Can a financial market investment be compared to a lottery investment? What are the similarities? Which is a better trade?

This piece will try and analyze these and other hopefully interesting conundrums when comparing the two.

I have often been approached by friends/acquaintances asking me to buy a lottery ticket. This only happens when the potential jackpot is a big one, never when it is small. I have always declined much to the chagrin of the friend even though I explain it is not in their interest that I do so.

Why is it not in their interest? The reason whilst self explanatory is almost always never accepted.

Investing in a lottery ticket is not linear. A potential lottery jackpot can only grow if more investors invest in tickets. That is obvious. What is not obvious to my friend the ticket holder, is the reason the jackpot is growing larger quickly is because the number of new investors grows exponentially and not linearly. In other words the number of new investors who participate do so at an ever increasing rate swelling the jackpot further and hence swelling the ranks of new players even more exponentially. This is the reason the size of the jackpot grows so obviously faster and bigger the closer we get to the fateful day of reckoning when the numbers are finally pulled out of the hat.

The end result of this mad frenzy of lottery ticket buying is that the jackpot in many cases ends up being shared amongst a number of winners, the same winners who would have made far more money not trying to entice me into buying a ticket.

So how does this relate to financial product investing? Obvious, it is exactly the same investor mentality that takes place.

The higher the price a financial product goes the more investors it pulls in. This results in its price rising even higher until a buying frenzy materialises resulting in a near vertical, exponential short term upside explosion, similar to the huge lottery ticket buying that takes place in the final countdown.

Why does this happen? Again for the same reasons an ever increasing jackpot draws in exponentially greater numbers of lottery ticket buyers, hype, the media and participant greed.

The end result is also the same. The vast majority lose and only a handful end up sharing the gain.

Ok so now that we have hopefully made a connection between investing in a lottery and in a financial product what can we do to overcome the obvious pitfall which is to overcome sharing the jackpot and keeping most of it for ourselves?

The answer lies in being a contrarian.

There is only one rule in investing that everyone MUST adhere to and that is the rule of “buy low and sell high”. It is the ONLY rule that will make you money. Incredibly it is a rule that very few follow.

The vast majority of market participants like and want to be part of the mass. We like to feel part of the majority. Being a member of the majority crowd is re-assuring, safe, comfortable. Add these psychological factors with a dread of buying a financial product that has/is undergoing a steep fall and we can now understand the mentality of the lottery ticket buyer and the financial product speculator.

Now let us apply this to what we see in the financial market place currently, in other words where are investors the most overweight expecting the biggest jackpot and where are they the most underweight and therefore not buying a ticket?

The recent market turbulence has resulted in a big move out of risk into hard assets in the form of commodities especially crude and the precious metals. Whilst we at TFF believe that this is a good medium to long term strategy, it is not one we wish to participate in at this stage. We are happy to take the opposing view by buying into potential jackpots which are currently small which include first world risk, the USD and emerging markets. We will shun today’s big jackpots which include precious metals, first world government debt and most currencies against the USD.

To summarize never buy a lottery ticket on a friend’s recommendation, always adhere to the only rule that works which is “buy low, sell high” and finally most importantly and the most difficult of all stay away from the in-crowd.

Remember financial markets benefit the small minority at the expense of the vast majority.

Please feel free to read our FUNDAMENTAL MACRO articles here.

This MACRO piece first appeared in the latest edition of FX TRADER MAGAZINE and can be read here.
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