Overpaying for Low Probability
by Eddy Elfenbein on December 28th, 2015 at 9:40 am
In Big Short, people betting on low probability events are geniuses. In reality, people do this all the time, generally overpaying.
— Eric Falkenstein (@egfalken) December 27, 2015
I posted this tweet from Eric Falkenstein because it’s one of the fundamental truths about investing. Markets are generally not very good judges of low-probability events.
One of the best examples of this comes from horse racing. Historically, the worst bet to make is to bet on the long shot. Why is that the case? I think it’s because a certain amount of people want to bet on the long shot precisely because it is the long shot.
Think of the guy who says, “Dude, that horse is 70-to-1! I’m betting $10 on it. How crazy would it be if he won?”
Not to get overly philosophical, but the price impacts the price. I’m sure you’ve heard stories of an art gallery owner who can’t move a painting. Then he triples the price and it sells the next day.
In stocks, this effect often happens with companies that are supposed to be the “next Apple” or “next Google.” Sure, it might work out, but the odds are against it. Some people just want to own for the big payoff, and that itself makes it overpriced.
I suspect that the historic outperformance of value stocks isn’t due to something within value stocks but rather it’s due to the underperformance of richly-valued growth stocks.
Copyright © Eddy Elfenbein
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
