By Steve Tepper, CFP®, MBA
It’s easy to pick sports winners. Without even looking at next weekend’s NFL schedule, I’m going to pick New England, the 49ers, Green Bay, and the Saints. Will all four of those picks be winners? Maybe not, but if I follow a strategy of picking big favorites every week, I’m highly confident I will pick a lot more winners than losers.
Stock pickers do the same. They look at all the “teams” and select the ones they think will win. And often, the difference in teams is as stark as the contrast between the World Champion Patriots and the currently winless Cincinnati Bengals. Apple or Motorola? Easy. Netflix or Vudu? No contest.
So why is it so hard to turn “winner picking” into financial success? Simple: the spread. You can pick the 49ers to win this weekend, but you can’t bet on it. If you try to place a bet, you’ll see a number after the team name. Something like this: “San Francisco -8.” The -8 is really important! It means if you place a bet on the Niners, you won’t make any money unless they win by more than eight points. That means you could pick a team to win, they could win, but you could still lose your bet if the team wins by less than eight.
That’s the spread. It’s the adjustment that is made in recognition of the fact that more people will bet on the favorite than the underdog. While you get a “penalty” you must overcome if you bet on the favorite, you get an incentive to bet on a bad team. The same week, the Bengals’ bet line might read: “Cincinnati +9.” That means if you bet on the Bengals (currently ranked the worst team), they could lose and you could still win your bet, if they lose by less than nine points.
The bookmakers (or “bookies”) who take bets on sporting events create the spread with one main objective: equilibrium. Specifically, they want the same amount of money bet on both teams in the matchup, no matter how evenly or unevenly matched the teams are. So if more money is being bet on the favorite, the spread will increase, while more bets placed on the underdog will shrink the spread. If the teams are evenly matched, the spread might be just a point or two, or it may be zero.
So the bookies set the spread and collect money from people making bets. If they set the spread right, they will have enough money to pay the winners. For example, they get $1 million in bets on the Ravens and $1 million for the Steelers. The Ravens are favored by 5, and they end up winning by 10. The bookies keep the money that was bet on the Steelers and use all of the $2 million collected to pay out to those who bet on the Ravens.
Except that isn’t the exact math. If you lose your bet, you lose 100% of the money you put up, but if you win, you don’t double up. The bookies keep a cut, which they call the “vig.” Instead of paying out the whole $2 million to the winning bettors, they may pay out only $1.9 million. The vig, the remaining $100,000, is the bookie’s profit.
At its simplest level, the vig is why it is so difficult to make money on the sportsbook. The game is set up so you will guess right half the time. When you guess wrong you lose 100%, but when you win, you get something short of 200%. Keep repeating that long enough and you will eventually transfer all of your money to your bookie. Any other outcome would be driven purely by luck—or cheating. I don’t recommend relying on either strategy, particularly the latter unless you know a doctor who is very good at bone setting.
Stock picking in the financial markets is similar, but presumably with less bone breaking. Picking Apple over Motorola is easy. But in this case, the bookies are the market makers who decide what the proper price is for a share of stock in every publicly traded company. In recognition of Apple’s status of “favorite,” they set the price higher than the price of Motorola, which has had disappointing results for many years. The goal is to get money flowing to both companies and, in a manner of speaking, to make half of your picks winners and half losers.
Thankfully, stock picking isn’t usually a double-or-nothing game. Who would play if you expected half of your investments to fall to $0? But your winners and losers add up to your overall return, with winners giving you a boost and losers being a drag on your portfolio value. And whether you win or lose, the bookie takes a cut. The same math comes into play: Repeat that strategy long enough and watch your money move from you to your broker.
The less vig you pay, the better you can preserve, even grow your money. The obvious way to pay less vig is to play less. Make fewer bets, make fewer trades.
Investing offers a solution not available in sports betting: the option to bet on every team! If you bet on all 16 NFL games each weekend (not accounting for bye weeks), you’ll have 16 winners and 16 losers, so you’ll break even and pay 16 vigs. Zero percent chance of making money.
But if you “bet” on every publicly traded company by buying low-cost, diversified mutual funds, even after counting up all your winners and losers, and paying the vig, you could still end up making money, because the overall value of all stocks tends to rise over time[1]. Over some periods, it falls, but the historical trend over long periods has been upward, a trend we have no reason to suspect won’t continue.
Many people think of investing in stocks as another form of gambling. If you do it wrong, by trying to pick winners, it is. But with a disciplined approach to diversification and lowering costs, it is reasonable to expect a positive return.
1 Past performance is no guarantee of future results.