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Casinos, Insurance Companies, and Indexers: What Do They Have in Common?

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To many people, the financial markets are nothing more than a giant casino where the odds are stacked against them. Certainly, one can hardly blame them when they repeatedly hear about the computers that now dominate trading or the hedge-fund related insider trading scandals. While this belief definitely holds true for people who are speculating by stock picking, time picking, or style picking, it does not apply to investors who buy, hold, and rebalance a portfolio of globally diversified index funds that is appropriate for their level of risk capacity. Like the casino owners and insurance companies, this group is playing a game where the odds are in their favor.

To understand this, let’s first think about how casinos make money. Essentially, they repeatedly take one side of a bet that is tilted in their favor. Whether it is the spin of the roulette wheel, the roll of the craps dice, or the dealing of the blackjack cards, the casino always has the house edge, albeit a small one. Of course, there are a few exceptions such as blackjack card counters, but the casinos make a great deal more money from people who think they can count cards than they lose from actual card counters. Regarding the fools who think they can get away with cheating the house, they might have wound up dead in a dumpster in the old days, but nowadays, the long arm of the law will usually reach them. The key to a casino’s profitability is its ability to play the same game thousands of times a day over thousands of days. Per the law of large numbers, this repeated play makes it a virtual certainty that the casino will collect on the house edge. While the casinos love their high rollers (or whales), they know how important it is to limit the size of any single bet.

Moving on to insurance companies, the underlying concept is exactly the same—they are making bets over thousands of policyholders over a long period of time. The only difference is that the bets are based on serious real life events, such as death and property destruction. The insurance company actuaries and underwriters set the premiums so that the company has a positive expected outcome. Naturally, there will be many policyholders on which the company will lose money, and a properly run company will avoid taking too much risk on a single policyholder by utilizing coverage limits and reinsurance. The process used to set insurance prices is not too different from that used to determine odds and payoffs of various casino and sports bets. In fact, one of the foremost experts on this subject, Michael Shackleford, is an actuary who runs the Wizard of Odds Website (wizardofodds.com). One important difference between casinos and insurance companies is that while the former simply provide entertainment, the latter perform a valuable societal function of spreading risk. Although most policyholders will end up paying more to their insurance company than the company will pay to them, they are still getting a good deal in that they are shielded from the threat of a potential bankruptcy resulting from a catastrophic event. As the economists would say, for a risk-averse person (i.e., most of us), buying insurance maximizes his utility, even if technically, he is overpaying for it. 

The key to understanding how this same concept applies to indexers is to realize that although stock prices move in a random walk, they still have a positive expected return. This must be the case, because if they had a zero or negative expected return, no rational person would want to own them. Their prices would adjust downward until the expected returns become commensurate with their risk. For indexing (i.e., owning all stocks) to be an optimal course of action, all we need is that every stock is continuously priced by the market so that buyers receive a positive expected return in accordance with the risk they bear. When an indexer holds thousands of stocks over thousands of days, the law of large numbers should work in her favor, as it does for the casino owner and the insurance company. By choosing a good provider of passively managed funds, an indexer can tilt the odds even more in her favor.  Dimensional Fund Advisors (DFA) and Vanguard generate extra revenue for their shareholders at the expense of active investors by engaging in securities lending to short sellers. Another method of enhancing shareholder returns is to utilize a patient and opportunistic trading strategy where the funds benefit from being a provider of liquidity rather than a seeker of liquidity. Again, this is an example of indexers benefitting at the expense of active investors.

As an indexer, you own the publicly traded casinos and insurance companies, so you are a beneficiary of their positive expected returns, assuming you are not a socially-responsible indexer who avoids gambling stocks. Ironically, you also own the actively managed mutual fund companies and brokerage houses that profit from active investors. Investing as an indexer is one of the few activities in life where you get the benefit of house odds, so take advantage as early and often as possible.