Daily Double? Could Be Trouble

As a teenager, I have fond memories of coming home from school every day and tuning into Jeopardy. I would sit and try to play along to see how much “money” I could win. Most of the time it would end in frustration, and I would change the channel to cartoons once categories like Fine Art and 18th French Literature would come on. While my viewing of Jeopardy has waned in the last twenty years, I have returned to watching twice. First, when the legendary Ken Jennings won 74 times in a row (I watched his final episode when he lost in Final Jeopardy, and I knew the answer!), and now with James Holzhauer. While only winning $1,691,008 so far in 22 shows compared to the $2,500,000 of Jennings, Holzhauer has made himself into a household name by breaking the single episode winnings record five times with the highest so far at $131,127. James is a sports bettor by profession and is fond of pushing all in on the daily doubles, helping him to achieve these lofty new records.

Watching James the other day I thought for sure that he would breeze through the sports category and leave his competitors in the dust. But he didn’t, which at the time I thought was curious. After further consideration, I think I know the reason why. It’s been written and said that professional sports bettors are experts not at picking the right team to win, but analyzing the games where the odds of a higher than expected return are more in their favor. Mostly what they are doing is finding mispriced games in terms of the odds and betting on the inefficiencies of the market, in this case, the house setting the odds. In essence, they are value investors. They know that over time these inefficiencies will result in growing their bankroll more than just intensely studying a handful of individual teams. In James’ case, he finds the daily double tiles in categories that he knows well and pushes all the chips in deeming it to be a mispriced tile in comparison to the payout if he answers correctly.

Ken Jennings Final Jeopardy question that I got right; the correct question was “What is H&R Block.”

So as investors can we use a similar approach as James when it comes to our investors?

The answer here is both yes and no. No, we can’t push all our chips in when we see an opportunity in the market that looks to be a sure thing because that doesn’t exist. And furthermore, while there may only be a few dozen odds-makers in the sports betting arena, in the stock market, you are competing against literally billions of other investors. Any information edge that you think you might have is overwhelmed by computers and algorithms that can react in nano-seconds to breaking news about the economy or individual company.

But we can take the same approach when we allocate our portfolios, and thankfully there are decades of academic research that point to where above average returns exist in the market that are consistent in implementing, persistent over time, pervasive across all markets, and cost-effective to capture. These factors that lead to above average returns are the following:

Market– Stocks outperform bonds over the long-term
Size– Small companies outperform large companies over the long-term
Value– Value companies outperform growth companies over the long-term
Profitability– More profitable companies outperform less profitable companies over the long-term

The graphic of how these factors play out over various periods is below.

It is clear that over 15 years that the factors soundly prevail, but in shorter-term periods there is more variability in how the factors perform. During times of underperformance, there has always been a snapback period where the premiums will again outperform over a 10 or 15-year period. So in Final Jeopardy, when Alex says “This research pair developed the three-factor model based on market, size, and value.”, hopefully, James answers “Who are Fama and French” and went all in.