Have your own odds-based system to beat the market

JAMES GRUBER, assistant editor for Firstlinks.com and Morningstar Australia, shares interesting perspectives.
By Morningstar |  11-01-23 | 

Most people think of gambling as randomized luck. And they’re largely right. At a casino, the casino normally has the advantage.

For instance, you can go to a casino and play blackjack. The dealer will give you, and all other players, two cards face up, while the dealer gets one card face up and another face down. From there, the aim is to get as close to cards totalling 21 as possible, without going over.

But your chances of winning a hand are 42.22%, while the odds of a tie are 8.48%. Conversely, the odds of the casino winning are 49.3%. That’s because the casino dealer has the advantage of going second and can make decisions based on your position. You may get lucky for a few hands, yet if you play long enough, the statistical odds will come back to beat you.

The best investors have a similar trait to the best gamblers: they bet when the odds are overwhelmingly in their favour. Bill Gross, the bond king, knew this. He wasn’t interested in relying on randomized luck, but applied an odds-based mentality to give him an edge in bond markets. I write about that in detail in Invest when the odds are in your favour.

Over here I look at the edge that Buffett and Munger have.

  • Warren Buffett

Buffett developed his own odds-based system for beating the stock market. He started by following his teacher Benjamin Graham into value stocks, where he’d often buy a stock valued well below the net assets on its balance sheet. He eventually changed his investment system to focus on quality stocks valued cheaply.

As his publicly listed company, Berkshire Hathaway, got larger, Buffett started buying whole companies. He became attracted to insurance companies, which gave him two things:

  1. A cheaper source of funding than offered by banks or equity markets
  2. A way to play the odds via insurance.

Buffett realized that insurance was an odds-based system, where you price insurance according to the odds of a future event happening. Insurance has since formed the backbone of Buffett’s empire.

  • Charlie Munger

Munger has expressed how he uses the horse racing betting system as a way to approach investing in the stock market:

“To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for the horse with one chance in two of winning which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”

(Pari-mutuel betting: Instead of placing bets with a bookmaker, you’re placing a bet against other players who have placed bets on the same event. This is the world’s most popular method of betting on horse races. In pari-mutuel betting, all bets go into a pool. This is then shared equally between those who win, after deduction of the management commission and tax.)

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