The favourite-longshot bias is a phenomenon observed in gambling and financial markets. It occurs when investors and bettors overvalue “long shots” and undervalue favourites. In a way it is similar to recency bias, where people tend to overestimate the likelihood of events simply because they occured recently. In both cases, people overestimate the probability of something happening.
The favorite longshot bias states that popular bets and investments are undervalued, while longshots or unpopular may in fact be overvalued. That is because the probabilities are badly estimated. So the investments or bets look like bargain, but actually they are even less attractive in reality than most people think. Thus it is generally better to go with the favourites. That is because, unlike what intuition suggests, the favourites may still be undervalued because people go for the longshot.
There are a number of explanations that may explain why people are attracted to longshots.
First, people may just be bad at estimating probabilities and may be biased in estimating the really small ones.
Second, people may be attracted to risk, i.e. they may be risk-loving when performing bets.
A third reason could be that people enjoy to take bets with potentially high payoffs, even when they rationally know that the probabilities are really low. Thus, they may just be willing to take bets with expected payoffs that are quite negative.
In stock markets, a good example of the “longshot” bias is the purchase of micro-caps and penny stocks. These stocks are trading at very low prices and thus a given price change can yield very high returns. As an example, consider a stock that’s trading at 5 cents. If its price change to 6 cents, the investor will have made 20%. This may explain why people tend to buy these stocks, even if the performance of these penny stocks is generally bad. Thus, due to their buying, these penny stocks become overvalued. In finance, such stocks are called “lottery tickets”.
Let’s take an example from betting markets. A good example is horse races. When one horse is given the odds 3-to-1, and the other 100-to-1, the actual odds may be closer to 2-to-1 and 200-to-1. Clearly, gamblers are overvaluing the horse with the 100-to-1 odds, because in reality it’s chance of winning is worse. But because it is a “longshot”, people are attracted to it. Because if the horse wins, the payoff is big. Thus, they overestimate the horse’s probability of winning. Thus, it would be more interesting to bet on the “favourite”, because it is undervalued.
We discussed the favourite-longshot bias, an effect where people tend to undervalue favourites and overvalue longshots. Because of the favorite-longshot bias, it may be better to bet on the favourite. This is against most people’s intuition, because we would expect the odds of the favourite to be well in line with actual probabilities. Thus, people think they can earn more, on average, by betting on the longshot.