Fall is here, which means football season. Many of the early games on the college schedule feature highly-ranked teams against weaker opponents. These match-ups typically end with lopsided scores.
The Oregon Ducks, for example, opened their 2014 season against the South Dakota Coyotes. A majority of football fans across the country expected the Ducks to win. A fan who wanted to wager on the Ducks winning the game couldn’t easily find a willing participant to take the other side of the bet. To make betting on the favorite or underdog equally attractive, the point “spread” was created.
A point spread is determined by the expectations of betting participants. In the case of the Ducks vs. Coyotes, the spread opened with the Ducks favored by 51 points. A fan that chose to bet on the Ducks covering the spread would need the team to win by at least 52 points to receive their winnings.
The spread can move up or down until game time. As more fans placed bets on the Ducks to cover the 51 point spread, it increased to 52 points and eventually settled at 54 points before kick-off. As it turned out, the Ducks won convincingly, 62-13, but failed to cover the spread. The better team, in this instance, was not a good bet.
As it turns out, the favorite often fails to beat the spread. The University of Chicago’s Steven Levitt analyzed results from nearly 5,000 NFL football games over 20+ seasons and found the favorite team covered the spread just 48% of the time.[1] Other studies, looking at NBA basketball games and NFL Super Bowls, have concluded the same: Favorites beat the spread about half the time. This is what we should expect when the “collective wisdom” of all bettors combines to set point spreads.
What does any of this have to do with investing? The investor buying or selling an individual stock is equivalent to the fan who bets on a team to cover (or not) the point spread. The better team may win the football game just as Apple may sell a record number of iPhones, but rewards may fail to materialize for the bettor/investor.
Since stock prices, like point spreads, are determined by the expectations of countless highly skilled, highly motivated, well-informed experts, an individual has to be extraordinarily confident (or oblivious) to think they can outsmart the crowd.
[1] Levitt, Steven D. “Why Are Gambling Markets Organised So Differently From Financial Markets?” The Economic Journal, Royal Economic Society, 2004.
Editor’s Note: This article was originally penned by our late colleague, Gordie Gorsuch, whose timeless wisdom lives on in Vista’s investment philosophy.