Thursday, December 6, 2012

Casino Capitalism and The Las Vegas Line

The idea of a casino intrigues me. Why would anyone go to play games at a place where they are absolutely guaranteed to lose money? Slot machines are computer controlled to pay out about ninety cents on the dollar, or less depending on the casino. Slot machines obviously require no skill, but what about bets that the casino can’t control, like those placed on the outcome of football games? I remember how fascinating it was to discover that Las Vegas sports books do not bet their money on anything as stupid and unpredictable as football games. Las Vegas bookmakers try to set the line so that exactly the same number of dollars are bet on each team. The casinos are quite content with the 9% or 10% they take from the gamblers for providing this service. If too much action is falling to one team, they will change the line to attract money to the other team. Back in the old days, handicappers who messed up the line and lost too much of their casino’s money were given one way rides into the desert in the trunk of a Lincoln Continental. The casinos are not gambling with their money. They are letting you gamble with your money.

Just for grins I looked up the line on the upcoming Army Navy game. Here is how it is presented.

Navy -7 (-115)
Army +7 (-105)

Translation: In order to win a bet on Navy, the midshipmen must score at least 8 points more than the cadets of West Point. The second number in parentheses means that in order to walk away with $200 in your pocket, you must place $115 at risk. If you win the casino keeps that extra $15.

If you wish to win a bet on Army your team needs to lose the game by no more than 6 points. Obviously if the teams tie or Army upsets Navy (an unlikely outcome) you will win your bet. The second number in parentheses means that in order to walk away with $100 in winnings you only need to place $105 at risk. If you win the casino is happy to keep your $5.

What happens if the Navy scores exactly 7 points more than Army? That is called a push. In theory it would mean that the casino should return all the bets placed on that game. Obviously that isn’t going to happen. Some casinos set the line with ½ points to make sure it can’t happen. Some casinos specify the push goes to either the winning or losing team. They are in business to make money.

The Las Vegas line represents the collective wisdom of every gambler in the world. Even though picking winners of football games requires a measure of skill, it also contains a measure of luck. It is difficult for anyone to beat the line over an extended period of time. In the aggregate, the entire universe of sports gamblers will lose 10% of their money over the course of a season. The casino will take this 10%, even though the gamblers are the people supplying all the money and accepting all the risk.

What does this have to do with anything sensible?

Consider financial vehicles such as mutual funds and variable annuities. The mutual fund does not place any of its own money at risk. It is gambling in the stock market with your money. Depending on the mutual fund provider, initial fees range from 0% to 8.5%. In order to recover from an 8.5% fee, your money must earn 9.3% just to break even. These commissions are hidden from the investor in various ways. Some funds are back loaded, that is you pay the commission when you cash out your money. Others prorate the sales charge over a number of years.

Mutual funds also charge ongoing administrative fees for running the fund, management fees for managing the funds assets, and transaction fees for buying and sell stocks on your behalf. These fees which are charged on an annual basis range from 0.05% for an index fund that requires no active management to as much as 2% of your entire investment! 2%! Every Year! These fees will have a very significant impact on the long term value of your holdings.

Like the sports book the mutual fund does not supply the money or take any risks. Keep that in mind when you study mutual funds.

Another thing to keep in mind is the Las Vegas line. Beating the major averages such as the S&P 500 or the Wilshire 5000 over time is very difficult. Consider the mighty Magellan Fund, once managed by the genius, Peter Lynch. As the fund prospered it attracted more money. The more money it had to invest the harder it became for Lynch’s successors to find outstanding opportunities. Finally, the Las Vegas line caught up with the Magellan fund. Under Bob Stansky, it under performed the market. During this time the fund’s holdings so resembled the S&P 500 Stansky described himself as a “closet indexer.”

When a salesman says his fund’s management is worth that extra large sales commission, be very suspicious. Morningstar rates mutual funds on the basis of their performance from a high of 5 stars to a low of 0 stars. Studies have shown that over time the high rated funds tend to drop and the low rated funds tend to get better. John Bogle, the founder of the Vanguard family of funds, has demonstrated that the impact of fund costs and the difficulty of beating the Wilshire 5000 over long time spans prove such claims to be false.

Of course betting on the outcome of a game played with a prolate spheroid by giant men on a pretty green field is not the same thing as investing in companies that produce real products. However, it is wise to consider some of the similarities especially when investing in financial products that contain fees and sales commissions.

Now, let’s be careful out there.

For those who wish to further explore the relationship between skill and luck across many kinds of human activities from chess (pure skill) to buying lottery tickets (pure luck), I would recommend an excellent white paper entitled Untangling Skill and Luck by Michael Mauboussin.

Untangling Skill and Luck

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