Psychology of the Longshot

The Favorite-Longshot Bias (FLB) is a pervasive market anomaly characterized by the overvaluation of low-probability outcomes (longshots) and the undervaluation of high-probability outcomes (favorites) ^[1]. This phenomenon, initially documented by Griffith in 1949, contradicts the Efficient Market Hypothesis, which posits that market prices reflect all available information ^[1].

Theoretical Underpinnings

The FLB can be attributed to several key drivers, including:

• Prospect Theory: Bettors exhibit a cognitive bias towards overweighting small probabilities, perceiving a 1% chance as significantly higher than its actual value ^[2]. This is in line with the findings of Kahneman and Tversky (1979), who demonstrated that individuals tend to overestimate the likelihood of rare events ^[2].
• Skewness Preference: Gamblers often exhibit risk-seeking behavior, trading Expected Value (EV) for the utility of a potential massive payout, also known as the "Lottery Effect" ^[3]. This is supported by the work of Golec and Tamarkin (1998), who found that individuals are willing to pay a premium for the possibility of a large win ^[3].
• The Shin Model: Bookmakers intentionally inflate the margins on longshots to protect against insider trading and asymmetric information, creating a "Longshot Tax" ^[4]. Shin (1991) demonstrated that this practice allows bookmakers to maintain a profit margin while minimizing their exposure to informed bettors ^[4].

Empirical Evidence

The FLB has been historically observed in horse racing parimutuel pools and has evolved into modern Parlays (Accumulators), where bookmakers generate their highest margins by exploiting the public's desire for life-changing wins from small stakes. This is evident in the work of Griffith (1949), who found that bettors consistently overbet on longshots and underbet on favorites ^[1].

References

^[1]: Griffith, R. M. (1949)

^[2]: Kahneman, D., & Tversky, A. (1979)

^[3]: Golec, J., & Tamarkin, M. (1998)

^[4]: Shin, H. S. (1991)