The Audacity of Hopeful Investing

Warren Buffet and many old experts note the distinction between gambling or speculating, and investing. Gambling is investing without an edge, such as when one plays the lottery, or invests in stock without alpha. Investing is what Warren Buffet does.

Nassim Taleb has become a prominent talking head with the advice to invest mainly in Tbills, but then a modest portion in something with large and unquantifiable upside: the potential next Google or Harry Potter. I think this is foolhardy, because uncertainty is correlated with volatility and factor loadings, and historically, earnings estimate variability, high volatility, or high beta stocks, all underperform, statistically (ie, on average). So too for the biggest longshot horses, or highest payoff lotteries, call options, movies, etc. Things that can generate lottery-like payoffs, have lottery-like returns.

The annual per capita lottery expenditure in the US is about $150, and the rate of return is about -47% per dollar played. These investments clearly cater to what is commonly called those seeking risk, or positive skew, in particular. A study of the popularity (sales) of lotteries found that average payout (expected return) did not matter, but the size of the top prize was highly significant in motivating popularity. In other words, the $100 million super lotto has a lot of sales even though the probability of winning is so small it basically is outside the realm of intuition (1 in 150 million). A St.Louis Fed article finds that those with household income of less than $25,000 spent twice as much on lotteries on a per capita basis, than those with a household income over $100,000. Such bad decision making is probably not orthogonal to their poverty status. Investing in lottery tickets, however packaged, is a great way to stay poor.

So I found it interesting that the otherwise sober Arnold Kling fell prey to the bias of finding these highly volatile--and uncertain--investments:

What if, instead of borrowing, students could arrange for investors to pay their college bills in exchange for a fixed percentage of their future income... If I were an investor in this market, I would be inclined to make Black Swan style bets. Philosophy majors, for example. Sure, a lot of them will end up as pathetic adjunct professors. But some of them will eventually apply their intellect and creativity to business.

to reiterate, in a different post he noted:

I'd invest in philosophy majors! (But I still think they have the best option value, and that a few of them will be very rich in a decade or two)

Basically, Kling hypothesizes that those wild, free thinking philosophy majors will have a higher average income because of a few 'whales' in their sample. A couple Steve Jobs or some other dreamer. Kling has fallen victim to the allure of hope, in that for things we have no data on, the classes of investments with conspicuous winners seem attractive. Thats why every millionaire from Ebay or Amway, or home forex trader prominently shills a 'system' and says you too can be rich 'just like me'. It's a nice thought, usually packaged with lots of motivational speaking themes, stuff from What the Bleep do You Know, etc. But its all untrue. These are scams that make money for those selling hope . There are a couple success stories to be sure, but they are exceptions, and not sufficient to make the mean look good, any more the success of famous athletes and rappers implies it is a financial advantage to be a poor black kid.

Of course, I can't prove this (I bet it's in a paper somewhere), but the bias suggests Kling is wrong because he thinks too much of conspicuous successes, and using the dreaded 'availability hueristic', does not adequately represent the mass of philosophers who end up wearing a name tag at work. Gambling, Buffet would note, is investing based on hope as opposed to an edge, and hope is anything but audacious, it is all too common.