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Why Nobel Prize Winners Never Win The Lottery | IE Finance Talks

Why Nobel Prize Winners Never Win The Lottery

By Eusebio Martin

Lottery therefore is properly a Tax upon unfortunate self-conceited fools.
William Petty (1662)

In the final months every year, Spain is engulfed by a mild form of economic irrationality. Following a well-established tradition, 24 million Spaniards ‘invest’ annually c. 3 billion euros in ‘decimos’ of the Loteria de Navidad. It is well known that the expected value of any lottery ticket is negative: the Lotería de Navidad distributes 70% on prizes, and the winnings will be charged a 20% tax, so the buyer of a 20 euros ‘decimo’ should provision c. 9 euros, which is the expected loss of such ‘investment’.

Putting aside the appeals to Christmas tradition, and the sentimental value of such purchase (i.e. a chance of dreaming, or to share hopes with your loved ones), so skillfully played by the lottery in its advertisements, analyzing why people buy lottery tickets offers a good opportunity to evaluate the mechanisms that lead humans to deviate from the rationality assumed by the classic economic analysis, which is the main theme of Behavioral Finance.

For that purpose, we can borrow a few concepts from Prospect Theory, which was the base of the Nobel Prize in Economics awarded to Daniel Kahneman in 2002. In essence, Kahneman states that the utility of any financial decision is not only economical but also psychological. This implies that our decisions are influenced by feelings of fear (we fear losses more than we value gains of the same magnitude), and of hopes of gain that may lead us to make decisions driven by our impulses, ignoring our long-term interests. This, in turn, causes several attitudes that partly explain the repeated purchase of lottery tickets by so many people:

  • Overweighting of extreme events: the fear of loss can lead us to pay a sum too large to bring the possibility of experiencing a large loss down to zero, as we can see with some insurance premiums. On the other hand, the ‘possibility effect’ makes us overpay for an investment if it promises hope of a large gain, blinding us to a balanced analysis of risks and returns. Buying lottery tickets is the most obvious example of the possibility effect, which also drives the investment in highly speculative ventures in revolutionary but unproven technologies.
  • Losses are measured not in absolute terms but in respect of a Reference Point that can change. This explains why most Spanish employees feel compelled to join their co-workers buying lottery tickets with the same number in the weeks leading to Christmas. The universal explanation for such behavior is that ‘I would feel miserable if I don’t buy and then they win a big prize’. The feeling of loss anticipated in such a dreaded situation stems from a change in the reference point, which is the prize that your colleagues, and not you, may win. Even if, objectively, you would not be worse off if they win, you would feel that you have lost the amount that you would have won if you had bought the ticket. As that vision flashes through your mind, you experience an instant fear of loss, and succumb to the temptation of buying the ‘corporate lottery ticket’, perhaps the only one you buy in the year, even if you positively know that it is a bad investment.

This phenomenon, which is also known as fear of missing out’, explains why companies rush to invest millions in promising projects or acquisitions without proper due diligence, driven by the fear of losing the fruits of the next wave of their industry. This was seen, for instance, in the $140m invested by Wallgreens in its JV with Theranos, or in the €540m paid by Santander for the internet portal Patagon, both of which were later written off.

  • The endowment effect, widely studied by Richard Thaler, winner of the Nobel Prize in Economics in 2017, is also shown in people’s attitude to their lottery tickets. The endowment effect makes people give more value to goods they own, just because they own them. The owner of a lottery ticket would not exchange their ticket with yours plus a premium of, let’s say, five euros, even if both tickets have the same (small) chance of winning. The endowment effect also explains why so many investors hold stocks at a price at which they would not buy them again.

But although the above can serve as a light-hearted illustration of some concepts of Behavioral Finance, we shall not forget that, as Thaler says, humans are not uber rational ‘econs’. Our lives are worth living because sometimes we succumb to our impulses or are driven by our emotions. And Christmas, by definition, is a time of the year fully loaded with emotions. We allow ourselves to overeat, overspend in questionable gifts, and endure long dinners with our in-laws, because, although wasteful or unwise, such ‘seasonal’ behaviors are worth to us. Or, in other words, we can afford to be irrational occasionally, provided that we are aware of it, and the stakes are not much higher than a 20 euros lottery ticket.

Lottery therefore is properly a Tax upon unfortunate self-conceited fools. William Petty, 1662.

 


Eusebio Martin, a graduate in Economics from Universidad Complutense of Madrid, and MBA from INSEAD has 30 years of professional experience in banking, industry and private equity in Spain, UK, Latin America, and Eastern Europe. Currently is CEO of Aquisgrán Finance, an alternative lending vehicle for SME’s in Spain. He is an Associate Professor of Finance at the IE Business School since 2013, where he teaches Private Equity and Behavioral Finance in executive and postgraduate courses.