The Business Lessons of the Belmont Stakes

I'll Have Another will try to enter the pantheon of horseracing by winning the Belmont Stakes, the final leg of the Triple Crown, on Saturday night (June 9, 2012). Following exciting wins in the Kentucky Derby and the Preakness, the chestnut colt is trying to do what no horse has done in 34 years. Win or lose, I'll Have Another's situation provides useful lessons about business and markets.

The first lesson is about adopting the inside versus the outside view. Daniel Kahneman, a renowned psychologist who won the Nobel Prize in economics, developed this concept in the 1970s along with his collaborator, Amos Tversky. Here's the idea: When we are asked to solve a problem — including one that involves a prediction — our natural approach is to gather lots of information about the issue, combine it with our own inputs, and come up with an answer. For example, an executive considering whether to acquire a target company will gather facts about the industry and target company, consider how the combined companies will perform, and come up with a value that shows the deal is good for the acquirer. This is called the inside view.

The outside view, in contrast, considers the problem as an instance of a larger reference class. In other words, the outside view asks: What happened when others faced this problem before? There are lots of problems that we tackle infrequently but that plenty of people have dealt with before us. Humanity has a large database, just waiting to be tapped. To continue with our example, instead of thinking about how a particular acquisition will succeed, an executive might ask what percent of deals end up being good for the acquirer. In M&A, we know that most deals fail to add value based on a large sample of empirical results. The inside and outside views — in racing as well as business — are often in conflict, and when they are, the inside view generally provides a more optimistic view than the outside view does.

It's easy to think about I'll Have Another's chances to win the Belmont using the inside view. He won the Triple Crown's first two races in impressive fashion, and his trainer and jockey gush that he is ready to go. And handicappers certainly like his chances (the betting odds suggest a 50%-60% probability that he'll outrun the other 11 horses in the race). The inside view sees mostly upside. The outside view paints a more pessimistic picture. Consider that of the 30 horses in a position to win the Triple Crown in the last 130 years, only 11 have succeeded. That's about a 40% rate. But it gets worse. Prior to 1950, eight of the nine horses that tried, triumphed. Since 1950, only 3 of 21 have managed the feat, and none have done so since 1978. A success rate of less that 15% is not encouraging.

Perhaps I'll Have Another is a really special horse, you may be thinking, a once-in-a-generation speedster. Well, we can quantify that with something called a Beyer Speed Figure, a measure of a horse's performance adjusted for track conditions. All you really need to know for this purpose is that higher speed figures belong to faster horses. Here are the speed figures for the Kentucky Derby and Preakness combined for the last seven Triple Crown aspirants, all of which failed, along with I'll Have Another:

Beyer Speed Figures for Triple Crown Contenders

Silver Charm — 233 Smarty Jones — 225 Funny Cide — 223 War Emblem — 223 Real Quiet — 218 Charismatic — 215 I'll Have Another — 210 Big Brown — 209

I'll Have Another looks pretty lead-hoofed. Big Brown, the only horse that appears worse, was eased coming down the homestretch in the Preakness, paring a few points off of his speed figure. And he went on to finish dead last in the Belmont in 2008.

To be clear, I'll Have Another is unquestionably the favorite to win the Belmont. It's just that his odds of victory overstate his probability of victory by a meaningful amount. He's like an overpriced stock. He's good, just not worth the price. This leads to the second lesson.

For a market to be efficient, where price is an unbiased estimate of value, investors must be cognitively diverse. In the stock market, for instance, you need bulls and bears, long- and short-term investors, technicians and those who rely on fundamentals. When there's a loss of diversity and everyone comes to the same belief, then price and value get out of sync. This is how the wisdom of crowds becomes the madness of crowds. The dot.com bubble of the late 1990s is a good case in point.

Most people don't pay attention to horse racing day to day, but the bettors come out of the woodwork when there's a prospective Triple Crown winner. The majority plunk their money on the favorite, creating a breakdown diversity that causes price and value to diverge. This is what is happening to I'll Have Another.

When views are diverse, prices tend to reflect value reasonably well. Indeed, analysis of a large sample of races shows that handicappers assess the ordinal finish of the horses with extraordinary accuracy. But when uniformed bettors, or investors, get on the bandwagon, they almost always lose. Too much optimism or pessimism leads to extremes. You can be sure that sharp handicappers have figured out how to take advantage of I'll Have Another's mispricing. And it's a lesson you can apply as you consider prices in the market.