April 25, 2023

The Power of Favorable Odds

The American Gaming Association reports that, in 2022, 84 million people, or 34% of the adult population visited casinos in the United States alone. That resulted in U.S. casino revenues of almost $60 billion. The latter figure has moderately increased every year for more than two decades with small declines during economic crises. Ever wondered what led to this outcome and its relation to investing?

If I told you to play a game where your odds of winning are built into the rules of the game, wouldn't you jump at playing it? Not only that, wouldn't you want to play it more and more? This is roughly how a casino's business model is structured such as they have a built-in edge. Every time you play in the casino the odds are stacked against you. A lot of people playing in casinos think somehow they can make money consistently. However, the statistical probabilities are against them. 

Let's take the case of American Roulette. It has 38 numbers you can bet on. If you bet $1 on a single number. The odds of you losing are 37 to 1. If you win you would expect a "fair" payout of $37. However, the casino only pays out $35. That equates to an edge of 5.26% (2/38). In effect, the more you play, the more the odds work in favor of the casino and against you, and the better the chances of the casino making money and you walking out of the casino with less money than when you came in. The same logic applies to other casino games. Here is a casino (house edge) of the most common games.

 source: https://www.casino.org/features/house-edge/

The casino's in-built favorable odds allow it to continuously take advantage of the human nature of gambling and make money consistently. Can public market investors have favorable odds while taking advantage of Mr. Market? It is one of the fundamental questions every investor should ask themselves. Current times are nowhere close to the old days when you can easily find companies trading below sub-working capital or underappreciated companies with valuable real estates like corner lots or companies with valuable investments on the balance sheet that the market hasn't recognized. The environment is very competitive. 

Every single day Mr. Market quotes prices on various businesses. If you figure out companies that are priced much below their intrinsic value you get a margin of safety which increases your odds of success. Just like the insurance business, if you buy a group of companies trading below worth to the private owner, your odds further increase.

One could argue how to find such companies from more than 50,000 publicly traded companies. One way is to look for companies within your circle of competence. It will be easier to penetrate the financial statements and understand the business models and competitive positioning of such companies.

Determining the accurate future prospects of a business is a difficult task. So, figuring out a range of outcomes is a helpful exercise. Investment opportunities with positive asymmetric returns usually increase the odds of success. 

Importantly, it is difficult to have an edge doing what everyone else is doing. One must stand apart from the crowd to have the chance to add value. To conclude, if an investor builds his or her investment process with favorable odds, he or she is likely going to outperform the market and generate consistent returns just like casinos have done.

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