Thaler and Ziemba on Efficient Betting Markets & Favorite/Longshot Bias

I’ve read it before (around 2005), but not since being exposed to Thaler’s other excellent work in behavioral economics a few years back. Ziemba (Dr. Z) is, of course, a legend for his work on arbitrage in place and show pools. I’ve always believed that betting markets are mostly efficient (especially regarding public information), but that certain public cognitive bias can be exploited to find long-term value. This article explores this area.

After re-reading it again, it’s still a very worthwhile read, and a solid introduction to the field. It’s chock full of rigorous examination of much of the “folklore” (the authors’ word) of the racetrack. It’s especially useful for conclusions regarding the public’s typically sharp handicapping, finding that “the racetrack betting market is surprisingly efficient,” which cuts at most of the common claims of the mainstream handicapping literature. It does however find inefficiencies (at least at the time), especially with the well-documented “Favorite/Longshot Bias,” which generally finds pricing errors at the very top (for example, 3/5 or less) and very bottom of the odds (for example, 20/1+). In my favorite part, the authors lay out the potential reasons for the bias:

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Indeed, just like with other decisions, bettors are motivated by a mix of both rational and irrational motivations. I especially like the serious consideration given to the process of betting and particularly, the added utility derived, especially from longshot betting. The short time horizons of most bettors also tend to influence irrational behavior, which also explains the increased severity of the favorite/longshot bias toward the end of racing cards. The goal of the sharper bettor is to find and exploit the irrational crowd decisions, while maintaining their own rationality.

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Image: Rachel Kramer, 2012.