Probably no other phenomenon presents a greater challenge to the model of Homo economicus — and better examples of the complicated relationship we humans have with money — than this: Last year, the American public spent about $69 billion of their hard-earned money on lottery tickets, even though each individual’s chance of winning is infinitesimal.
Why do so many people fall for this “mental trap”? This photo caption from an NBC News article says it all: “Ryan Zhang, after purchasing a Powerball ticket in Flushing, Queens in New York City. ‘I’m not a regular buyer. Just for fun — my wife just sent me a text saying ‘powerball is 425 Million.’ Two dollars is nothing, why not?’”
After all, someone has to win. Right? And it feels so good to imagine, if only for a few minutes, what it would actually be like to win the jackpot. Would you quit working? Travel the world? Become a philanthropist? Blow it all?
Somewhat surprisingly, a recent Gallup poll found that two-thirds of American workers said they would continue working even if they won $10 million in the lottery. And Carl Richards, aka the “Sketch Guy” on the Bucks blog, recently wrote that when it comes to winning, “We say we want more money (who doesn’t?), but it’s surprising to me how few people can explain exactly what they’d do with that money. Oddly enough, not knowing why we want more can create problems.” This is something he calls the “more dilemma.”
Richards went on to quote Paul Graham, a successful programmer and venture capitalist: “Most people would say, I’d take that problem. Give me a million dollars and I’ll figure out what to do. But it’s harder than it looks. Constraints give your life shape. Remove them and most people have no idea what to do: look at what happens to those who win lotteries or inherit money. Much as everyone thinks they want financial security, the happiest people are not those who have it, but those who like what they do. So a plan that promises freedom at the expense of knowing what to do with it may not be as good as it seems.” (See: “The Beauty of Limits“)
Still, most people who buy lottery tickets aren’t having an existential debate about how winning will change their lives right as they’re shelling out the money for a ticket. Instead, what they are doing is buying a very small dose of hope.
To better understand why millions of people spent $5.9 billion over the last year on Powerball — a game where the odds of wining are 1 in 175 million — or played any one of the other lotteries, “you have to suspend logic and consider it through an alternate set of rules — rules written by neuroscientists, social psychologists, and economists,” writes Adam Piore in “Why We Keep Playing the Lottery.”
“When the odds are so small that they are difficult to conceptualize,” Piore writes, “the risk we perceive has less to do with outcomes than with how much fear or hope we are feeling when we make a decision, how we ‘frame’ and organize sets of logical facts, and even how we perceive ourselves in relation to others . . . . It’s a game where reason and logic are rendered obsolete, and hope and dreams are on sale.”
Daniel Kahneman, the Nobel Prize–winning psychologist, echoed this point in a recent article in the New York Times: “For emotionally significant events, the size of the probability simply doesn’t matter. What matters is the possibility of winning. People are excited by the image in their mind. The excitement grows with the size of the prize, but it doesn’t diminish with the size of the probability.” (For more from one of the founding fathers of behavioral finance, see: “Daniel Kahneman: Psychology for Behavioral Finance.”)
It turns out that fantasizing about winning the lottery activates the same parts of our brains that would be activated if we actually won. “The motivational areas of the brain can be heavily influenced by vivid daydreaming,” Daniel Levine, professor of psychology at the University of Texas at Arlington, tells Piore. “Just like seeing something can activate the emotional system, so can envisioning it.”
Sounds a bit like what happens in the minds of some retail investors when a stock is surging: They buy on what they envision will be a handsome reward when it comes time to sell. (But what we know, of course, is that they continually buy high and sell low.)
This got me thinking about the images the lottery invokes and whether there was anything to be gleaned from an investor’s perspective.
In a 2009 article, “The Mistakes We Make — and Why We Make Them,” Meir Statman writes that investment success stories are as misleading as lottery success stories:
Have you ever seen a lottery commercial showing a man muttering “lost again” as he tears his ticket in disgust? Of course not. What you see instead are smiling winners holding giant checks.
Lottery promoters tilt the scales by making the handful of winners available to our memory while obscuring the many millions of losers. Then, once we have settled on a belief, such as “I’m going to win the lottery,” we tend to look for evidence that confirms our belief rather than evidence that might refute it. So we figure our favorite lottery number is due for a win because it has not won in years. Or we try to divine — through dreams, horoscopes, fortune cookies — the next winning numbers. But we neglect to note evidence that hardly anybody ever wins the lottery, and that lottery numbers can go for decades without winning. This is the work of the “confirmation” error.
What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that have done well in 2008.
Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don’t chase last year’s investment winners. Your ability to predict next year’s investment winner is no better than your ability to predict next week’s lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.
And if you have ever wondered whether a lottery ticket could be a good investment, the authors of an award-winning paper, “Finding Good Bets in the Lottery, and Why You Shouldn’t Take Them,” have the answer.
Using some mathematics and some economics (modern portfolio theory), mathematicians Aaron Abrams and Skip Garibaldi conclude: “don’t buy lottery tickets. It’s too risky. Even the enormous returns we found are not big enough to counteract the enormous likelihood of not winning.”
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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