I, like a lot of Americans, have developed an interest in the stock market over the last 10 or so years. That interest has been waning along with the balance in my portfolio, such as it is. That�s just human nature: now would probably be an ideal time to start buying stocks rather than ignore the stock market. And I would too � but I can�t afford it because I�ve lost too much money in stocks.
But studying stock speculation (which lately seems like a more accurate term than investing) has reaped lessons about my favorite form of institutionalized risk: horse-race speculation. For instance, David Dremen, in his book Contrarian Investment Strategies: The Next Generation, talked about the effect of surprises on different types of stocks. He compared the 20% most-favored stocks, those with high P/E ratios and lots of stock analyst attention, to the 20% least-favored stocks, those with low P/Es and apparently dim prospects. He analyzed how both positive and negative surprises affected the stock prices of these groups over time.
To cut to the chase, the bottom line was this: Favored companies had little positive reaction to positive surprises and a very negative reaction to negative surprises. Unfavored companies had a very positive reaction to positive surprises and very little reaction to negative surprises. It makes sense � a favored company is supposed to perform well, and its price reflects that. Any negative news is like a bug in your soup at a fancy restaurant: a quick perception-change may take place regarding the former attractions of said hash house. On the other hand, negative news for an unfavored company is taken in stride because nobody expects much from the pig. But a positive surprise can really make that pig fly.
"Always look out for negative surprises with favorites and positive surprises with longshots."
Horse-race betting isn�t always analogous to stock-market betting, but this situation does remind me of the track. Surprises, both negative and positive, happen all day, every day, around the oval. Always look out for negative surprises with favorites and positive surprises with longshots. When you�re looking at a favorite, keep an eye out for any drawbacks. Be suspicious � if you even smell the hint of a serious negative on a favorite, get off it. A speed figure he�s bounced off before, the first race after a layoff, a classified allowance for a stakes-level horse, a track condition or surface he hasn�t succeeded at previously, a higher class level than he has won at before, and so on � these are all reasons to be suspicious of a favorite. You're not getting paid well enough to take a serious risk with a favorite.
Longshots, however, often only need one positive sign to make them a good bet. A terrible-looking horse who�s switching to a better jockey for no apparent reason, a slow-poke who suddenly showed early speed last race, a horse who usually works at an average level who suddenly posts a bullet work, a horse who repeats the situation of his last win even though it was nine races back, and so on � these are the types of longshots that can generate positive surprises.
Longshots have a lower effective takeout than favorites. Horses with a morning line of 20/1 or greater only generate about a .50 ROI (50 cents loss for every dollar bet). But if you can filter out the subset of longshots that may surprise, you can make up for that. If you look at the pps of a winning longshot after the race, you will often see that one-factor positive clue in the horse�s record. This is not just 20-20 hindsight � not all longshots have these one-factor positive clues. Successful longshot handicapping is an intuitive skill that can be developed by looking at the pps of winning longshots after the race. Look at enough of them and you will start seeing these one-factor patterns in the races you handicap.
So, when you handicap, be on the lookout for surprises: negative surprises with favorites and positive surprises with longshots. It may help you cut your losses and increase your payoffs in a surprising manner. NC
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