Don't bet on horses with fast-sounding names

In a new paper to be published shortly in the Journal of Behavioral and Experimental Economics (open access), Oliver Merz, Raphael Flepp, and Egon Franck (all University of Zurich) undertake an interesting test of behavioural economics. The affect heuristic suggests that our decisions are influenced by our emotions. In other words, the affect heuristic forms part of our System 1 thinking (to borrow from Nobel Prize winner Daniel Kahneman's excellent book Thinking, Fast and Slow), where our decision-making is fast, instinctive, and emotional.

However, the affect heuristic (and System 1 thinking more generally) is completely at odds with the Efficient Markets Hypothesis, which in its strongest form suggests that all relevant public and private information is incorporated into the price of an asset (such as a share price). The efficient markets hypothesis essentially suggests that in financial decisions we rely on System 2 thinking - slow, deliberative, and logical, and not influenced by our emotions.

Merz et al. look at the case of betting on horse racing, and in particular they look at whether the names of horses affect betting behaviour. The name of a horse should be reasonably uninformative about how fast the horse can run - there's no rule or law that says an owner can't name their slow nag Rocket Roger, for example. So, if betting behaviour is affected by the names of the horses, then that is likely to be the affect heuristic at work.

Using Betfair data from over 400,000 horse races in the UK, Ireland, the US, South Africa, and Australia, and involving nearly four million horses, they find that:

...a fast-sounding horse name has predictive power with regard to the race outcome beyond the winning probabilities implied in the odds. In particular, our results show that the winning probabilities of bets on horses with fast-sounding names are overstated, implying that the prices in betting exchange markets are not completely efficient, as prices become distorted by incorporating affective, misleading information from a horse’s fast-sounding name.

In other words, bettors place bets on horses with fast-sounding names far more often than the horses' underlying win probabilities suggest that bettors should. But before you get carried away and rush off to bet against horses with fast-sounding names:

...we find significantly lower returns for horses classified as fast-sounding compared to other horses. A simple trading strategy of betting against all horses classified as fast-sounding yields a return of approximately 2.9% before the commission but a negative return of -1.6% after deducting the standard commission of 5% from Betfair.

Even though in theory you can profit from other bettors' irrational preference for betting on horses with fast-sounding names (in apparent violation of the Efficient Markets Hypothesis), when you take into account that Betfair takes a commission on every bet, there isn't a positive profit-making opportunity here. The best you can probably do is to avoid betting on horses with fast-sounding names, because the return is going to be significantly more negative than it should be.

[HT: Marginal Revolution]