Thursday, September 03, 2009

Mega Millions Mentality

By Sam Ro - Last Friday, I did not win the $336 million Mega Millions jackpot. But I played. Sure, the chances of hitting the right numbers are only 1 in 175 million. Even if you hit the numbers, you may have to split the winnings. And this is all before taxes.

But how often are you presented with an opportunity to earn a 336,000,000% pre-tax ROI on a minimum investment of $1? And in the worst-case scenario, you lose a buck.

Obviously, playing the lottery is not a prudent investment strategy. But the mentality of taking unreasonable risks for unlikely returns exists in the stock markets. Consider bankrupt companies whose stocks are worthless. Lehman Brothers (LEHMQ.PK) hit 32 cents on August 31, just a day after trading at 5 cents. Motors Liquidation Company (MTLQQ.PK), formerly known as the old General Motors, traded as high as $1.20 on August 12. Each stock sees millions of trades every day. But neither is trading on fundamentals. Even if a company were to emerge from bankruptcy, the old common equity is almost always cancelled. In other words, the stock price movements of bankrupt companies are not signs of life; they’re more like postmortem muscle spasms during rigor mortis.

However, if you were savvy enough to buy low and sell high in August, you could’ve gained up to 700% on LEHMA and 140% on MTLQQ.

Then there are the stocks on government-sponsored life-support including Freddie Mac (FRE), Fannie Mae (FNM), and AIG (AIG). Even after significant declines in recent days, these stocks are up between 260-350% in just six months. However, many question the rationale behind these price moves. Some analysts have suggested the common equity in these companies could be worth nothing. Even the more bullish arguments for these stocks come with warnings of high uncertainty.

My favorite pitch goes like this: “FRE and FNM were $60 stocks two years ago! They’re trading at under $2 right now! I could see them at $10. But if I get $5, that’s still a pretty good return.” It’s an unsound argument but not unused. Structurally, it’s very similar to the rationalization that goes into buying a lottery ticket: limited downside and tremendous upside. And you have to pay to play.

Perhaps you’re disciplined enough to avoid irrational investment decisions. But it would be totally irrational to ignore the existence of irrational behavior in the markets. According to La Fleur’s World Lottery Almanac, Americans spend around $50 billion each year on lottery tickets. Surely this includes a lot of amateur and professional traders and money managers who are unknowingly bringing that mega millions mentality into the stock markets. They get the newswires about FRE, FNM, and AIG. Some might also follow the pink sheet action of bankrupt companies. They know these are not good investments. But the allure of outlandish gains is irresistible, even if those gains are highly unlikely.

Full Disclosure: Author is long FRE and 1 Mega Millions lottery ticket.