Even playing with the house’s money isn’t enough

November 29, 2010
Bum on a bench

The only thing more pathetic than a horse player? A dog player.

If you don’t know anything about sports, read this instead. Or try and slog through today’s post. If you want the conclusion first, today’s moral is that gambling remains a moron’s pursuit.

——————-

Not only can you not consistently win gambling, you can barely win if the house pays for your bets.

A Control Your Cash acquaintance (we’d use the generic pseudonym “Bob”, except that’s his real name, so let’s call him “Stu”) recently found himself in possession of the kind of thing most gamblers only dream about – a free, hot ticket. Here’s the story.

Bob Stu likes to gamble on sports occasionally. (Whatever, we don’t hold it against him.) You might not know this, but the IRS lets you deduct gambling losses up to a certain amount. We don’t mention that in the book, because you shouldn’t be gambling anyway. When most gamblers lose a bet in the race & sports books in Las Vegas, they discard their tickets, not realizing that they count as effective receipts and proof of loss. It’s fairly common for enterprising gamblers to scour the aisles looking for discarded tickets written for large enough amounts. Stu isn’t above this.

One weekday afternoon during the NFL preseason, Stu thought he’d hit the jackpot, so to speak. He found a perfectly preserved $100 ticket that would make a great addition to his tax return.

On closer inspection, it turned out to be three neatly folded $100 tickets, each for the same wager.

On still closer inspection, the wager turned out to be live. Each ticket was a 10-1 bet on the Baltimore Ravens to win the Super Bowl, written hours earlier. Some schlimazel up and lost his tickets.

Stu, being the honest guy he is, returned to the book the next day and spoke with the manager. He explained the situation, slightly tempering it. (“I found a $100 ticket…”) As Stu acknowledges, “I wasn’t going to admit to having all 3. I’m not that honest.” The manager, shocked that a customer was asking him for anything other than a light, said that unless the buyer had taken the extremely unlikely precaution of writing down the ticket’s 15-digit serial number, there was nothing he, the manager, could do. The ticket and its siblings were Stu’s.

So there it was – a potential $3000, just for being in the right place at the right time.

But also a potential $0. After all, the Ravens, like any other given team, probably won’t win the Super Bowl. So how to maximize Stu’s return?

Hedging. If you’re only vaguely familiar with the term, it means forgoing the possibility of a particular payout for the greater possibility (or better yet, the certainty) of a smaller one.

Say Stu had found the tickets the week before the Super Bowl, and the Ravens happened to be playing in it. To hedge optimally, Stu would wager enough money on the other team to guarantee him the same payout regardless of who wins. Formula coming henceforth. Formula contains one addition and one division, two operations you hopefully mastered by the 4th grade.

But Stu found the tickets during the preseason. Although the oddsmakers expected the Ravens to have a good year, giving them 10-1 odds to win a 32-team league, there’s no guarantee the Ravens would even make the playoffs. Baltimore is leading the AFC North at 8-3 and looking as good as anyone expected in a tight division, in a tight conference, in a tight league.

But had T.J. Houshmandzadeh dropped on 18-yard touchdown pass with 32 seconds remaining against Pittsburgh on October 3, and Ray Lewis not recovered a fumble 3 weeks later in overtime against Buffalo, Baltimore would likely be on the outside looking in at the playoff picture.

Say Stu had advance knowledge that the Ravens would miss the playoffs. Could he have hedged enough money to guarantee himself a payout?

No. It’s unlikely any offshore wagering site offered a proposition on something as esoteric as the Ravens missing the playoffs, but if one did, it would likely set the odds around 2-5 (given that Baltimore was 10-1 to win the whole thing). That’d be a 40% return on Stu’s money, but then what if the Ravens do make the playoffs, which the oddsmakers say they probably will? Now Stu’s out the price of his hedge bet, and still needs to have multiple playoff games break the right way. After all, Stu’s ticket wasn’t for the Ravens to simply get invited to the pageant, but to win the talent and swimsuit competitions too. Stu would have to hedge every playoff game the Ravens are alive for, approximately doubling his bet and thus halving his potential return every time.

What if the midsummer genie said “the Ravens will make it to the Super Bowl” without specifying who’d win? Which is a pretty bold proclamation for a genie to make. Yet now, at least, we can get this down to exactly one hedge bet. But for how much?

Say Atlanta represents the NFC. The smart thing would be to place a bet on Atlanta costing
$3300/(m+1)

where m is the odds on Atlanta. Stu’s payout would be
$3300m/(m+1).

We use $3300 because that’s what Stu would pocket if his original tickets all came in: $1000 on each of three $100 10-1 tickets, plus the original $100 that the anonymous poor sucker spent on each.

Let’s say after Atlanta wins the conference, the odds on them to win the Super Bowl are 5-11. Stu would bet $2143.75 on them, guaranteeing himself $1156.25. If Atlanta paid even money, he’d wager $1650 to guarantee himself $1650. If Atlanta was an 11-5 underdog, Stu would wager $1031.25 to guarantee himself $2268.75. The better Baltimore does this year – the bigger a favorite they are – the better it is for Stu.

But this is the Super Bowl, and neither team is likely to be as big a favorite as 5-11 nor as long an underdog as 11-5. The game is supposed to be between somewhat evenly matched teams.

What if the genie said “the Ravens will make it to the conference championship”? That’s still a valuable thing for a gambler to know going into the season, or so you’d think.

By the time we get to the NFL’s round of 4, Stu could truly hedge his Super Bowl bet only by wagering on the 3 remaining teams. Which, on average, would probably each pay around 3-to-1. Or could pay a lot worse. So if he took them all, covering every outcome, Stu would be winning close to even money.  But again, he’d still have to risk a ton to keep his original, “free” bets live.

Working backward yet another step, even when there are still 8 teams alive, Stu couldn’t hedge himself more than a few bucks. Every time the number of participants increases, the number of possible outcomes does too. Double them, and you again halve (or close to it, depending on odds) Stu’s potential payout. Were the genie to guarantee Stu that the Ravens would make the playoffs, he still couldn’t make any money.

And that’s with the benefit of a nonexistent genie. Even a free 10-1 wager can’t be manipulated into a bet that guarantees anything more than a tiny sum.

If free gambling isn’t worth the effort, think about how useless it is to pay for the privilege.

**This post is featured in the Carnival of Wealth #15**

Filed Under: Bad Examples, Making Smart Choices, Math, Personal Finance, Shopping Tagged With: , , , , , ,

MAILBAG!

November 22, 2010
Mailbag

Oh no, that's not a European male carry-on at all. Very masculine.

Where do you suggest buying hard assets like gold or silver?
John, Las Vegas

Let’s start with someone who clearly read one of our previous posts.

Two ways to go here – ingots or coins. You’d think ingots would be the more liquid, easily transferable form. They aren’t always, and here’s why.

National governments issue coins, which means they come with some implicit guarantee. Should the gold market bottom out, your $10 American Eagle gold coin will still be legal tender. A bar is easier to fake. Even if you know a bar is real, a seller won’t and will insist that you pay to have a dealer examine and verify it if it doesn’t come with an assay certificate. That’s less likely with a coin, which is harder to counterfeit.

The U.S. Mint sells coins at huge markups – like, 20% (or 36% if you buy in tenths of ounces.) Better to go through a private dealer like Goldline or Monex, which sells at a smaller markup (around 4%).

The latter will also sell bars, which are forged privately. They’ll carry the logo of the manufacturer, stamped right on the bar. Johnson Matthey, a UK company, is a big one. So is Credit Suisse.

Your local bank might sell you gold over-the-counter, too. Not surprisingly, your chances are better with a big national or multinational bank than with a community bank.

My company takes $x per pay period and puts it in a 401(k). They match up to $x that I contribute. What is my company doing with my money?
Donnie, Austin

They’re doing exactly what you told them to, whatever that is.

Your company almost certainly uses just one provider to handle its employees’ 401(k)s. If your company’s big enough, once a year someone from that provider shows up and tells everyone where they can invest their 401(k) money. The provider will probably let you choose from a bunch of mutual funds – some that focus on growth, others that focus on dividend income, etc. You selected one and with your next paycheck, the money started going to whichever 401(k) instrument you chose. The money your employer matched your contributions with went to the same place. So ultimately, that money probably ended up with Hewlett-Packard or American Learning Corporation or Overland Storage or Burlington Northern Santa Fe or whatever. Or all of the above. But again, it’s only going there because you specifically asked for it to.

I love being grandfathered into the SARSEP plan I set up for my company before Billy Bob Clinton abolished them. No reason to look to get out of that, correct?
Andy, Indianapolis

No.
A SARSEP is, was, a Salary Reduction Simplified Employee Pension Plan. As you can tell, the IRS took acronymic license with that one.
As Andy mentioned, SARSEPs went the way of the passenger pigeon 14 years ago. Under a SARSEP, if your business had under 25 employees, and most of them agreed, you could direct part of their pay to an Individual Retirement Account. SARSEPs were a special class of the SEP-IRA, which is a little more relevant to our discussion.
A SEP-IRA is a way for small businesses to circumvent the rule that an employee can only contribute $15,000 annually to an IRA. (You want to be able to contribute a lot, as that’ll lower your tax liability today.) The maximum an employee can contribute under a SEP-IRA depends on how much the company earned. A SEP-IRA is essentially a profit-sharing plan. The most you can contribute on an employee’s behalf is either
a) ¼ of his salary, or
b) $49,000, whichever’s less.
That latter number rises annually. If you work for yourself, substitute 1/5 for ¼ and factor in the self-employed tax deduction. Isn’t accounting at the government’s behest fun?
One more thing: if you work for yourself, you know what the maximum you can contribute is? It’s a percentage of net profit.
20%?
Lower.
19%?
Lower.
18%?
Higher.
18.587045%?
Yes! And you read that correctly; the functionaries at the IRS actually drew the percentage out to 6 decimal places. Because if they let you contribute 18.587046%, which is an extra 1¢ on every $1 million, it would be unfair to some interest group.
How many examples have we given of the tax code needing to be imploded and started again from the ground up?
An aside: what’s the breaking point? At the rate we’re going, the IRS code will exceed a billion pages in the lifetime of some of us. Would a code that size be long enough to make taxpayers agree that the process under which their money’s confiscated is too confusing? Would the politicians of that era care enough to do anything about it? Is this as futile as trying to stamp out corruption or get everyone on the planet to quit smoking?
We do a mailbag whenever we get enough good, legitimate questions. Send yours to info@ControlYourCash.com.

Filed Under: Estate Planning, Finance, Healthy Living, Investments, Making Smart Choices Tagged With: , , ,

What do numbers and humans have in common? The irrational ones predominate.

October 25, 2010

This week marks the 23rd anniversary of Light Gray Wednesday. On October 19, 1987, the Dow Jones Industrial Average lost 23% of its value. Alas, no Goldman Sachs employees jumped out of their windows and ended up literally on Wall Street, which would have been awesome.

Over the course of one shocking trading day, the typical individual pension fund went from having 20 years worth of reserves to having 15. Stock options were instantly rendered worthless. Frightened American seniors started pricing cat food brands (Fancy Feast Classic Savory Salmon, 39¢ for a 3-oz. can.) High school juniors started downgrading their aspirations and applying to state colleges. The kids’ parents started smoking off-brand cigarettes – even the non-smoking parents – and saving up the frequent-buyer points. President Reagan and Congress were under pressure to do something to stop the carnage (more on this later.)

The first 100-point drop in the Dow began early in the morning: and this was back when the index itself was at barely 2000, less than one-fifth of where it stands today. Panicking investors copied the lead of previously panicking investors, selling their shares and forcing stocks to drop another 100 points by lunchtime. People on the West Coast woke up, assessed the devastation and followed suit. By the time investors in Honolulu and Anchorage were in a mood to eat breakfast, they’d seen their portfolios blown apart.

The drop wasn’t confined to the United States, nor did it originate here. It hit our shores after already overwhelming Hong Kong, not unlike Pai Gow. Once Hong Kong’s market crashed, so did the markets in Australia, then Western Europe. (An ancillary point: one of the biggest differences between international commerce of a generation ago and that of today is that back then, there was a 6000-mile swath ranging from Singapore to Tallinn that had no stock markets to speak of.) That very month, R.E.M. released “It’s The End of The World As We Know It”, a clear choice for the opening track on the soundtrack to the financial apocalypse that we were all going to have to face.

Who or what to blame? Favorite culprits included:

-computers. Those newfangled machines were blindly selling stocks, often to each other with negligible human input;
-an anti-inflation policy in the United States, though Europe had nothing similar and even if it did, something as gradual as that wouldn’t explain such a sudden drop in one day.

The real answer to what caused the crash is “it doesn’t matter.” What no one mentions is that within 2 days, the market had regained the vast majority of its losses. On net, the Dow actually rose that year. The relevant politicians at the time were either wise enough to know – or too busy to worry over the fact – that you can’t legislate opinions. Which is exactly what stock prices are.

So many of the indicators that we use to measure our prosperity are subjective, but especially the Dow. If you select a random public company, read its financial disclosures, and examine its income statement and balance sheet, a fair and reasonable stock price ought to correspond to that data. But that’s not necessarily the case. A profitable oil company with a rich history (BP) can suffer one huge setback and watch its market cap tumble. An over-the-counter company with almost no assets and no finished projects (Prime Sun Power) can trade at tens of thousands of times earnings, just because of its ecologically correct name.

The point? If you see unjustifiable movement, step away and breathe for a second. Investors sold off on the afternoon of October 19, 1987 for no better reason than investors were doing the same thing that morning, too. Playing lowball was, to put it simply, a fad. Just like bidding up the prices of online toy retailers would be 13 years later.

Collective rationality, or some form of it, usually wins out. In the case of Black Monday, it took almost no time at all for that to happen. The crises are rarely as important as the mundane, day-to-day activity, and the extremes rarely represent any market’s true level. Think about that when mortgage rates and home prices hit another nadir this week.

Filed Under: Book Promotion, Economy, Investments, Making Smart Choices, Net Worth, Newsflash Tagged With: , , , , ,
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