What horse racing tells us about investing

In 2009, a horse left watchers shocked.

His name was ‘Mine that Bird’.

He was considered abnormally smaller in size as compared to other racehorses.

But his trainer believed in him. The trainer had a broken leg – but he still came with the horse to watch him race.

Kentucky Derby Race – one of the most watched horse races in the US.

The race has been held every year since 1875!

A lot of hope, greed, fear, and excitement ride on these races.

This entire industry is extremely competitive.

Horses are bred carefully – the father and mother are matched after research.

Horses that win races also earn a lot of money by breeding.

There are star trainers who train the horses for racing. There are jockeys (horse riders) who specialize in making the horses run faster.

The price of one horse can run into millions of dollars.

Spectators bet money on the horses.

The horses’ reputation is well known among those who are betting.

People go to extreme lengths to understand each horse.

They keep tracking past victories and losses.

Even the great-grandparents of the horses are tracked and their history is studied.

People start looking at young horses’ races to predict the next big racing hero.

The point is, that people do in-depth research on the horses — like good investors research stocks.

Most people bet on the best horses.

There are around 20 horses in a race. But most people place their bets on 3 or so horses. One of the 3 usually comes first.

Few people place bets on other horses.

It’s almost like the race is actually between ~3 horses, and the other horses don’t even exist.

2009

Something similar happened at the Kentucky Derby in 2009. Most people had bet on a few horses.

19 horses were lined up in the stands.

When everybody was ready, the gates were opened – and the horses shot forward.

A pattern similar to what was expected happened.

Two horses darted to the front of the race.

Most of the others were close behind.

The competition was intense. A lot of money had been bet on the horses. Everyone watched anxiously.

Some of the horses in the front overtook each other.

Far behind all, there was an unfortunate horse. Horse number 8.

He had been bought and sold a few times.

He had also spent 21 hours traveling to reach the race.

As the race drew closer to the end, horse number 8 seemed to suddenly gain an immense amount of energy.

He started overtaking one horse after another – in the final leg of the race. This almost never happens.

From being last in the race, he reached the 3rd position.

Even at this position, he kept charging ahead like a train.

He crossed the 3rd horse. Then the 2nd horse. And then, he crossed the 1st horse.

Number 8 was still not slowing down.

He kept going – increasing the gap between himself and the 2nd horse.

He crossed the finish line – first.

Horse number 8 — whose name was ‘Mine that Bird’ — had won.

Almost nobody expected him to win. But he won.

For a $2 bet, he returned $103.20 – the second-highest return given by any horse in the race.

Let’s look at another Derby race that was held in 2015.

In this race too, people mostly bid on a few horses.

As the race started, a few horses shot forward and remained in the lead.

Horse number 10 shot first. Close behind him was horse number 8.

And in 3rd position was horse number 18.

The race progressed rapidly. Horse numbers 8 and 10 kept overtaking each other.

In the race’s final leg, horse number 18 leaped forward and overtook both horses.

The horse’s name was ‘American Pharaoh’ — horse number 18.

Many bettors expected him to win.

His victory was not surprising. He was one of the best horses out there.

The payout from this race was $7.8.

Now, you might be curious.

The winning horse in 2009: return of $103.20 The winning horse in 2015: return of $7.8

Why so low?

Why the big difference?

Answer: expectations.

Expectations Affect Rewards

The way horse racing works is this: the amount is not fixed.

It depends on the number of people who get the answer correctly.

Let’s say the winning horse fetches a total of $1000.

This $1000 will be divided among all the people who had bet on him.

So, if 500 people bet the horse will win, the amount will be divided by 500 — which means everybody will get $2.

If only 10 people bet that the horse would win, then each person would get $100.

Other people’s bets matter here.

The actual math behind the payout is a bit more complicated. We have simplified it to make it easier to understand.

Expectations and Stocks

Why are we talking about horse racing in this newsletter?

Well — because expectations matter in investing too!

Time for an example.

There are two chocolate companies:

New Delhi Chocolates Ltd:

-Revenues: Rs 1,000 cr per year. -Sales: 1 cr chocolates per year -Total shares: 10 cr shares -Share price: Rs 800 per share

Mumbai Chocolates Ltd:

-Revenues: Rs 1,000 cr per year. -Sales: 1 cr chocolates per year -Total shares: 10 cr shares -Share price: Rs 800 per share

Both these companies are extremely similar.

Then, the CEO of Mumbai Chocolates makes an announcement: “In 5 years we will double our sale

Investors are happy. They start buying stocks of Mumbai Chocolates.

Why?

Because they expect the revenues to go up in the future. They feel the share price will go up too.

Many investors think exactly this. And so, they start buying shares of Mumbai Chocolates.

This causes the share price to go up at present.

Mumbai Chocolates share price: Rs 1000.

The share price of New Delhi chocolates stays the same: Rs 800.

After 5 years, both companies have grown the same.

Which is:

-Mumbai Chocolates has doubled its sales (as the CEO promised). -New Delhi Chocolates has also doubled its sales (even though the CEO never said anything).

So now, both their share prices have reached a similar level.

-New Delhi Chocolates share price: Rs 1700 -Mumbai Chocolates share price: Rs 1700

So, if an investor bought shares in both companies, which investment would have made more profit or gain?

New Delhi Chocolates:

-Buying price: Rs 800 -Current price: Rs 1700 -Gain: Rs 900

Mumbai Chocolates:

-Buying price: Rs 1000 -Current price: Rs 1700 -Gain: Rs 700

Just because more people expected Mumbai Chocolates to perform better, gains from its stocks will be less.

Others’ expectations affected the investment!

Note: this example makes many assumptions and generalizations. Things are never this simple in real life.

There are many other factors — all acting at the same time. This example is just to demonstrate the point about expectations.

This is why many investors try to stay away from overhyped stocks.

When the expectations from a stock are too high, it stops being a great investment — even though the company and the business is still a good one.

Take the example of Cisco.

But expectations from it were so high in 2000 that its share price reached astronomical levels.

Even today, Cisco’s share price has not crossed the level it was at in 2000 — despite its revenue having increased consistently.

Its revenue is actually the highest it has ever been — it is 3 times higher now than it was in 2000.

But things are not that simple (sadly).

Investors have also observed that over time, many overvalued stocks do well in the long run.

A classic example of this is the Amazon stock.

Despite being called ‘overvalued’ for many years, it proved to be a great investment.

There really is no clear formula for this.

Investors have to learn to develop this ‘6th sense’.

It comes with experience.

No article or video will be able to teach that in 20 mins.

The images above were generated using AI tools.