Waterhouse VC: The Mathematics of Betting and the Psychology of Human Financial Behavior

Tom Waterhouse, an analyst at Waterhouse VC, delves into the mathematical acumen exhibited by professional bettors in the pages of IGB, shedding light on the rationale behind specific bets. For many, grasping the mathematical prowess retained by a small percentage of individuals in our world is a challenging feat. It becomes even more awe-inspiring when these individuals manage to amalgamate rare math skills with business acumen, resulting in the creation of a highly profitable enterprise.

We contend that professional betting stands out as one of the most challenging fields globally, demanding exceptional intellectual abilities, intuition, and business acumen for success. The triumvirate keys to victory in betting include selecting the right bet, placing a wager at an appealing price, and understanding the appropriate amount to invest in each venture.

Achieving success in professional betting necessitates a fusion of incredibly intricate skills:

In-depth knowledge of the sport, encompassing player statistics, adeptness at handling last-minute changes, familiarity with every location and playing surface (e.g., clay/gravel/hard tennis courts, Emirates Stadium vs Etihad Stadium).

Successful betting involves the intricate modeling of numerous factors influencing the probability of a player or team winning, juxtaposed with their true odds compared to bookmakers' offerings (e.g., time since the last match, social media activity, injury statistics, travel time to the match, age, weather, and market misjudgments).

Managing the bookmaking business entails handling aspects such as betting management, bet settlement risk, access to refunds, intellectual property theft risk, and bet theft/bet leak risk.

In the world, there are fewer than 50 bookmaking syndicates capable of earning over a million dollars annually through bets, with only a select few approaching a billion dollars in winnings.

Waterhouse VC holds a stake in one of these billion-dollar syndicates, focusing primarily on tennis. The syndicate's success is challenging to replicate due to proprietary data and intricate factors integrated into its operational model. Beyond Waterhouse VC's involvement in Project Tennis, the fund is exploring additional opportunities in the professional betting space—a realm challenging to navigate without specialized knowledge of the industry.

Those Who Pay Get Discounts

Paying clients enjoy discounts in the world of professional horse racing betting syndicates. The scarcity of successful syndicates in this domain can be attributed to the dominance of established ones, deriving their profits primarily from betting, irrespective of the sporting event outcomes. While this approach proves effective for existing betting companies, it poses a formidable challenge for new syndicates aiming to enter the competitive landscape.

In the realm of racing syndicates, returns are obtained from the pari-mutuel/totalizator in exchange for providing liquidity. However, to qualify for these advantageous discounts, syndicates must engage in substantial betting activities. As an illustration, American betting shops typically extend discounts only to those who wager more than $5 million annually, as reported by Sports TradingNetwork. This industry practice, driven by the leadership of established entities and their discount benefits, results in considerable profits. Nevertheless, it remains a viable strategy for only a select few of the largest syndicates.

Greed Leads to Loss

Human psychology stands out as a primary driver of financial cycles, with investors oscillating between fear and greed. This fluctuating human behavior becomes a profitable avenue for trading companies, capitalizing on the emotionally charged decisions made by retail investors.

Similar dynamics are at play in the realm of betting, where professional betting syndicates can exploit retail gamblers through platforms like Betfair and Matchbook. Succumbing to fear and greed, rather than basing decisions on thorough analysis, emerges as a significant pitfall for both investors and bettors alike.

The presence of numerous cognitive biases, including the "illusion of control," adds to the complexity, making successful investing and profitable bets exceptionally challenging. Even professional fund managers, armed with technical resources and brilliant analysts, often find themselves underperforming. Over the past decade, a staggering 85.6% of active funds failed to outperform the S&P500. In developed markets, the underperformance rate exceeds 80%.

Warren Buffett, hailed as the world's best investor, substantiated the challenges of active management by winning a million-dollar bet that the market would outperform such strategies.

Impatiently Flipping Coins

Numerous experiments have delved into the intricacies of how individuals perceive money and make financial decisions. A noteworthy experiment conducted in 2013 by Victor Khaganiand Richard Dewey involved participants engaging in a game where they virtually tossed a coin. They were informed that there was a 60% chance of landing heads. Each participant initially received $25 and had the liberty to place bets. After approximately 300 flips in a span of 30 minutes, participants received their ultimate payout, capped at a maximum of $250.

Haghani and Dewey's findings indicated an intriguing outcome. While they estimated that 95% of participants would reach the $250 payout, only 33% ended up losing money, and a mere 21% successfully reached the maximum payout. Surprisingly, 67% of participants took the chance to bet on heads at least once, despite being informed of the actual 40% probability of landing heads. This serves as a compelling example of the illusion of control in financial decision-making. 

The Kelly Criterion in Action

The success principles observed in the coin toss experiment can find application in both professional betting and investing, thanks to the straightforward implementation of the Kelly criterion (K%). This criterion serves as a tool to optimize portfolio or bankroll diversification, determining the most efficient allocation of funds for each individual investment or bet.

Applying the Kelly Criterion to the aforementioned coin toss experiment would lead to a recommended betting amount of 20% of the available funds on each iteration. For instance, if starting with $25, the initial bet would be $5. Subsequent bets would be recalculated based on the outcomes, ensuring an optimal allocation. This disciplined approach helps avoid excessive risk-taking.

A similar scenario is presented in the case of a bet with a 51% probability of winning. Striking the right balance with the Kelly Criterion is crucial; being too cautious results in modest gains, while being too aggressive could lead to significant losses.

The significance of position sizing is vividly illustrated in both betting and investing through this chart. Minor adjustments in the size of bets play a pivotal role in determining success or facing the risk of losing everything.

While winning at betting poses practical and cognitive challenges, there are select groups that manage to achieve it. Typically, these individuals are financially literate, proficient in numbers, and possess a precise understanding of their actions.