“Something that everyone knows isn't worth knowing.”
-- Bernard Baruch, Wall Street legend


Our clients sometimes ask us questions such as “With China’s economy growing so much faster than the U.S., shouldn’t we be heavily invested in China?” or “Europe looks like it’s going to have a weak economy next year, so shouldn’t we avoid it and stick with the U.S.?” While these observations about the different economies may be true, it does not necessarily result in any actionable investment strategy. The reason is that, in the financial markets, information that everyone knows has already been incorporated in asset prices. For example, it’s no secret that China’s economy has grown much faster than the U.S. for many years and that the trend is expected to continue. So of course investors will have factored those expectations in when they compare investments between the two countries.

The world of sports betting offers a relatively simple but powerful analog into how financial assets are priced. To be clear, we don’t think that investing is akin to gambling, but the process by which investors change security prices has parallels to how bookies establish a point spread on sporting events.

We’ll start with a point spread betting example from NFL football. This year, our hometown Minnesota Vikings have been, to put it kindly, down on their luck. Across the border in Wisconsin, the Green Bay Packers have been one of the best in the league. So when the two teams met on the field in Green Bay recently, most rational observers would have picked Green Bay to win the game. But is that useful information if you want to bet on the game? Not so much. The reason is that the bookie doesn’t just let you pick a team to win, but instead sets a point spread that has to be beaten. So instead of betting on “Packers to win”, you might have to bet that “Packers win by 10 or more points”. These are two very different bets and it clarifies the point that predicting a Packer victory might get you bragging rights with your friends, but it’s not going to make you any money in an organized gambling operation.

So where does that 10 point spread come from? It is based on the desire of bettors to pick one team over the other. The bookie does not want to bet on the outcomes of games. His goal is to earn money on the quantity of bets themselves (by charging a vig) and not who wins or loses the game. (In fact, the bookie is the one person in the house who does NOT want to bet on the outcome of the game.) He does this by adjusting the point spread.

Using our Vikings/Packers example, the bet of “Packers to win” is equivalent to a spread of 0 points. If the bookie allowed bets to start at 0, what would happen? Savvy bettors would jump all over it, picking the Packers to win. Almost no one would pick the Vikings. This would expose the bookie to huge losses if the Packers win as expected. In order to balance out the betting, the bookie thus raises the spread until there is a relatively balanced amount of betting for each time. As expectations for the game change over the week (e.g., player injuries, weather changes, etc.), the spread will move so as to always maintain the balance of bettors on each side at any given time. That sounds a lot like how the price of a financial asset moves!

So let’s look at an investing comparison. Say you have two hypothetical company stocks that you are evaluating. Packer Corp earns $1 per share this year and investors expect it to grow its earnings at 10% per year. Viking Corp earns $1 per share this year and investors expect it to grow its earnings at just 5% per year. So the comparable sports bet of “Packers to win” is replaced here by “Packer Corp will earn more money over time”. This is information that everyone knows.

If these companies are equally risky and were both trading at $10 per share (i.e., a point spread of 0), what would you do? You would want to sell shares of Viking Corp and buy shares of Packer Corp until there was a sufficient spread between the two. Instead of a bookie standing in the middle and moving the spread based on supply and demand, the investors themselves move the share prices by bidding for higher prices on Packer Corp and asking for lower prices on Viking Corp until the prices end up at say $13 for Packer Corp and $7 for Viking Corp. Since investors all know that Packer Corp has better prospects, they give it a higher current valuation ($13 price per $ 1 current earnings) than that of Viking Corp ($7 price per $ 1 current earnings), for a “valuation spread” of $6 per dollar of earnings. So now we ask the question: does the fact that we know Packer Corp will earn more money than Viking Corp do us any good? Probably not, because investors have already priced in those expectations.

So what the point spread or valuation spread is telling us is that the collective view of the participants see the  actual outcome to be just as likely to be on either side of the bet or trade. If one team is favored by 10 points, then the wisdom of a large number of bettors has come to the conclusion that 10 points is a fair spread. If one stock trades at a higher valuation than another but is considered the same risk, then the wisdom of many investors is equalizing the expected future returns of the two stocks by adjusting their prices in the present time.

Does this mean the price is always right? Not at all! In fact, if bettors do a good job on average of assessing the odds, then 50% of the time, the favored team should beat the spread and 50% of the time it won’t. In 2011, European stocks did poorly in comparison to the U.S. market precisely because investors have concluded that the European economy will do poorly relatively to the U.S. in the near term. It’s impossible to calculate odds on it, but we assume going forward that U.S. stocks are just as likely to outperform Europe as underperform. If that was not the case, investors would adjust prices accordingly. If prices were obviously wrong, you would certainly adjust your portfolio, so wouldn’t you expect everyone else to do the same?

The conclusion reached from both sports betting and investing is that common knowledge is already incorporated into prices; there is no money to be made betting on what everyone already believes. The only way to outperform is to have some sort of edge; you have to know something that is uncommon knowledge or have much better analysis capabilities than the average participant.

Think about it this way. If you walk into a room full of people and make a statement about the expected winner of a football game or the prospects of a particular company and everyone agrees with you, then your statement can be 100% true, yet completely useless in the pursuit of profit.
 

 
This article’s comparison between investing and gambling is for illustrative purposes only and should not be considered an endorsement of gambling.  Investing in stocks is subject to risk including possible loss of principal.  No strategy can assure success or guarantee against loss. International investing involves special risks such as currency fluctuations and political instability and may not be suitable for all investors.