The efficient market hypothesis
The efficient market hypothesis (EMH) has been a staple belief within the economic world for ages. In simple terms, EMH implies that the prices of all items in financial markets are correct, that is neither under-priced nor over-priced.
From a betting scenario, EMH would imply that odds represent the true probability of an outcome – adjusted to the bookmaker’s margin. If EMH was true, then no one can make long-term profits through betting and trading; or rather any long-term profits are a result of luck rather than skill.
Yet, it is a hypothesis that has been proven to be incorrect in many cases. For example, throughout the Premier League battle this year, I argued many times that the price on Leicester was simply not right.
What do the odds represent?
Consider that even if a bookmaker is aware of the true probability of an outcome, they would be very unlikely to price it completely different from the market, as they would be risking being in a position to offer arbitrage in the market and/or being uncompetitive.
Conventional wisdom implies that if there are more traders in a market, then prices should be closer to the true estimate. On the other hand, more traders might mean more noise.
In the betting world, the true value of an outcome is dependent on the outcome itself. So if we were to ask “Are odds at evens true?”, a simple analysis would be to take all past odds at evens and see whether these occurred half of the time. In the financial world, assigning the true value of an asset is slightly harder which is why betting markets are used as a microcosm of financial markets in academic research.
Pricing betting outcomes
Pricing is mostly about anticipating what others will think the correct price is. A brilliant way to look at it is a competition in which individuals try to guess what two thirds of the average of all guesses will be.
Pinnacle had run a version of this guessing game and the winning outcome was 20. It seems that the winner was a level two thinker as per Thaler’s explanation who had also run this experiment for the Financial Times.
If all numbers have to be between 0 to 100 at random, then the average would be 50, two thirds of which is 33 (as a level one thinker would reason). Yet, if everyone does this, the correct number would be two thirds of this, which is 22 as a level two thinker would realize.
Should we continue at this rate ‘ad infinitum’, the Nash Equilibrium (google ‘A Beautiful Mind’) is zero. Quoting the book “If and only if all participants guessed zero would no one want to change his or her guesses”. For your info, when Thaler had run the competition for the Financial Times – the winning number was 13.
Assessing fair prices
While disproving EMH has been a key element for behavioural economists, they have also provided possible causes. Specifically, I found the section about mental accounting in this book very stimulating. Mental accounting relates to the behavioural features that may limit the best use of our money.
Two such items are our love for bargains, coupled with our distaste of rip-offs and sunk costs. The former revolves around the fact that we purchase items because they are a good price rather than them being a need, which explains why so many shops seem to have a permanent sale going on.
We also consider rip-offs differently. The person sitting next to me on my last low-cost airline flight was very willing to purchase three one-glass bottles of wine at six euro each during a 3.5 hour flight, even if she complained that alcohol in English pubs is so expensive.
Well, they are not as expensive as the purchasing price on the flight, plus she could have waited a bit and bought a very good bottle of wine for 12 euro on landing. Notwithstanding, paying six euro on a flight did not feel like a rip-off to her. On a similar tone, we might have been tempted to place a wager because it feels good rather than it being a value wager.
The other mental accounting feature is sunk cost. For example, gym membership payers tend to attend the gym more often just because they had paid for it although attendance fizzles out after a while, implying that the hurt in not using the money already spent eventually dies off.
Applying behavioural economics in betting
From a betting perspective, one must be careful in considering sunk costs. Say for example one wagered on Manchester United to win the Premier League in November. This should not limit one to bet on another team winning in February given the new information. Some of my friends can never understand how I could bet on the same team winning a group and being last in the same tournament, but with wagers having been made at different times. The danger is to bet more heavily just to make back your money.
In conclusion, ‘Misbehaving: The Making of Behavioural Science’ provides a history of how economic theory has come to a situation to finally considering that not all market participants are perfectly rational – ‘econs’ as Thaler calls them. Just like his earlier book ‘Nudge’, this is a must read for anyone who is interested in the wisdom, or lack thereof, of the crowds.