The link between investments and lottery tickets (MoneyWatch) As we have discussed before, there's ample evidence from the field of behavioral finance that individual investors strongly prefer investments that exhibit the same characteristics as lottery tickets. In the jargon of statistics, they have high kurtosis (fat tails) and positive skewness (values to the right of [more than] the mean are fewer but farther from the mean than values to the left of the mean). And just as is the case with lottery tickets, this preference leads them to over-invest in the most highly (right-) skewed securities. The increased demand leads to higher prices, with the consequence that those securities will have lower subsequent average returns. I recently came across a study that specifically sought to examine the link between the lottery and stock markets. Two researchers, Xiaohui Gao and Tse-Chun Lin, from the University of Hong Kong, studied lottery and stock market behavior in Taiwan. They chose Taiwan because 70 percent of trading there is done by individual investors (as opposed to as much as 90 percent of U.S. trading being done by institutional investors) and other than the public lottery all other forms of gambling are prohibited. The following is a summary of the findings of their study, called "Do Behavioral Needs Influence the Trading Activity of Individual Investors?": Trading of highly volatile stocks noticeably drops on days when the lottery was offering a jackpot, with a direct correlation between the size of the jackpot and the reduction in trading. The effect of the lottery on stock trading was strongest among the types of stocks favored by individual investors -- small stocks with high past returns and high turnover. The authors concluded that the entertainment value of the lottery was seen by many investors as a direct substitute for how they viewed stocks. "A large jackpot satisfies investor needs and caters to preferences that are similar to stock trading," Gao and Lin wrote. Therefore, a lottery with a large jackpot can affect trading activities in certain sectors of the market. It's likely that individuals playing the lottery are well aware that while buying lottery tickets can provide thrills and entertainment, they know that lottery tickets are poor "investments." In fact, they're not investments at all. Instead, they're speculations with a large negative expected return. On the other hand, while individuals may get the same thrills and entertainment value from investing in stocks with lottery-like characteristics, it seems unlikely that they're aware the stocks they buy with those lottery-like characteristics have poor returns. The bottom line is that the same motivations for buying lottery tickets leads to investors driving the prices of lottery-like investments to levels that produce poor average returns. In other words, bringing your motivations for buying lottery tickets to the stock market is not prudent behavior. And while it's okay to buy an occasional lottery ticket, you shouldn't "invest" your retirement account in lottery tickets, or lottery-like stocks! Image courtesy of Flickr user Mark Ou