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 One sells lottery tickets and the other sells insurance.
Ma pulled off the largest-ever IPO last week when he floated Alibaba
in what might be called the most successful lottery in history, at
least from the ticket seller’s point of view.
But I don’t just mean that in the sense that Alibaba is a major
speculation. Alibaba’s flotation, and IPOs generally, are lotteries
in a very specific and technical sense, and they are structured in
the way that they are because the market makes such a fantastic bid
for them.
Buffett, in contrast, has made much of his fortune selling
insurance, which is a kind of anti-lottery ticket; insurance doesn’t
give you a small chance of getting rich it gives you a reduced
chance of getting poor.
Both products, IPOs and insurance, are by definition mis-priced,
which is what helps to make them such great businesses. And when I
say mis-priced, I speak not simply of the reality that all
businesses must turn a reasonable profit or cease to be, but rather
that they offer fat margins to sellers not justified by their
benefits.
“The empirical evidence is unambiguous: Selling insurance and
selling lottery tickets have delivered positive long-run rewards in
a wide range of investment contexts. Conversely, buying financial
catastrophe insurance and holding speculative lottery-like
investments have delivered poor long-run rewards. Thus, bearing
small risks is often well rewarded, bearing large risks not,” Antti
Ilmanen, of AQR Capital Management, wrote in a 2012 survey of the
phenomenon published in the Financial Analysts Journal.
At the heart of all this is a concept called skewness, an ugly word
for a simple concept. Skewness is a measure of asymmetrical
outcomes, or in an investment context, returns.
Lotteries have positive skewness because, while most of the outcomes
are losers, some small number of ticket holders strike it rich with
outsized rewards. Sellers of insurance, on the other hand, accept
the possibility of getting hit with a big loss in extreme events,
but do so in exchange for usually making small regular gains.
A SKEW-ED WORLD
A number of investments act like lotteries, two excellent examples
being small-cap growth stocks and IPOs. While a small number of
small-cap growth stocks hit it big, data from Dartmouth professor
Kenneth French shows that between 1926 and 2011 such stocks
underperformed all of the other five major categories, lagging small
value issues, for example, by close to six percentage points
annually.
Another 2012 study found that IPOs which are expected to have a high
chance of providing lottery-like returns, like Alibaba, show worse
negative abnormal returns in the following one to five years.
There are a number of competing theories for why investors love
playing the lottery so much, but one clear possibility is the
'dollar and a dream' school of thought which is so easy to get
caught up in. You only need to see the ticket lines round the block
when the Powerball jackpot hits a record to see this in action.
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Some of this may also be because the risk/reward decisions are being
taken by delegated asset managers, who have a different set of
priorities. Since people like lotteries, money managers are wise to
indulge them, window dressing their funds to show they hold Alibaba
or other hot stocks.
The attractions of selling insurance, a la Warren Buffett, is less
about hope and more about fear, which too can tend to be
over-priced. Investors, and the managers who represent them, have
very good reason to not want to be impoverished by a huge draw-down
in the event of a crash, or any other kind of low-probability event,
and pay high premiums to be relieved of the possibility.
Several strategies which do well steadily but sometimes come
completely unstuck, such as foreign-exchange carry trading and
merger arbitrage, show long-term positive rewards often higher than
typical equity risk premiums. Of course they also carry with them
the possibility of ruin, especially considering that, at least in
financial markets (as opposed to physical insurance) bad events
often run together.
And remember too, the kind of insurance Buffett has sold so
successfully is not simply the kind you buy for your car or house,
it is also injections of capital such as the $5 billion he injected
into Goldman in the dark days of 2008.
No-one knew if Goldman would survive, just as no one knows when the
next big California quake will come.
Insurance, then, is expensive because it is hard to price, while
lotteries are expensive because we all love to dream.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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