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Investment lessons from the racetrack

Investment lessons from the racetrack

11-10-2017 | From the field
Misperceptions matter. Underestimating risk often leads to wrong investment decisions. At Robeco, we believe overconfidence is a key reason why investors tend to overvalue risky securities. Horse-race betting provides a natural laboratory to understand such decision making where uncertainty is a factor.
  • Pim  van Vliet
    Pim
    van Vliet
    Managing Director Conservative Equities - Pim van Vliet

One frequently discussed finding in the literature is the “favorite long-shot bias”. That is the fact that bettors value ‘long shots’, horses highly unlikely to win, more than they should, given how rarely they finish first. At the same time, they value safe bets too little, given how often they win. But is this phenomenon due to misperception of risk (overconfidence), or simply to risk-loving behavior?

This study* by Erik Snowberg and Justin Wolfers found that the former explanation is probably the main driver. By analogy, the low-volatility anomaly can also be framed as a long-shot bias on the equity market. From this perspective, the anomaly is not driven by risk-loving preferences, but by chronic overconfidence of investors.

*‘Explaining the Favorite-Longshot Bias: Is it Risk-Love or Misperceptions?’, Erik Snowberg and Justin Wolfer, NBER Working Paper No. 15923, 2010.

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