Eric Houssels

# Everything I Ever Needed to Know about Investments I Learned at the Racetrack -- Part I

October 10, 2007

My career at the horse races began in earnest in the summer of 1985 midway through my tenth year. My father, a racetracker for the previous 50 years or so before this, needed a companion, the result of his wife/my mother finally refusing to spend her summers being ignored for five hours per day at the Del Mar Turf Club by her Daily Racing Form-engrossed husband. Ignorant at the time of what I was getting myself into, I leapt at the chance to hang out with dad. As I write this piece 22 years and a few weeks into the meet later, I remain a horseplayer and am grateful for it. Here are the six lessons (broken out over three parts, for readability purposes) on what I have learned, so far, from my well misspent days at the track.

Lesson #1: Probability-based Decisionmaking and Value

Within days of day #1 with dad, I broached the question of what-on-earth was he doing with 4 different colors of pen and a calculator at the racetrack! I had been cashing tickets with reliable frequency by simply betting on Chris McCarron (a hall-of-fame jockey who was at the top of his game at the time) to place (run first or second) and all that was required of me was a racing program and a wagering partner who didn't have qualms with illegally running bets for a 10 year-old (thanks, dad).

On the subject of the calculator and pens, my father coolly explained to me that he was creating a discrete probability distribution describing each horse's likelihood of winning his/her event. The pens were used to make markings distinguishing the most significant, unique factors upon which the horse's probability of winning would be determined. As each event's probabilities must sum to 100%, the calculator adjusted the markings to produce theoretical soundness. He continued that based on his adjusted line that summed correctly to 100%, he would bet on all of those horses that represented value as determined by their track pari-mutuel odds being greater than (or market probabilities, after track take, being less than) the odds that his multi-colored pens/calculator system produced.

Wow, I thought my father to be brilliant; the precision of his logic was and is infallible (unfortunately, the precision of his line's probabilities based on his analysis of factors still needs work). The pleasant ease of betting the hot jock to place era of my life ended at this point, probability-based decisionmaking was planted in my cranium, and my life was forever changed.

This core lesson that I learned at 10 I believe to be at the heart of investment decisionmaking. The future is uncertain; there are many different ways a business can turn, good and bad. Our job is to isolate, as best we can, the major outcome scenarios (within our time horizon) and then to estimate the probabilities associated with them. If the distribution produced yields a return superior to our alternatives (and there is always cash!), we have a value, we have a bet.

Lesson #2: You Will Lose

This is a not-so-lovely thought that is very difficult for many, but it nonetheless remains unquestionably valid at the races. Even if you are betting, as a value system would have it, 2-4 horses per race, the very real probability is that you will lose well over half the races on the card. This frustrates the less initiated to the point where they are often strongly biased to pick favorites and even to bet these favorites to show (a win if the horse runs first, second, or third). Academics call this loss aversion and, for us rationalists, it is completely illogical.

The lesson of "You Will Lose" is to be focused on Miller/Maubossin's "process, not outcome." Run your numbers, place your bets, and then repeat for the next race and all races after that. In quieter times, you should question and test the validity of your numbers, but woe to those who begin questioning them during race day or, worse, at the betting window.

The track will tempt its wagerers from the moment of arrival through to the finish line of the last race: if I double my bet, I would be "even" for the day...I have to bet the trifecta - I could win over \$1,000 for just a buck...and my proverbial favorite which I will be discussing in a later lesson in more detail - it's the last race, I should go for it! We give into temptation for short-term emotional indulgence; in the long-run, this is what will destroy our outcomes.

There will be days (far too many at the horse races, it seems) where the outcomes will be repeatedly poor - you will lose. Hold fast to the process, nonetheless, and shun temptation. When betting or investing loses its rational, businesslike anchor, I believe it becomes doomed to a long-run inferior result.

Permit me one quick and final thought on Buffett's famous admonition to not lose money, not lose money as this warning would not seem to jibe with the lesson of this section. I marry his wisdom with my learning through a simple redefinition of "losing" in the two games. I agree with Buffett in the investing game: know the downside, accept very little risk of permanent capital destruction. This approach greatly helps our long-term ability to compound. "Losing" with this strategy does nevertheless occur in the form of dead money, no alpha investments (Budweiser, anyone?). And it will occur. From time to time, you will lose. As for the races, losing often means capital destruction - it is a binary game; each ticket either wins or loses. Rational horseplayers expect to have their fair share (again, well over 50%) of capital-destroying losses.

Eric Houssels
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

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Dr. Paul Price - 10 years ago    Report SPAM
Good analysis. All that matters is that you get paid disproportionally for your risk and that you have a big enough sample [number of wagers] to achieve statistically predictable results.