Pick 666 and All Lucky 7’s!! The Battle Between Vice and Virtue!

What should you do if you won the lottery? Try to woo a supermodel/actress?

First off, the odds are against you; the expected return for a lottery ticket is negative. The jackpots just aren’t big enough; people just perceive the jackpot to be large enough to satisfice any chance of winning. Although it’s irrational, good for you if you win one day. Just make sure you don’t blow it off or become depressed in a few years.

The lottery has expected return paradoxes; there’s a negative expected return almost all the time, but high jackpots which can lead to retirement, despite low odds. One buck (or a few) is a minimal cost, so the risk is essentially zero. So basically you are guaranteed to lose money, but since the loss is so minuscule and potential award is large (even post taxes and the lump-sum decrease), people go for it. For example, even under the most lenient conditions (low tax rate, conservative lump-sum multiplier), the required jackpot for the expected return to equal your USD$1 would be at least USD$311Mn. Under more realistic assumptions, such as a 35% tax rate, this increases to USD$361Mn.

Those lottery creators aren’t stupid; it’s the same game for the gambling casino owners. Do you think they would really be in the business, or be able to sustain their businesses if they didn’t/couldn’t make money? They are profiting from the irrationality of people just like many investors do. Expert statisticians, mathematicians, and financiers run the numbers to make sure it is worth their while. What’s this boil down to? TANSTAAFL. But that doesn’t mean there never will be or can be a pseudo-free lunch. It is possible, just unlikely in the long run. So even though you can make some money if the jackpot is over USD$361Mn, it’s not going to happen enough that the businesses need to worry about it. And when it starts becoming likely, they’ll change the odds in their favor. An extra gotcha is that when you actually win the lottery, you have to choose between the lump sum payment versus the annuity. Going along the lines of lottery makers not being stupid, they’ve calculated the present value of the annuity so that it is exactly the same as the lump sum payment. What to choose? It’s pretty simple; the annuity is paid off by bonds averaging around 5% interest a year, so if you think your opportunity cost of capital (what you can make over 26 years, in the case of the lottery annuity) is higher than their discount rate of 5%, then take the lump sum, else take the annuity. Chances are that with a time horizon of 26 years, you will be able to get and want something better than 5%.

Is this justification for sin stocks or funds like VICEX? No. Although they may be relatively stable (historically), we need to think about the future. Are people becoming “better” or “worse”? If we analyze what can happen to these securities in the future, we come across some bad possibilities. These companies are increasingly becoming regulated for health concerns, negative public sentiment is increasing towards them, they can potentially go out of business if everyone becomes “enlightened,” and last but not least, they may be publicized to the public sector to be part of the government since they need the guaranteed money.

There’s a conundrum in wealth management: the rich[er] are able to take more risk for more reward but don’t need to, while the poor[er] are unable to take more risk but want more reward. This catch-22 perpetuates wealth condensation (the rich getting richer, and vice versa) since those HNWI (high net worth individuals) will generally want more wealth conservation from their financial advisers. This concept applies to many aspects of distributions: the most ___(insert “downloaded/viewed/read/emailed”)___ get more downloads/views/reads/emails because of what I call the “condensation multiplier.” The big get bigger more easily, while the small naturally get smaller relative to the big getting bigger. This is not to say that the small can’t get big, it’s just harder or less likely. I mean, the list has to start somewhere and although the avalanche isn’t much right away, it picks up speed as it goes.

What should you do if you were extremely wealthy? Do what you love, love what you do. Only keep as much as you, your family, and your friends need with a buffer for bad times. Donate and invest or vice versa. Recently, there’s been a lot of commotion about socially responsible investments (SRIs) like KLD or IDS. Although the KLD Select Social Index and Domini Social 400 Index provides a benchmark for SRIs, many people have many different moral philosophies. It’s because of this that SMAs have an advantage over the bucket that MFs put everyone in their fund into. Good ones should be able to customize each account according to each individual client’s perspective of what is socially responsible and what is not. There is one caveat though; by eliminating non-SRIs, you are decreasing your opportunity set for maximizing risk-adjusted returns. On the flip side, you may be doing exactly that because of the reasons mentioned before. So evaluate your opportunity costs of capital, your code own code of ethics, and your investments. Now there’s just a limit on what SRI PMs think are SRIs and are not SRIs, financials anyone?

When in doubt, plenty of internet “Buffetologists” would point you to what he is doing. I’m not so sure about the Bill and Melinda Gates Foundation; although they help the world a lot, I don’t think Buffett or the Gates are diversifying their investments. Essentially by donating their fortunes to the foundation, they are putting all their eggs in one basket. While it’s important to have a certain amount of scale to have fruitful operations, many things are overlooked. To help “save the world” you need to cheer for prevention to lead the way, not just treat the sick to slow it down; education plays a huge part, as in almost all aspects of life.

(Image CC-BY pinguino. Image Copyright Square Enix.)

High Five for Love!

Often the quote, “Better to have loved and lost than never to have loved at all” is used around this time of year, but is the same true for investments? Is it better to have invested and lost than to never have invested at all?

Clearly, in monetary terms, the answer is simple – no. Underneath this there are some other underlying factors. By having invested any money at all, a person is gaining a new experience that they can learn something from. Now I’m not saying, that this very yoctosecond you go out and invest your life savings, rather people should consider investments as a quintessential part of anyone’s retirement plan.

Too many people don’t understand their opportunity costs, costs of capital, and risk tolerances. People say they are risk-averse, but when the market is booming, they no longer care to hedge and diversify risks. Eventually the bubble pops and there’s a landslide. People may come to see their mistakes, but somehow they forget and the vicious cycle continues. This increases market volatility and should be discouraged.

In Behavioral Finance, Daniel Kahneman and Amos Tversky developed Prospect Theory. One of the key takeaways of this theory is that people get more disutility through losses than utility through gains. This plays a very important role in downside protection of wealth and gives a reason to why value has outperformed growth for extended periods of time.

As seen in the graph, as your losses increase linearly, your gains needed to recover to zero increases exponentially. “Extra needed” shows the difference between “what is needed to make up” and the “loss.” “Marginal increase of need to make up” is the increase of what is needed to make up as losses increase.

This ties in with Prospect theory because people in reality don’t want to lose money, not really because of the snowball effects, but more because they are losing hard-earned money that is hard to get back.

The thing is, hard-earned money, should be used for intensely researched investments. People shouldn’t invest just so that they can “get rich quick,” but rather because they love finance and investments, what it means to learn more about a company, the economy, and human psychology. The returns are a bonus to continue what you are doing. This is why I believe in that passion and prestige in not just Finansophy, but in anything that you are interested in and passionate about. Warren Buffett says, “you should do the job you love whether or not you are getting paid for it. Do the job you love. Know that the money will follow…. If you’re doing something you love, you’re more likely to put your all into it, and that generally equates to making money.” Perhaps this is the meaning of life that everyone’s intrinsically searching for.

(Image CC-BY-SA *Zara.)