Why Lotteries are Great Investment for Poor People

by JT McGee

Scratch off tickets, lottery, lottery investmentsThe lottery is supposedly one of the worst of all economic institutions as it presents a guaranteed method to lose money over the long-run.

In the past, I’ve written about why I buy lottery tickets, and I even provided a logical explanation for lottery ticket purchases later that week.

I still think the lottery is a fantastic investment for most everyone, due to what is known as the “small to big transformation.” That is, the lottery provides a vehicle through which $1 can become $5,000, or even $300 million, if you’re a lucky son-of-a-gun like this guy. The alternative is losing only a small amount of money—an amount so small it hardly makes a difference.

Commitment Devices

The lottery is just one of many so-called commitment devices, an economic institution that forces us to commit to a certain task, goal, or objective. Some of the more common commitment devices include a gift to ourselves for weight loss, a vacation after months of hard work for a promotion, etc.

Layaway, a service that many retailers are bringing back, is another commitment device. One must contribute regularly to a big purchase in order to ultimately receive the good or service he or she wishes to purchase.

The lottery is an excellent commitment device. Those who play the lottery regularly are more likely to be poor, less likely to have a bank account, and naturally less likely to save for major purchases. (The middle class can’t even be bothered to save for retirement.) The lottery presents a unique kind of savings vehicle through which one can make routine “contributions” in exchange for a large, lump sum payment every once in a while.

Thus, lotteries are actually good for poor people.

Scratch-Offs are Better than Bank Accounts

While a lottery player may lose frequently, they won’t lose much in the long-run. Many scratch-offs, for example, pay out some 60-70% of the total amount “invested.” Similar contributions to a savings or checking account may have a very similar return, since the real rate of interest is currently negative, and because major banks now charge $10+ monthly fees for checking accounts. (Bank of America currently charges $12 per month.)

If the choice was to save $40 per month in a checking account at a major banking institution, or invest $40 in scratch-offs, a saver would realize virtually similar outcomes. Each month, the $40 saved in a bank account would turn into $30 due to fees, whereas the $40 would result in $30 of winnings, on average.

However, there is a behavioral benefit to purchasing lottery tickets—the payoffs are random, and always larger than the initial investment.

Lotteries force good, but irregular spending habits. Someone with ordinarily poor spending habits would rob their bank blind at any chance to spend a few dollars. Someone with ordinarily poor spending habits cannot rob their lottery “bank account,” and can thus spend their earnings only when the lottery rewards them with a payoff. It’s all about time preference.

We know that people spend their money wisest when it comes in large quantities. Large lump sum payments (such as tax returns and stimulus checks) are more likely to be saved or spent on major purchases like washing machines, ovens, or so-called “durable goods.”

Lotteries as Free Welfare Programs

The lottery would be better used as a welfare program. Rather than seek profitability from the lottery, we should seek break even, with smaller margins.

Lotteries should be as close to zero-sum as possible, while remaining incredibly democratic in their rewards. That is to say that the pay-off should be kept as close to 1:1 as possible, and the payoffs should be smaller (1,000-$1,000 prizes instead of $1,000,000 prizes) in order to encourage good savings habits for as many people as possible.

Does it provide a real fix to the problem? No, of course not. It does not promote behavioral change, though it is likely just as effective.

Lotteries are to savings what debt snowballs are to debt reduction. Dave Ramsey doesn’t agree – he says lotteries are a tax on people who can’t do math – but the math, in this case, makes perfect sense to me.

Lotteries could be far better for the poor than a bank account.

Photo by: qnr

{ 10 comments… read them below or add one }

PKamp3 November 28, 2011 at 12:43

“The lottery presents a unique kind of savings vehicle through which one can make routine “contributions” in exchange for a large, lump sum payment every once in a while.” – I’m not convinced. The people I know (I know, the plural of anecdote is not data) who play regularly are more likely to say, “I’m lucky; I’m going to spend this money I just won on more tickets!” then to go to the bank and make a deposit. Maybe the lottery is good for a little entertainment but I don’t think it’s a good savings vehicle (even if it were zero-sum, luck would redistribute the money to someone – and expenses would slowly erode the principal). Also, lottery tickets make great gifts – so I end up playing a fair amount of scratch tickets during this season…

Of course, a lottery is just insurance without the moral hazard – so I think it is defensible on those grounds… and maybe our insurance purchases aren’t?

An interesting thought, however!

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JT November 28, 2011 at 13:00

People don’t go to the bank after winning a lottery because the people who play the lottery are far less likely to even have a bank account. You seriously know people who would spend all $1,000 of a jackpot on more tickets?

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JT November 28, 2011 at 13:00

The moral hazard is a really good point–that’s a whole different article, but equally interesting!

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Jonathan November 28, 2011 at 12:50

Do checking accounts seriously charge monthly fees now? None of ours do…one from a local bank, one from a credit union, and one from a large west-coast bank. We find it convenient to have the three different banks for various reasons, but if any of them started charging monthly fees, I think we’d find it convenient to have two banks.

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JT November 28, 2011 at 13:10

Yeah, they do – I know it’s hard to think that anyone would pay it. I’ve never seen one, but I bank at a credit union that doesn’t really even have fees for any service.

Thing is, the fees are most often assessed on accounts with total balances of less than a certain amount – $1,000 is the typical threshold. The people who have only $1,000 cash on hand are likely the working poor who have limited access to transportation to another bank, or who lack the financial sophistication to know what they’re getting. Sad, but true.

Fees make sense in a perverse way. It’s difficult to justify a new bank branch, especially in the inner cities. However, if a bank can open a branch and fill it with customers who will pay a $12 monthly fee for checking accounts, then it makes perfect sense to build a new location.

The reality is that most of the customers who pay fees for checking accounts are practically worthless to banks. You’re a real estate investor, so it makes sense for banks to take the loss on managing your checking account in order to get you in the door for a loan on an investment property. Imagine, however, that you didn’t know anything about personal finance, had a very limited income, and would never borrow significant amounts of money from any bank (to finance a home, for example.) Unless a bank can hit you with a monthly fee for managing your account, the bank has no incentive to give you a bank account.

You and I would never accept a monthly fee for a checking account. There is a crisis in this country, however, as some 25% of people are unbanked, or underbanked. I would not be surprised to hear that a majority of people in the United States are either underbanked, or currently paying a monthly fee in exchange for a savings vehicle. It’s data points like these that make me realize how good we have it.

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Barb Friedberg November 29, 2011 at 00:19

As presently structured, lottery wins are very low probability. Thus, a poor place to put your cash. I like your recommendation to restructure with higher payouts and smaller prizes. More winners mean more folks would be happier and wouldn’t risk winning a huge payout and losing it in a few years.

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JT McGee November 29, 2011 at 01:07

They’re very low probability and it’s a shame. More payouts of smaller sizes just makes sense to me, and it would be incredibly beneficial to those who play the lottery even though they really can’t afford it.

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Darwin's Money November 29, 2011 at 00:20

Interesting thesis. I think lotteries are horrifically inefficient (30-40% of the funds are pissed away in state coffers and admin fees before the winners see anything; then, there are taxes to pay on large winnings), regressive taxation tools, so here’s a counter I feel compelled to offer :> :

– If the ONLY alternative were to trade the example $12 monthly fees you cited vs gambling, the thesis might make sense, but that’s not representative of the only real-world options available to the poor. I mean, they could rightly store the money under a mattress and take a 0% return over the losses from lotteries OR checking accounts.

– Next, the thesis assumes they are paying the exorbitant fees because they need a checking account. If the money were diverted to lotteries instead, wouldn’t the person still need access to checks anyway as part of their everyday life (and hence, need a checking account in addition to pissing it away on lottery tickets)? Or if they didn’t need a checking account, then the example above wouldn’t be representative.

– Finally, since one of the reasons people stay poor is high interest debt, wouldn’t they realize the highest return by putting those funds toward paying off high interest revolving debt?

I liked the thesis and it got me to think, but had to add my 2 cents.

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JT November 29, 2011 at 01:04

I’m glad you left your view; always good to have differing opinions. As for inefficiency, I agree entirely. They are horribly inefficient due to admin fees and marketing. There’s no reason to market lotteries, IMO.

I think it’s fairly “real world” for people who are poor with no access to transportation to go to other banks. Sure, my credit union is awesome on fees, but only because they have fewer locations, and a good online banking system. I have access to the internet, and transportation, so it’s not a problem for me.

25% of people in this country don’t have a checking account. And yes, the money is better invested in high interest debt. Getting people to make logical decisions is, for whatever reason, incredibly difficult. Dave Ramsey makes millions a year from people who reject logic and embrace comfort as an alternative.

I don’t even agree with my own article (at least not entirely.) It was really just to make a point that, in light of high banking fees and an unbanked populace, even lotteries aren’t all that bad. In fact, with a few changes, we could have far better outcomes. Adjusted for human irrationality, they could be very, very close to zero-sum.

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Money Infographics April 30, 2012 at 06:32

Big call champ! I’ve never won anything from the lottery or scratchcards, although there’s always a first I guess……

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