I enjoy watching the World Cup—not because I’m a big soccer fan (sorry, football) but because of the grand stage on which it takes place. It is like the Olympics for the sport that everyone in the world (except Americans) loves the most. It feels really important—something you can’t miss. Plus watching any sport played at its absolutely highest level is something to behold and appreciate.
As a casual fan that tunes in every four years, I don’t know much about soccer aside from the fact that the teams from Brazil and Germany are always among the best. To help me narrow down the games I want to watch, I have to look at the betting odds to understand who the favorite is and who the underdog is and which games project to be the closest and most interesting.
High Risk ≠ High Reward
In the opening-round World Cup match between Cameroon and Brazil, the odds stated that Cameroon was a 25-to-1 longshot to beat Brazil. That means that you would get $25 for every dollar bet if Cameroon pulled off the upset. Those odds translate into a 4% probability, which illustrates that taking a risk and betting on Cameroon to win could pay off handsomely if the unexpected happened.
Cameroon was a high-risk pick because Brazil, which always has a top soccer team, was playing at home where it hasn’t lost a non-exhibition game since 1975. And being the World Cup tournament, this couldn’t be further from an exhibition game; Brazil would undoubtedly be giving it their all. Additionally, Cameroon hasn’t won a World Cup match since 2002, and that victory came against Saudi Arabia, which doesn’t exactly have the same soccer tradition and success as Brazil.
A 25-to-1 payday was certainly high reward if you were right about Cameroon winning the match, but that was not likely to occur. The more likely result was that Cameroon would lose the game, and anyone who wagered on them to win would lose money. (Brazil won 4-1)
One common mistake that investors make is assuming high risk equals high reward. It doesn’t necessarily. More accurately stated: High risk means a higher chance of greater rewards, but it also means a higher chance of loss.
The Favorite-Longshot BiasLimit the Longshots in Your Portfolio
Studies in sports and horse wagering have demonstrated a clear psychological bias from bettors when it comes to picking favorites and longshots. The favorite tends to be undervalued while the longshot tends to be overvalued. In simpler terms, the favorite actually has a higher chance of winning than the odds imply, and the longshot actually has a lower chance of winning than the odds imply. In the context of the Brazil vs. Cameroon game, this means that the probability that Cameroon would win was likely meaningfully less than the 4% probability that the odds implied. Because of the misconception that high risk equals high reward, the negative outcome (the risk of loss) is often overshadowed by the positive outcome (the reward) due to the eye-catching potential payoff.
Another common mistake investors make is falling prey to this favorite-longshot bias in their portfolio design by overweighting high-risk investments. Rather than take a slow-and-steady approach to investing with small, consistent gains over time, investors often seek out longshot investments—ones with a higher potential for a significant gain but also a higher potential for a loss that often goes largely ignored. If your portfolio contains concentrated stock positions, leveraged ETFs, IPOs, uncovered options, or penny stocks in any consequential amount, you are likely succumbing to the favorite-longshot-bias.
Limit the Longshots in Your Portfolio
For investors who view high-risk investments as high-reward investments, the lure of a potentially large return on a longshot investment is often too appealing to resist. Unfortunately, the probability of that large potential gain is likely being -overestimated while the probability of a large potential loss is likely being underestimated.
The best advice for investors in overcoming these commons mistakes is the same piece of advice you would give someone who gambles on soccer games or horse races: don’t bet more than you can afford to lose. Therefore, if you must engage in longshot bets in your portfolio, limit their allocation to a point where they can’t hurt your long-term returns. This typically means an initial allocation of 5% or less of your portfolio. Even if you ultimately lose everything on your longshot investments, you won’t completely derail your portfolio’s return. The last thing any investor should want is to make their retirement a longshot.