Gamble on Powerball or energy?
The U. S. Powerball lottery and its “world record” US$1.5-billion j ackpot ( or thereabouts) certainly caused quite a stir over the past few days. Even Canadians, apparently, were scrambling to get in on the action, flocking to American border towns to buy tickets. Jeesh.
I don’t want to be a party proper, and US$1.5 billion is a lot of shekels, but really, you’d probably have been better off putting the price of a Powerball ticket and whatever you spent on gas into something else. Like, say, paying down your mortgage, adding to an RRSP or — heaven forbid — buying a Canadian stock.
Lotteries, lest it need to be said, are a crappy investment, and the bigger the jackpot, the crappier they tend to be.
And while I’m not suggesting that investing is gambling — because that would be just wrong — lottery fever might yield some lessons for investors, if they consider the numbers.
When people say investing isn’t gambling, what they really mean is that investing shouldn’t be gambling. We are all told that investors are supposed to look at long-term historical trends, broadly diversify, hedge their positions where possible, be patient, don’t market- time and — well, the list of good advice goes on and on.
But hey, where’s the fun in that?
So in the spirit of fun, let’s take a look at Powerball as an investment and draw some learnings from what we find.
Let’s assume that our Powerball “investor” is living in Toronto and went to Buffalo to buy one US$2 ticket. If he won the US$ 1.5 billion, he’d realize a return of 75,000,000,000 per cent. Not bad.
Of course, that’s a big “if.” The stated odds of winning the jackpot were 292 million to one, which would make any sane person question whether the hope of winning makes Powerball a good use of two bucks American.
To figure that out, you’d look at your expected return, which is calculated by multiplying the potential return by the odds of realizing it.
This only precisely applies if you play the same game at the same odds over and over again, but it’s a fair rule of thumb for comparing options for placing your money.
The expected rate of return matters a lot, for instance, in casinos, where it indicates the house edge. According to the Problem Gambling Institute of Ontario, for example, the casino’s expected rate of return for roulette is 5.3 per cent; for certain bets on craps, it’s 1.4 per cent. That means if you played roulette for long enough with a $100 stake, you would expect to lose $ 5.30, but you’d only lose a buckforty if you played craps.
In the Powerball case, the payout on the surface looks a lot better than a casino. Multiply US$1.5 billion by one-in292-million odds, and your $2 ticket has an expected return of $5.13, for a profit of 157 per cent.
Trouble is, you only get the US$1.5 bill if you take it over 30 years. If you want it upfront — and hey, you do — then you have to settle for a one- time payout of US$ 930 million. That drops your expected return to US$3.18, or a 59-per-cent gain on your two bucks.
That’s still pretty good, but Uncle Sam will want his cut, so after paying income tax of, say, 30 per cent, you’ll end up with US$651 million, depending on which state you’re claiming it from. Taxes drop your expected return to US$2.23, or 11 per cent.
Then there are expenses. If you factor in the price of the gas you burned to get to Buffalo, your expected return dips into negative territory. You might as well play craps.
It gets even worse when you consider that there were probably a record number of Powerball players, given the record potential payout, which increased the chances that somebody else had the same winning number as you, further reducing your expected return.
Granted, people playing lotteries don’t think this way. They have their eyes on the prize. They wouldn’t care about a few bucks on gas if they won US$1.5 billion, right?
But investors are supposed to grow their money over time, and looking at the expected rate of return might give them a sense of where they might better use their money.
For example, let’s look at oil. It’s plumbing US$ 30 a barrel; some analysts have it dipping to US$20; others, such as the Organization of Petroleum Exporting Countries, believe it will reach US$70 by 2020.
For the sake of argument, let’s say the odds of any of those outcomes (33-per-cent loss, zero- per- cent change, 133- per- cent gain) is equal. That means the expected rate of return if you bought a (fictional) barrel of oil today is 33 per cent in four years, for an annual compound return of 7.4 per cent.
To win in this game, everything depends on how good you are at estimating the odds. But there are a couple of things investors need to bear in mind when playing.
Like our Powerball winner has to worry about taxes, investors have to pay attention to costs that eat into their expected returns, such as MERs, transaction fees and taxes.
Also, just as the expected return from Powerball goes down when more people play, so does the cost of playing the stock market when everybody is doing it. If you make your picks before more players can get in the game — keeping your price of entry low, and your expected rate of return high — then bully for you.
Of course, that would involve trying to time the market, which really is a kind of gambling. Still, if you didn’t play Powerball and instead bought, say, an energy stock — well, you might just be thanking yourself come 2020.