The enthusiasm for ‘meme’ stocks that gain cult-like social media followings has thrown a spotlight on the ‘lottery effect’ in investing. This refers to people’s willingness to accept extremely poor odds in return for the remote possibility of hitting the jackpot. On one level, the practice seems mad. On another, it appears quite understandable.
People do like a flutter, even amid a global pandemic. According to the UK Gambling Commission, ticket sales in the National Lottery totalled £8.4 billion in the year to March 2021, the highest on record.
Yet the chances of striking it rich in the lottery are abysmal. The official odds of winning six numbers in Lotto are one in more than 45 million. To get five numbers plus the bonus ball, the odds narrow to a mere one in nearly eight million. To put that in perspective, your chances of being struck by lightning in the UK are about one in a million, according to the Royal Society for the Prevention of Accidents.
So given these odds, why do people keep buying lottery tickets? It’s the same reason people are drawn to meme stocks — the hope of an outsized payoff.
Behavioural finance view
More than 20 years ago, US finance professor Meir Statman, a pioneer in the field of behavioural finance, wrote a paper comparing the behaviour of lottery buyers and day traders who speculate on individual stocks. His findings rejected textbook assumptions about human motivations in favour of looking at the myriad ways we actually are.
First, Statman showed that people by nature tend to think they are above average, over-estimating their chances of striking it rich in the lottery and over-estimating the future performance of their investments relative to the market return.
Second, we have aspirations. Buying a lottery ticket or a meme stock gives us the opportunity of dreaming of a better future, but without hard work or having to wait. For those who have fallen on hard times, the gamble can appear as the only way out.
Third, we are driven by our emotions – particularly hope, fear and regret. Lottery companies exploit that by telling us that missing a round could expose us to severe regret. “Don’t let the numbers win without you”, goes the advertising slogan. In stock trading, speculators, fired up about the hype over hot companies, are often reluctant to realise losses until it is too late. They typically buy high and sell low.
A final motivation is that people speculate simply because they find the process itself enjoyable. As seen in the Reddit communities over GameStop, punting on individual stocks can engender a feeling of camaraderie. The sense of excitement and anticipation of a win are seen as rewards in themselves. An illusion of control — in picking numbers for the lottery or market timing in stocks — adds to the psychological payoff.
“Stock trading, like lottery buying, is a negative sum game,” Statman wrote. “On average people lose. So why do people trade stocks and buy lottery tickets? We can answer this question by focusing on our common aspirations, thoughts and emotions.”
A way out
For lottery buyers, the weekly ticket may their only way out of a life they hate or their only chance to dream big. For day traders, the risky punt on outsized gains may be the only way they can see of making an aggressive win quickly.
In other words, the lottery effect may not make sense from a statistical point of view, but from a human one, it is all too understandable.
“We want more from our investments than the utilitarian benefits of wealth,” Statman wrote. “We want the expressive and emotional benefits of hopes for riches and freedom from the fear of poverty, nurturing our children and families, being true to our values, gaining high social status, playing games, winning, and more.”
So the emotions and motivations driving the lottery effect are real. The big question is what can you do about them? One suggestion, advocated by some financial advisers, is to seek that gratification of the outsized payoff, the camaraderie, and the status of winning against the odds in other less harmful ways – like playing Fantasy Premier League for instance.
Alternatively, you could treat betting on individual stocks as a hobby, limit your stakes, and accept that your chances of winning are slim. Your real, long-term investments could be held in a portfolio of highly diversified global stocks and bonds.
Finally, you could just keep it really simple, go back to square one and buy a weekly Lotto ticket. After all, you never know, do you?
WHAT TO READ NEXT
Here are some other recent TEBI posts we think you will enjoy: