I heard this provocative quote at a recent conference. As far as I could tell, the speaker was trying to make the point that you don’t need an accurate forecast of the future. Instead you understand the probability of different events happening and choose one that gives you an advantage over others.
This quote is from Will Bonner’s book “Mobs, Messiahs, and Markets: Surviving the Public Spectacle in Finance and Politics.” Bonner is CEO of Agora Inc., one of the world’s largest financial newsletter companies. The next few sentences of the book do a good job of explaining what Bonner meant:
You can be right about the future and still not make any money. At the racetrack, for example, the favorite horse may be the one most likely to win, but since everyone wants to bet on the favorite, how likely is it that betting on the favorite will make you money? The horse to bet on is the one more likely to win than most people expect. That’s the one that gives you the best odds. That’s the bet that pays off over time.
Bonner, and the speaker who quoted his book, are talking about an arbitrage in an inefficient market. While we normally associate the term arbitrage with the financial markets, it applies in many other situations. An example from parimutuel betting happens in an episode of the crime drama Numb3rs when the ‘criminals’ take advantage of the higher expectation of betting on the second-best horse. Here’s a good explanation:
Since the odds are set by the bettors, they may not actually reflect the true odds of a horse winning a race. Most bettors will concentrate on the best horse and place their bets there, often forgetting about the second best.
There are legal and tax differences in every country (and in every state in the U.S.) which provide another kind of arbitrage. Residents of the state of Washington might drive to Oregon to purchase expensive goods because Oregon has no sales tax (while Washington has no income tax). Cultural and geographic differences also provide an opportunity for arbitrage.
Netherlands’ Aalsmeer flower market is world-renowned as the place to purchase flowers and plants; blooms flown in from India are sold to international customers on the day they arrive, fetching a much higher price than they would have back in India. A similar situation exists for the diamond markets in Antwerp Belgium.
Even in fact-based businesses, most decisions are based on arbitrage. We collect lots of data about what happened but we cannot know the future with certainty. Given an unpredictable future, management estimates the probability of multiple events happening and chooses the one that gives them a competitive advantage.
So embrace your inner arbitrage. Don’t spend your time trying to predict the future; focus on getting the odds right.
This blog was originally posted on Manage by Walking Around on September 18, 2016.