Swedroe: Parallels Of Betting & Investing

August 21, 2015

Two of the most-well-known factors that help explain stock returns are the value effect (where equities with lower prices relative to metrics—such as book value, earnings, cash flow, sales and dividends—tend to outperform the equities with higher prices relative to those metrics), and the momentum effect (where assets that have outperformed in the recent past tend to continue to outperform in the near future).

Academic research has uncovered the fact that combining these two strategies (value and momentum) results in more efficient portfolios (because their correlation is highly negative).

Importantly, this holds true across the globe and across asset classes (meaning that it holds true not only for equities, but also for bonds, commodities and currencies). For those interested in the evidence, I recommend the study “Value and Momentum Everywhere,” which appeared in the June 2013 issue of The Journal of Finance.

While the existence and explanatory power of the value and momentum factors aren’t debated, there are two competing theories that attempt to explain the sources of their premiums: risk-based explanations (what we might refer to as the Eugene–Fama camp), and behavioral-based explanations (the Robert Shiller camp). Interestingly enough, Fama and Shiller shared the 2013 Nobel Prize in economics.

Behavioral research has found prices can deviate from their fundamental values due to cognitive biases (leading some investors to underreact and overreact to news) or erroneous beliefs. And because arbitrageurs cannot keep the market efficient by their actions—thanks to costs and limits to arbitrage—mispricings can persist.

University of Chicago professor Tobias Moskowitz sought to shed some light on the risk versus behavioral explanations for these premiums by testing the momentum and value effects in the world of sports betting. The theory is that if behavioral pricing models work, they should explain returns across all markets. Alternatively, if they don’t work, it becomes clear we need different models for different markets and/or asset types.

Why Sports Betting?

Sports betting provides a great laboratory, primarily because there are no macroeconomic risk explanations (only purely idiosyncratic ones) to account for the existence of a factor. In short, the only explanation possible is behavior-related.

If the value and momentum factors that appear in investing are indeed based on behavioral mistakes, then the same behavioral errors that materialize in investing should show up in sports betting. What’s more, sports betting (where terminal values are found very quickly) provides an excellent out-of-sample testing ground for behavioral theory, since any pricing errors are discovered quickly when bets pay off.

So the question becomes: Do we find the same patterns in sports betting and investing?

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