Hope springs eternal in the human breast. – Alexander Pope

People love huge, lottery like gains. Fast gains get attention, which is why I titled this post “1,000% Returns” instead of “Earn 1,000% Over 30 years.” In pursuit of quick riches, we sometimes turn to lottery-like stocks: companies that trade at outrageous valuations, have exciting stories, and have the potential to be wildly successful. Lottery stocks are expensive because they have such exciting prospects for the future. Their stock prices don’t reflect what they have accomplished, but what they might accomplish.

We love these stocks because we love innovation, new technologies, and revolutionary companies. Many of the best companies in the world today were once revolutionary upstarts themselves, and investors want to find the next big thing and ride it to the top. Also, because they are usually smaller, younger companies, lottery stocks give us the chance to get rich very quickly. IBM isn’t going to grow 10-fold in one year, but a small biotech company with a drug that fights cancer might.

Lottery Stocks Defined

I define lotto stocks as the most expensive stocks in the market: the 10% of stocks with the highest prices relative to their sales, earnings, cash flows–which means they are the stocks for which the market has the highest expectations. On average, about 40% of these stocks come from just three of the twenty-four major industries: Pharmaceuticals & Biotechnology, Technology Hardware & Equipment, and Software & Services. Here’s the sobering picture of how lotto stocks have done historically:

Of course, some lottery tickets pay off—as the Powerball slogan says, “Hey, you never know.” Google and Apple have both fallen into the “lottery stock” category at times. But on average these stocks are dangerous, and today’s lotto stocks—including biotechnology companies, some internet stocks, battery companies, and so on—should be avoided at all costs. Contrary to the Powerball slogan, for the most part you do know what will happen to these stocks. They’ll kill your portfolio.

We play regular lotteries like Powerball because of what is possible, not because of what is probable. Everyone knows the odds are terrible, but the prospect of great fortune has always been, and will always be, very seductive.

Lottery Brain

Our brains suck at processing odds in general, but our handicap gets worse when dealing with large potential rewards. We tend to significantly overestimate the probably of an outcome if that outcome means a big reward. Take horse or dog racing. We prefer to bet on the long shots—despite their terrible odds—because of the huge potential payoff.

There is a great chapter in my favorite behavioral finance book (Inside the Investor’s Brain) on probabilities. Author Richard Peterson explains:

As the size of a potential monetary gain increases, so too does reward system activation (specifically the nucleus accumbens). Potential reward size is more emotionally arousing than proportional changes in probability…When an outcome is possible but not probable, people tend to overestimate its chance of occurring. This is called the possibility effect. When an outcome is likely, people tend to underestimate its odds. This bias has been named the certainty effect. Events of probability less than 40 percent are susceptible to the possibility effect. Outcomes with greater than 40 percent probability are in the realm of the certainty effect.

If there is a chance that we might earn a big reward, our brains push us towards going for it, even if the odds stink. Here is a visual representation of how we should evaluate odds versus how we actually do. The straight diagonal line is how we should assess them: if something has a 10% probability then we should give it give it a 10% chance when weighing our odds. The curved line is how we actually do assess them. We make huge mistakes, especially for very improbable events. As the figure shows, we might think something has a 15% chance of happening when it in fact has a 1% chance.

Peterson lists conditions under which we are likely to screw up our assessment of the probabilities, including:

Vivid or easily imagined results

Minimal awareness about the event’s likely outcomes

Event is represented as a novel/unique phenomenon

Wanting the outcome to occur

Feeling a personal or emotional stake in the outcome, or feeling excited about the outcome

The biotechnology industry fits these definitions. These stocks have usually not produced big earnings, but have huge potential if a drug comes through. Here is how biotech stocks have stacked up to the rest of the market in terms of value (cheap or expensive) and momentum (popularity) since 1980. Their popularity ebbs and flows as the prospect of great fortune waxes and wanes, but they are always expensive.

Lottery Stock Results

Using my definition of lottery stocks (the most expensive 10% of the market), let’s first look at the exciting possibilities of these stocks. Here are some examples of winning lotto tickets, so to speak, from the last 10 years:

Like usual, these stocks enticed investors because they represented new technologies and innovations that had the potential to lead to massive success (and earnings) if their new car/energy/medical technologies panned out. Like the regular lotto, every so often you will hit it big.

But it is stories like these that keep the fire burning for future lottery stocks (“I know it’s a long-shot, but this might be the next Tesla!”). The chance, however small, that one might catch lightning in a bottle is seductive enough to get investors buying.

But there is a big difference between what is probable and what is possible. Since 1963, the most expensive 10% of the market has underperformed by 8.5% annually. If, since 1963, you bought every lotto stock in the market every year, 60% of those buys would have lost money in the next 12 months (and they’d have been down an average of -41%). Even though the remaining 40% made money, the entire group of lottery stocks has grown at a tiny 1.5% annual rate since 1963—that’s worse than inflation, and significantly worse than the S&P 500 which grew at roughly 10% per year over the same period. The historical record is clear: it doesn’t pay to play the stock market lottery.

Don’t Play the Stock Market Lottery

So what does it mean for stocks today? Some stocks in the typical industries—technology, biotech, cutting edge energy—are once again priced at insane levels. There will always be companies like Apple and Google that work out. But picking those winners ahead of time from a crowded field of competition is extremely difficult to do. You are much better offer buying the overall market or buying cheap stocks (which will be the subject of another post soon).

History teaches us that we should avoid lottery stocks like the plague. Just like the actual lottery, the probabilities of a big payoff are just too low. When you buy a lottery stock, you are paying for the excitement that your ticket might pay off–a decision that is emotional not rational. A good rule of thumb for lottery stocks and investing in general: if it feels good or excites you, it is probably a bad idea.

Photo by Kevin Moraczewski