Jack Ma and Warren Buffett embody two great and contrasting businesses in finance.
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. (http://www.cfainstitute.org/learning/products/publications/faj/Pages/faj.v68.n5.7.aspx)
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.
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.
(Editing by James Dalgleish)
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