What Sports Betting Teaches Us about Financial Markets

Two stock market strategies stand out for their consistent effectiveness: value trading and momentum trading. Value traders look for stocks that seem in some way underpriced—for example, companies that have high earnings but low share prices—and wait for other investors to get wise. Momentum traders seek to identify stocks on the rise and sell them when they reach their peak—essentially, to buy high and sell higher.

Why do these strategies work? Two camps of economists arrive at different answers. For proponents of market efficiency—those who think prices correctly reflect all available information in the market—investors can only gain above-market returns by taking on additional risk; value and momentum effects emerge from that process.

Behavioral economists, by contrast, argue that value and momentum traders are shrewdly identifying irrationality in the market. In their view, these investors have correctly picked out stocks that are simply mispriced due to human foibles. Momentum traders are leveraging the false but widespread belief that winners will keep on winning; value traders appreciate some aspect of a company that others are overlooking.

So, who is right? The stock market itself makes it hard to prove one story or another, since there’s no way to objectively determine whether a company’s stock price is “correct” or not at any given moment.

This problem got Tobias Moskowitz thinking. Moskowitz, the Dean Takahashi ’80 B.A., ’83 M.P.P.M. Professor of Finance at Yale SOM, has a longstanding interest in the intersection of sports and economics. (He even co-authored a book on the topic, Scorecasting: The Hidden Influences Behind How Sports are Played and Games are Won.) He realized that sports betting markets might offer a useful analogy to financial markets, and provide a way to test the competing theories about asset pricing.

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