Cognitive Bias & Lessons from the Lottery

Every time the Powerball lottery reaches some stratospheric figure (like a recent $2.04 billion jackpot), my inbox gets inundated by journalists looking for quotes explaining what a person should do if they win.  These articles receive a ton of page views because people love the lottery. According to this New Yorker article:  

“Americans spend more on lottery tickets every year than on cigarettes, coffee, or smartphones . . . and they spend more on lottery tickets annually than on video streaming services, concert tickets, books, and movie tickets combined.”    

I don’t bring up the lottery because I think it is good or bad. I bring it up because a lot of the same biases that cause people to buy lottery tickets, are the same ones that cause people to make terrible investment decisions.  Below are a few of my favorite examples. 

The Bandwagon Effect

Most people don’t buy lotto tickets on a regular basis BUT once the massive jackpots begin inundating the news and the lottery becomes part of daily conversation, the FOMO kicks-in and they buy lottery tickets “just in case.” This is the same reason many investors came to own crypto currencies, NFTs, and meme stonks. 

Availability Heuristic

The availability heuristic makes us overestimate the likelihood of events that easily come to mind. It’s much easier (and fun) to imagine ourselves celebrating our winnings than it is to envision ourselves as just one of millions of losers.  We therefore discount the odds of losing. This same thing happens when investors get pitched on an exciting investment opportunity.  It’s much more fun to imagine turning $50,000 into $50,000,000 than it is to envision the more likely scenario of the company going bankrupt and losing everything, so investors discount the risks and make the investment.   

Overconfidence Bias & Illusion of Control

Similar to the last point, as humans, we are wired to believe the odds of good things happening to us individually are better than the odds of good things happening to everyone else.  We also believe we can control events. It’s why lottery players pick lucky numbers, why sports fans wear lucky shirts, and why investors that may be skeptical of a passive investment in the S&P 500 often won’t think twice about investing in a business startup suggested by a friend despite being aware that, statistically, most will fail.     

The Near Miss Effect

Almost winning often produces the same dopamine response as actually winning.  I remember going to McDonald’s as a kid when they were having the Monopoly contest.  Every time I pulled the Park Place sticker, I would get excited because I was so close to getting the Boardwalk sticker and $1 million dollars.  I JUST NEEDED ONE MORE HAPPY MEAL!  The same thing happens to lottery players when they get a couple numbers correct.  Just a few more and they would have had it.  This near miss effect converts sadness into excitement. I regularly hear this happening to investors.  Their efforts to time the market may have lost money, BUT if they had just held on longer or sold sooner or traded based on that thing they knew would happen, it would have worked.  They just need to keep trying.    

Summary

This has gone a little longer than intended but the point I’m trying to make is that these biases do not discriminate.  They impact large decisions - like determining how you are going to allocate your retirement savings - just as easily as they impact small decisions - like spending $2 on a lottery ticket when the odds of winning are 1 in 292,000,000. 

Your awareness of your own psychological quirks may not dissuade you from buying a lottery ticket ($2 may be a fair price to pay for a good dream) but I hope it will at least make you think twice before taking excessive risk in your IRA.