Behavioral Finance in Everyday Life – The Lottery as a Case Study

Is lottery a tax on stupidity or are our flawed psychologies playing another trick on us?

My wife and I usually enjoy strolls around our neighborhood on weekends, especially on sunny winter days. We live in the city and in our last stroll I kept noticing lottery advertisements everywhere as if they were beckoning to me.

Lottery has been deemed a tax on stupidity for a good reason. Every smart and aware consumer knows better than to throw money away on odds smaller than those of getting hit by lightning 3 times in a row.

Still, I couldn't help but buy a ticket. I felt I'd be I'd ignoring all the signals I had received that day calling out to me: buy and ye shall win. After having bought the ticket, for some reason, I'm full of hope and a very strong sensation of confidence in my chances of winning something.

I'm sure many of you have experienced that feeling before as well. Somehow, even though I am aware of the slim odds an unjustifiable feeling of optimism surges and the thoughts of all the things I'm going to do with my soon to be acquired financial independence overwhelm me.

There's a certain bias at work here and as my readers know I love psychological biases. This feeling of elation and of profits to come reminded me something. I usually get the same feeling when I make a stock investment. I simply can't be more certain this particular stock will drive my portfolio to new highs. Where does this conviction come from?

Behavioral finance and hedonic psychology - Daniel Kahneman and Amos Tversky's work

Daniel Kahneman is an Israeli psychologist and Nobel laureate, notable for his work on behavioral finance and hedonic psychology. With Amos Tversky and others, Kahneman established a cognitive basis for common human errors using heuristics and biases, and developed Prospect theory.

Kahneman and Tversky's work on behavioral finance is one of the most interesting and important to anyone who wishes to learn of the limitations of human rationality and the psychological biases that play a key part in our "rational" thinking. Their work is very relevant for investors everywhere as it ties in very tightly to stock market success and failure due to the affects of psychology on us, as investors or traders.

The Representativeness Heuristic – A wrong perception of chance

Would you choose consecutive numbers like 1,2,3,4,5 for the lottery? I'm guessing that you won't. But why not choose these numbers?

1,2,3,4,5 have the same chances of appearing than 2,8,12,23,35 but the last seems much more probable to be the winning numbers due to their randomness. Our minds are programmed in such a way as to correlate order with intention, which is mostly true. Still, there are times when this is obviously false.

The same phenomenon exists in the roulette where the combination red-red-red-black-black-black is thought of as much less likely than black-red-red-black-red-black. We have a certain expectation of nature restoring order to it, offsetting the results.

The Overconfidence effect and Optimism bias

Very common in investors the overconfidence effect is a bias in which people are correct in their judgments far less often than they think they are. For example, for certain types of question, answers that people rate as "99% certain" turn out to be wrong 40% of the time. Overconfidence is one kind of what is called the miscalibration of subjective probabilities.

You really can't get any more optimistically biased than hoping to win the lottery against unbeatable odds.

Apparently the lethal combination of overconfidence and optimism bias is very common and very hard to resist. According to Kahneman and Tversky only seasoned stock market brokers, weatherpersons and dog track analyists have shown some resistance to the effects of these biases.

I'm still hoping to win something but somehow I'm a little less confident in my guesswork. Still, people do win.

If you find judgement under uncertainty and heuristics and biases as interesting as I do please let me know. In the near future I hope to write more on these issues. In the meantime, you may be interested in Kahneman and Tversky's Judgment under Uncertainty: Heuristics and Biases

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