Analysts playing the lottery (stocks)

Playing the lottery is commonly frowned upon by educated people as a “tax on people who are bad at maths”. And that’s true, playing the lottery may be “a bit of fun” but it is costly fun because on average you lose money for the small chance of winning the jackpot. It’s a bit like smoking. If you do it once it is fun, but do it long enough and it will become very costly indeed.

The problem is that while it is easy to see that playing the lottery is a losing game, lotteries come in different shapes, and even highly trained analysts and portfolio managers engage in playing the lottery. In this case, I am talking about lottery stocks, i.e. stocks that have a lottery-like payoff where the most likely outcome is a negative return on investment but there is a small chance of a very large profit. Typically these are stocks of companies that burn cash (Gamestop, AMC, WeWork, or Tesla before it became profitable, come to mind). They promise high growth in the future if their business investments work – and bankruptcy if they don’t.

You might say that the examples of lottery stocks I gave are all stocks that are very popular with retail investors and there are plenty of professional investors who have warned against investing in them. Indeed, I am one of the people who have warned against investing in these stocks, for example here and here. Unfortunately, while these warnings most of the time come true, there are the exceptional cases when a lottery stock manages to hit the jackpot, at which point sensible professionals look stupid (I admit to being a Tesla bear for a long time and looking very foolish for doing so).

But the stocks I mentioned are only the most extreme cases. There are thousands of lottery stocks in the form of fast-growing young companies or companies with a broken business model engaging in a turnaround attempt. And with these stocks comes a big problem. They play into our human weakness of not being able to deal with probabilities very well. Cumulative prospect theory describes how everyone overestimates the likelihood of a rare event while underestimating the likelihood of a common event. For example, an event may happen in 5% of all cases, but we treat it as if it were to occur in 7% or even 10% of all cases. Meanwhile, an event that may occur 95% of the time is treated as if it were to happen only 90% of the time.

If we deal with lottery stocks, this propensity to overweight rare events plays against us because we tend to become too optimistic about the prospects of a company. A study of earnings forecasts by professional equity analysts showed that even these professionals are not immune to this bias. The more lottery-like the return profile of a stock was, the more optimistic the forecasts of the analysts were. And the fewer information analysts had to sense-check their forecasts, the more optimistic their forecasts became. If a company is very small and only covered by a few analysts, analyst forecasts become more optimistic than for widely covered stocks. And of course, the more excessive this optimism becomes, the more likely it becomes that the forecasts are wrong. And not just a little bit wrong, but very wrong.

But there is one factor that reduces this bias of analysts when dealing with lottery stocks: Experience. The more experience an analyst has with a stock or the industry the stock operates in, the less likely he or she is going to make excessively optimistic forecasts. Analysts seem to learn from their mistakes and over time gravitate to more middle-of-the-road forecasts.

Personally, I know that I am not better than other analysts and am prone to fall prey to overoptimism just like other investors. But over the years, I have developed tools to re-calibrate my biases and gradually reduce them. One such technique is investment diaries as I have described in my book. And in my professional publications, I make a point to always show the performance of past recommendations to make sure, I cannot get away with wrong forecasts.

Fighting these biases that make me a worse investor also has led me to develop my 10 rules of forecasting. Rule number 2 is key here:

Don’t make extreme forecasts. Predicting the next financial crisis will make you famous if you do it at the right time but will cost you money and reputation in any other instance. Remember that there are only two kinds of forecasts: lucky and wrong.

Unfortunately, it takes time and experience to learn this rule, even if you are a professional investor.