Portfolio Investing Blog: Portfolioist

In the academic finance world, it’s fairly common to find comparisons of investors to gamblers and certain types of stocks have been referred to as ‘lottery tickets.’ I’ve found that this comparison is actually quite important. There is an odd paradox between the assumption that investors are rational when it comes to investing, yet still spend an awful lot of money playing the lottery.  When we speak of “lottery ticket” investments, we are talking about investments that have a small probability of a big “win” and a large probability of a modest “loss.” And this is precisely the situation with lotteries.

The reality is that people spend considerable sums of money on lottery tickets, a money gamble that has a negative expected value. This same appeal (big, low-probability win, modest high-probability loss) also seems to motivate some investors. For an excellent review on this topic, you’ll want to read “Who Gambles in the Stock Market,” by Alok Kumar. He finds that the people who buy lottery tickets also “gamble” in the stock market—and the outcome is just the same as when they play the lottery. Investors who approach investing like playing the lottery, end up substantially poorer (on average) than investors who are not driven by the low-cost-big-win ticket.

Why Investors Like to Get ‘Skewed’

Academic literature often refers to “lottery ticket investments” as being “highly skewed.”

This term refers to the types of returns that an investment has historically generated. “Skewness” refers to a statistical property in which the outcomes of an investment (or gamble) and its probability has the lottery-like quality of having a higher probability of low (or modest) returns and a smaller probability of extremely high returns than the “normal” distribution (or investment).

A finance professor that I know likes to say that ‘investors like to get skewed.’

The literature suggests that the tendency of investors to buy stocks with lottery ticket characteristics (i.e., low probability of massive win, high probability of modest loss) is widespread and can be used to understand why investors pour so much money into IPOs— even when they are fully aware that IPOs tend to lose money. From the perspective of a wealth-maximizing rational gambler / investor, neither one makes sense. However, this doesn’t mean that investing in highly-skewed investments is inherently irrational, though.  I loved Jason Zweig’s comparison of buying into an IPO (Facebook as it happens) to a classic game of chance with highly skewed outcomes.

The visceral appeal of landing a massive windfall with the purchase of something as inexpensive as a lottery ticket (or a few shares of an IPO stock) is powerful. Getting a little charge out of dropping a few bucks on a daydream will not matter to most of us.

Unfortunately, many people spend a lot of money on lotteries that they simply can’t afford.

Can We Blame Human Nature?

What all of this means is that investors need to understand why they are investing in a specific stock or mutual fund.

There is a natural visceral appeal to investing in IPOs (and other highly-skewed investment types) and there is nothing inherently wrong with these investments. Large percentages of investors’ portfolios end up concentrated in highly-skewed positions and a large fraction of individual investors have portfolios that are heavily weighted towards ‘lottery ticket’ investments. Not surprisingly, high-skewed portfolios tend not to be highly diversified and investors who hold these portfolios tend to end up with poor investment performance.

I suspect that the companies promoting and selling “lottery ticket” investments are well aware that they are tapping into a powerful drive in human nature. The latest case-in-point: The massive promotion leading up to Facebook’s IPO. Effective marketing and promotion taps directly into our visceral drives causing us to be hungry, thirsty, or to buy that new car. Buying an IPO stock is no different—investors crave the excitement that comes with purchasing the ‘lottery ticket’ investment regardless of countless studies that consistently show that, on average, IPOs are a bad bet (see “What You Need to Know Before You Invest in IPOs.”)

What the recent Facebook IPO has reminded us, is that at the end of the day, many investors are looking for the excitement that comes with “lottery ticket” investments and don’t always think through the actual odds of making money. This is essentially a “gold rush” mentality—aided and abetted by much of the mainstream media.

Related Links:

• Are We Hard-Wired to Make Bad Financial Choices?
• Financial Literacy is the Issue of the Month? Try the Issue of the Century.
• Stocks and Shocks: What to Do?

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