks associated with owning these riskier companies.
Although the similarities between pari-mutuel betting and investments will not guarantee a given rate of return for any given stock or bond, they do shed some light on the idea that there may be different odds, or expected returns, associated with companies based on their implied risks and probabilities of success. At the very least, this should be fully considered when building portfolios and can be instrumental in the development of an asset allocation strategy.