If a bookie presented you with the opportunity to bet on a basketball game between the Raptors with a 5-0 record and the Bobcats with a 0-5 record, which team would you bet on? The obvious answer is that the Raptors with their undefeated record will trump the Bobcats who have not won a game; this outcome is very easy to predict. If bookies allowed people to bet like this they would not make any money, so they use something called the spread. It’s not nearly as easy to predict the outcome If I present you with the same betting opportunity but the Raptors don’t just have to win, they have to win by 30 points. That 30 point differential, or the spread, is what allows bookies to make money. The bookie will go to great lengths to create a spread that has about a 50% chance of being beaten. If this is done properly, the bets on each side of the spread will cancel each other out and the bookie will profit from the premiums people paid to place their bets. When they create the spread, bookies will know everything about the teams in a match; they will know what the star player had for dinner, whose girlfriend is in town, the weather forecast, everything. Once the spread has been set, it will be the new information that develops throughout the course of a game that determines if the spread will be beaten; an injury, a lucky shot, or a bad call could all be the difference makers. In investing, the collective knowledge of the markets is the bookie, and the price of a security is the spread. Every day highly motivated market participants act on massive amounts of information and in doing so they inject the information they have into market prices, effectively setting the spread. It’s easy to look at a company and see that it is well managed, pays a strong dividend, and is positioned to dominate a growing market, but all of this is included in the market price. Whether the price goes up (beats the spread) or goes down will depend on the development of unpredictable new information. Investing isn’t about picking the winning company, investing is about beating the spread.
Original post at pwlcapital.com