Gambling is not glamorous

In November 2024, auto mechanic Edwin Castro stopped at Joe’s Service Center on his way home outside Los Angeles.

He paid $2.00 for a Powerball ticket. The $2.00 bet led to a $2.04 billion payday, the largest payoff in lottery and Powerball history.

Castro’s bet was how most of us view gambling or investing. We want to make that small bet that has an enormous payoff. The odds of winning the jackpot at the lottery or Powerball fluctuate, but hover around one in 300 million. A number that is pretty close to zero.

What about professional sports bettors? Do they rely on such odds? Nope. Professional sports bettors have an average winning percentage in the range of 52% to 55%. (Recreational bettors average 42% to 47%.)

Professional investors? The most successful investors in the world make profitable investments just over 50% of the time.

While most of us will bet on a team or pick a stock for reasons like, “the Cowboys are on a hot streak,” or “Meta’s new product is going to take off,” there is no such thinking for the professional bettor or investor.

Professionals always want an “edge” when placing a bet or buying or selling a stock. The edge is what pushes their winning percentages above 50%, if only barely. The edge is almost always information the gambler or investor has that other players do not.

For example, an investor might have a computer scientist on staff who understands a company’s AI strategy better than most.

The investor would use the knowledge like this: the way the company’s AI strategy will play out in a year will be a game-changer, but no investors today realize this, so the company’s stock price is low but will skyrocket in a year when the AI strategy is implemented.

Since having the edge is so valuable, there is a long history of investors gaining the edge illegally.

Matthew Martoma was a trader at what was once called SAC Capital. He specialized in healthcare stocks and was deep into studying Wyeth and Elan, two companies developing drugs for treatment of Alzheimer’s Disease.

Before a pharmaceutical company can release a drug to the public, the drug must go through a set of clinical trials, during which time the drug is tested first on animals and then on small groups of humans before being approved by the FDA for release to the public.

Martoma got to one of the scientists running a trial and learned that patients in the trial were not responding to the new treatments. The Alzheimer’s drugs under development would likely be denied FDA approval and never make it to the market. An utter disaster for Wyeth and Elan.

Martoma had SAC Capital sell all its stock holdings of Wyeth and Elan. Guess what happened next? When news of the failed trials was made public, stock prices of Wyeth and Elan crashed, and SAC Capital avoided almost $300 million in losses thanks to the edge provided by Martoma.

Unfortunately, Martoma’s acquisition and use of the information was illegal, and he wound up with a nine-year prison sentence.

During his trial, it came to light that while at Harvard Law School, Martoma hacked the computer system to change his grades. He was caught and expelled. Undeterred, he changed his name and went on to get an MBA from Stanford, which was subsequently revoked when Stanford found out Martoma failed to disclose his expulsion from Harvard. What a guy!

What do professionals do that we don’t? Many professionals rely on the Kelly Formula or a variation of it to govern their investing and betting. The key principle of the Kelly Formula is to risk a small portion of your fortune with each bet.

The basic rule starts with a maximum bet of 1-2% of your fortune and the value increases as your edge increases. So, in a rare sure-fire situation, you might have as much as 20% of your fortune at risk on a single bet.

Let’s use the 52% win rate and start with $1,000. According to the Kelly Formula, we bet 1.0% or $10 at a time, once per week. Over our first 100 investments, we win 520 and lose 480, for a net win of 40 bets, or $400. In the stock market those 100 investments would take 100 weeks or almost two years of trading days, but we made a 40% return in those two years, or about 20% per year, which is pretty good.

But those 100 investments used an exhaustive amount of research and probably required 10 people working full time searching for an edge to justify each of the investments.

All the while, the investor was not focused on huge gains (like when a stock triples in value overnight). You know what she was focused on: Not losing her fortune.

Ask any professional gambler or investor and they will tell you it’s not about picking the winners but all about cutting your losses quickly. A professional I know who we will refer to as Mr. Southwest, echoes this sentiment:

We all want to be as lucky as Powerball winner Edwin Castro, but as Mr. Southwest tells us, winning is more about not losing than it is about hitting it big.

Key Takeaways

Gambling and investing are professions. Decide if you want to be more than a recreational player, then learn how to use the Kelly Formula and other foundational tools relied on by the pros.

Martoma proves right something we mention often in these pages: once a liar, always a liar. I bet if we track down Martoma’s high-school friends they would have stories about how brilliant he was, but how he cheated at Scrabble.

Gambling and investing provide a type of psychic income in that they give us the thrills associated with risk-taking. That is all well and good, but as the saying goes, bet with your head, not over it.

Please provide me some feedback.

Things I think about

In a typical year, there about 250 trading days and the stock market goes up on 54% of those days.

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Full reading list is here.