Financial events on both sides of the Pacific Ocean are testing the ability of us humans to keep our emotions out of our financial decisions. On one side we have fear, with China’s stock market plunge. On the other side we have greed, with the Powerball jackpot now worth an estimated $700 million. Ironically, the default reaction of our brains to both is driven by loss aversion.
China’s CSI 300 index plunged 7.2% this morning before circuit breakers halted trading. It was the second time this week that trading was halted following a plunge in prices. Today’s drop followed a devaluation of the yuan and reflected fears about a weakening Chinese economy. Overshadowed by the headlines was a new limit on the amount of stock major corporate shareholders can sell.
The reaction of Chinese regulators was swift. First, Reuters said the People’s Bank of China intervened to reverse the decline in the yuan after the currency fell more than expected. Then the China Securities Regulatory Commission announced it was suspending the circuit breakers.
(It’s worth noting that the United States has circuit breakers as well. Trading is halted for 15 minutes if the S&P 500 falls by more than 7% or 13% before 3:25 p.m. ET. Should the index fall by more than 20% at any time during the trading day, trading in the U.S. will cease for the remainder of the day. Individual stocks may also be halted if their prices move too much in a very short period of time.)
The Powerball jackpot appears likely to set a new record on Saturday night. The previous U.S. record was a $656 million Mega Millions prize won in 2012. Last night, the local news here in Chicago aired a live report from a convenience store. My guess is that we’re going to see more such stories and longer lines inside (and potentially outside too) of stores selling lottery tickets.
What’s often ignored when lottery jackpots grow to huge sums is that the odds of winning do not change. The odds of winning anything, be it $4 or $700 million, are 1:24.9, or 4%. Put another way, when you spend $2 on a Powerball ticket, there is a 96% chance of losing the entire $2. Spending $200 doesn’t change your odds much either. While you might get a few tickets worth $4, there is a high probability that you will have just handed most of your $200 to your state lottery commission.
These odds are no secret. They are widely published and easily accessible. Yet when the jackpot grows large, our aversion to loss kicks in big time. Our minds fear missing out on the chance to win the big jackpot. We are hardwired to believe we’ll lose by not playing. After all, those who do not play are guaranteed not to win. What our brains don’t consider is the expected outcome: playing the lottery is a losing proposition.
This leads to a key problem with economic and financial theories. The human brain does not like to calculate the odds of making and losing money. It prefers to act on intuition, leading to suboptimal and often bad financial decisions being made. Influencing how the brain thinks is loss and risk aversion. As Nobel laureate Daniel Kahneman and his late colleague Amos Tversky found, humans feel greater aggravation from losing a sum of money than pleasure from gaining the same amount of money. You will feel greater aggravation from having wasted $4 on lottery tickets then winning $4. (Four dollars is the payout for matching the Powerball number or matching one number plus the Powerball.)
Which brings us back to China. The drop in Chinese stocks is front and center. If it makes you nervous about the implications for U.S. stocks, realize that you are not alone. You are feeling the pain of wealth lost due to this week's drop (and the volatility of the past few months) as well as the pain of wealth potentially lost in the future. The Chinese news is front and center, so your mind is focused on it even though what really matters is what your portfolio balance will be several years into the future.
I think it’s helpful to simply acknowledge our emotions. If you’re nervous about China, stop paying attention to the financial news. You may also find it helpful to hold the equivalent of one to five years of living expenses in cash, CDs, etc. Doing so can ease your short-term fears about the stock market while still helping you to make progress towards your long-term goals. As far as the lottery, if you really feel the urge to buy a ticket, spend a minimal amount and then put the same amount into in your savings. You’ll satisfy your craving, while still doing some good for your financial well-being.
The Week Ahead
Dow Jones industrial average components Intel Corp. (INTC) and JPMorgan Chase (JPM) will report on Thursday. Joining them will be nine other S&P 500 member companies, including Alcoa (AA) on Monday, CSX (CSX) on Tuesday and BlackRock (BLK), Citigroup (C), U.S. Bancorp (USB) and Wells Fargo (WFC) on Friday.
The first economic report of note will be the November Job Openings and Labor Turnover Survey (JOLTS), released on Tuesday. Wednesday will feature the Federal Reserve’s periodic Beige Book. December import and export price data will be released on Thursday. Friday will feature December industrial production and capacity utilization, the December Producer Price Index, December retail sales, the University of Michigan’s preliminary January consumer sentiment survey, the January Empire State manufacturing index and November business inventories.
Several Federal Reserve officials will make public appearances: Atlanta president Dennis Lockhart and Dallas president Rob Kaplan on Monday; Richmond president Jeffrey Lacker on Tuesday; Boston president Eric Rosengren and Chicago president Charles Evans on Wednesday; St. Louis president James Bullard on Thursday; and New York president William Dudley on Friday.
The Treasury Department will auction $24 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.