Irrationality in the market tends to benefit a small pool of investors, as seen in subprime mortgage bubbles. Believe it or not, there are similarities between this and the world of sports betting, where the prevention of information signalling can also cause market inefficiency.
When an asset is overvalued – that is, a higher value is attached to it than it is actually worth – the result is a bubble. In sports betting, a value bet is defined as one in which the probability of an outcome occurring is more likely than what the odds on it happening infer.
In The Big Short, Michael Lewis explains how the Subprime Mortgage Crisis in the United States benefited a small number of people (around 20 in the entire world) who predicted that the crisis would occur and then bet against the housing market.
Cornwall Capital, an investment company, were one of the beneficiaries. Jamie Mai, an employee, revealed that the firm identified “positive expected value” because they recognised that the market prices were not accurate.
But if that was indeed the case, why did so few groups get in on the act? The expected returns were huge, and the bubble was apparently clear to see.
The answer to the above question concerns the lack of accessibility to the act. Betting against the housing market was not akin to placing a wager on Arsenal to beat Chelsea in the weekend’s Premier League action. If there is not an easy way for a party to profit from an asset’s decline, the price is set by the most optimistic buyer.
These optimistic buyers could choose to bet on a steady rise in the value of the housing market by buying properties. Those with a more pessimistic outlook do not have such an easy choice – the only thing they can do is sell houses, which is not always practical in the real world.
A similar instance is the Bitcoin bubble, where the market price was set by those with an optimistic interpretation of the market. This created a bubble, because the currency was overvalued by those with a positive outlook who could buy Bitcoin; those at the opposite end of the spectrum could only sell.
However, when it comes to sports betting the situation is different – the price is determined by the most pessimistic seller. Let us use a real-world example to demonstrate this: the boxing match between Floyd Mayweather and Connor McGregor in 2017. Mayweather, an undefeated boxing world champion, was the heavy favourite to triumph over McGregor, a mixed martial artist. The latter had never boxed before and, to all intents and purposes, was never likely to come out on top.
On the day of the fight, Mayweather’s odds were 1.196 – meaning the market felt he had an 83.6 per cent chance of emerging victorious. Yet when he fought Andre Berto, a champion boxer, in a previous bout, he was available at 1.02 – equivalent to a 98% chance of success. If we look at odds from other fights, only two boxers – Manny Paquiao and Canelo Alvarez – had a better chance of defeating Mayweather than the untried and inexperienced McGregor.
This is not simply an example of favourite-longshot bias, because the market was not corrected by customers – his true odds should have been around 1.01, such was his undoubted superiority to McGregor. The entire bookmaker margin – and more – fell down on the Irishman, meaning Mayweather offered a huge expected value bet. Perhaps this was because value bettors simply could not counter the payout on the outsider, since significant sums of money were placed on this right. If this is true, the inefficiency could not be fixed due to the sheer volume of cash.
The market was thus set by the most optimistic buyer, who in this case could not look past a McGregor triumph despite all the evidence to the contrary. Inefficiencies appeared because the money bet on each outcome did not match the reality of the situation. Optimistic buyers distorted the market, which is rare in the case of sports betting – principally because bettors are usually on the lookout for when bookmakers have been pessimistic about an outcome – but can sometimes happen.
In practical terms, it makes sense to seek out scenarios where the odds-setters have made pricing errors, where two-way money flow is not required for correction. For bettors in search of value, finding uncorrected markets would be a sensible avenue to pursue.