What are the consequences of increasing public information in a market of risk-seeking participants? Academics and policy makers alike are grappling with this question following the influx of speculative capital flows from individual investors in financial markets. As platforms such as Robinhood take root, the influence of gambling behavior is likely to increase and further affect the functioning of markets. The topic is also a key policy issue in light of the Securities and Exchange Commission (SEC) plan to review new policies aimed at increasing transparency to address market developments such as the frenzy of trading in “meme” stocks like GameStop and AMC.

In a new study, we examine the effect of increasing information on capital flows and market efficiency in a setting with market participants who have revealed gambling preferences. Theory highlights at least a few possibilities.

• One class of theoretical models posits that risk-averse individuals demand a risk premium to hold assets that are not transparent. Of course, this argument flips for risk-seeking participants. So, this line of reasoning suggests that an increase in information will lead to an exodus of capital from the markets.
• A second argument is that an increase in public information can lead to better allocation of resources, even for gamblers. More information can help participants pick risky investments with the level of speculation that is of interest to gamblers. Thus, asset classes with more information could receive more speculative capital flows.
• The third alternative arises from behavioral economics. Individuals deviate from standard utility theory when making choices in the face of uncertainty due to cognitive errors and misperceptions of probabilities. In this context, they may exhibit an illusion of control. Even in chance situations, agents often wrongly believe they can exercise control over the outcome – a canonical example is craps players “setting” the dice. The fundamental issue relevant to debates about transparency is that information itself can exacerbate this false sense of control. For instance, public information and related tools that supposedly aid the decision process can magnify bettors’ perceived control, persuading them to bet even more (and more recklessly).

For our empirical approach, we turn to the thoroughbred horserace betting market and exploit a near-laboratory setting. We focus on how race betting changed around April 1992, when Beyer speed figure (“Beyer”) information was made available for races at North American tracks as part of the Daily Racing Form (DRF), the dominant provider of handicapping information for bettors at the time. The Beyer is a popular numerical measure of a racehorse’s speed based on past performance in races, designed to facilitate comparisons of horses’ abilities. In this way, the Beyer is representative of much information in financial markets – it is a summary measure of performance that enhances comparability, akin to similar measures imposed via financial disclosure regulations, such as prior period earnings, credit ratings, etc.

As a textbook model of contingent markets, horserace betting has been used as a way to test theories of information aggregation, market efficiency, and other topics in economics and finance. Both securities markets and horserace betting represent decision-making under conditions of risk or uncertainty and share characteristics such as extensive market knowledge. Relative to equity markets, horserace betting offers several distinct advantages in identifying the effect of investors with gambling preferences, which we discuss in detail in our study. The primary advantage is that a horserace betting market clearly represents gambling, which permits us to directly study effects of information on relatively risk-seeking participants.

Our empirical approach uses a difference-in-differences design to examine the effect of the introduction of the Beyer on total race-level capital flows – specifically, the total parimutuel betting pool for each race. The results show that betting flows increase in races for which the Beyer could be calculated for most participating horses relative to races for which it could not. In other words, capital flows follow transparency even when market participants are largely risk-seeking. The magnitude of the effect is reasonable given that it incorporates offsetting forces and is similar in magnitude to the effects of fundamental control variables, such as the number of horses competing in the race.

Overall, the main finding of this study conflicts with typical interpretations of evidence that capital follows transparency. The exact mechanisms underlying the effect are unobservable, so future research is needed. However, we find evidence from two tests that is more consistent with the illusion of control than alternatives. First, we show that the effect is greater in settings where participants are more likely to use information as a basis to exercise control (rather than view participation as chance-based gambling). Second, we examine how the introduction of the Beyer affects betting market efficiency. A reduction in misperceptions would suggest an improvement in efficiency after the change in disclosure. On the other hand, if a psychological mechanism such as the illusion of control or private benefits of information consumption underlies the results, the shift towards more transparent races would not necessarily be coupled with any change in efficiency. We do not find significant evidence that the introduction of the Beyer is associated with a significant change in market efficiency based on either of two related measures.

Ultimately, our study suggests regulators and academics adopt a more complete view of the mechanisms by which transparency affects capital flows. Consider, for instance, that casinos learned long ago that skill cues beckon gamblers – at least, so suggests the array of information on fluorescent display around roulette tables and craps machines. If public information begets gambling in Las Vegas, it probably does the same for the hordes of risk-seeking investors now playing in U.S. financial markets.

This post comes to us from professors Karthik Balakrishnan at Rice University’s Jesse H. Jones Graduate School of Business and Darren Bernard at the University of Washington. It is based on their recent paper, “Public Information and Capital Flows: Evidence from a Betting Market,” available here.