[LINK] Bets do not (necessarily) reveal beliefs

Cyan

When does a bet fail to reveal your true beliefs? When it hedges a risk in your portfolio.

If this claim does not immediately strike you as obviously true, you may benefit from reading this post by econblogger Noah Smith. Excerpt:

...Alex Tabarrok famously declared that "a bet is a tax on bullshit".

But this idea, attractive as it is, is not quite true. The reason is something that I've decided to call the Fundamental Error of Risk. It's a mistake that most people make (myself often included!), and that an intro finance class spends months correcting. The mistake is looking at the risk and return of single assets instead of total portfolios. Basically, the risk of an asset - which includes a bet! - is based mainly on how that asset relates to other assets in your portfolio.

When does a bet fail to reveal your true beliefs? When it hedges a risk in your portfolio.

If this claim does not immediately strike you as obviously true, you may benefit from reading this post by econblogger Noah Smith. Excerpt:

...Alex Tabarrok famously declared that "a bet is a tax on bullshit".

But this idea, attractive as it is, is not quite true. The reason is something that I've decided to call the Fundamental Error of Risk. It's a mistake that most people make (myself often included!), and that an intro finance class spends months correcting. The mistake is looking at the risk and return of single assets instead of total portfolios. Basically, the risk of an asset - which includes a bet! - is based mainly on how that asset relates to other assets in your portfolio.

You appear to be unclear on the meaning of "arbitrage". Simply taking a position that has positive expected return is not arbitrage; it's just plain investing. Arbitrage has positive (or at least nonnegative) 'guaranteed' return. Arbitrage involves taking both sides of a bet, but with a spread. If a lot of people are "overpaying" for one side, that doesn't create arbitrage unless there's someone else "underpaying". In cases where people are hedging on both sides (for instance, corn growers hedge by selling corn futures, pig farmers hedge by buying corn futures), assuming an efficient market the effects of the two hedgers will cancel each other out and the price will converge on an equilibrium price. You would have arbitrage only if you have some special ability to sell to one and buy from the other that market participants in general do not have.

You appear to be unclear on the meaning of "arbitrage". Simply taking a position that has positive expected return is not arbitrage; it's just plain investing. Arbitrage has positive (or at least nonnegative) 'guaranteed' return.

Casino owners are often said to be practicing "statistical arbitrage". What would you call it?

Is there a fundamental difference between 1) a casino's "really high" probability of earning a profit (on bets before expenses), 2) real-world true arbitrage, and 3) positive expected return in the large?

It... (read more)

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[LINK] Bets do not (necessarily) reveal beliefs

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[LINK] Bets do not (necessarily) reveal beliefs

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