Thoughts on Finance

Aug 11, 2019

Benefits of Betting

Usually when two people bet on something, each side believes that they will make money. One way this happens is information asymmetry. Once the outcome of the bet is determined, the loser pays the winner (and hopefully updates their beliefs about the world). In this way, betting indirectly allows information to be shared. Investing in stocks on an exchange is kind of like betting. If you buy shares of a company, then you are making the bet that the value of the company will go up in the future. As market particpants buy and sell shares to each other, they are essentially distributing their own knowledge and beliefs about the company. Eventually, everyone has basically the same beliefs which causes the price at which shares trade at to converge. This price determines the valuation of the company as a whole, so I guess we have betting to thank for unicorns.

Betting also encourages people to be more certain about their uncertainty. In daily life, there's usually no punishment for saying "I'm sure about [x]" only to have [x] be false, except maybe your friends trust you less in the future. However, if every time you said "I'm sure about [x]" your friends said "I'll bet you $100 with 9-to-1 odds that [x] is false", then you better be sure that things you're "sure" about are true at least 90% of the time.

Financial Products

Let's say you believe that 40% of people drink coffee daily while your friend believes that 60% do. Your friend bets you $100 that a random person on the street drinks coffee daily. Would you take the bet? Sure, you're expected to make money, but there's a pretty big chance you'll lose - even if your belief is correct, which sucks! However, if your friend instead bet you $(x - 60), where x is the number of people in a sample of 100 that drink coffee daily, then you're much more likely to make money assuming your belief is correct. In other words, there's less risk.

An ETF is kind of like the second example. An ETF is essentially a basket of many stocks, so investing in an ETF is less risky than investing in an individual stock. One cool thing about financial products (like ETFs) is that they allow people to express their beliefs in different ways. In this case ETFs allow people to express their beliefs at lower levels of risk, while other financial products like options allow people to express more complicated, non-linear beliefs.


Hedging is another way to reduce risk besides diversification. Let's say you believe that AAPL will perform better than other tech companies this quarter, so you buy shares of AAPL. However, due to a shortage of silicon, all stocks in the tech sector drop and you end up losing money. The problem is that buying shares of AAPL does not correspond to the belief that AAPL will perform better than other tech companies, but that AAPL will perform better than it is now, which is subtly different. A bet that is more in line with your beliefs would be to not only buy AAPL but also short (sell) a basket of stocks in the tech sector. This way, you actually make money when AAPL performs well relative to other tech companies, irregardless of how the tech sector moves as a whole. Making one investment to reduce the risk of another is known as hedging.

I like the idea of hedging because it can be broadly applied outside of finance. If there's something you want to happen, you can bet against it so that in case it doesn't happen you're not as sad.