Wednesday, September 30, 2009

The Power of Imagination

For the most part, people are not well-equipped to handle probabilities. When it comes to flying, either we imagine an uneventful flight and get on, or we imagine a crash and refuse to get on. Discussion of probabilities of various outcomes does little to influence behaviour.

A good example of this phenomenon is the willingness of people to buy lottery tickets. In Canada’s Lotto 6/49, only 47% of money collected is returned in prizes. This means that the average $2 ticket gets back only 94 cents. And from an investment perspective, the volatility of the returns makes the ticket worth even less than 94 cents.

However, none of this makes any difference to the thinking of lottery players. Many will say that they play for fun, but the truth is that they can imagine winning, and that’s enough to keep them playing. A long run of lottery ads even used the line “imagine the freedom.”

Most businesses that sell goods attempt to sell extended warranties along with their electronics, furniture, and other items. Part of the sales pitch is to plant the idea that something could go wrong (but not until after you seem fully committed to buying the item). You imagine that something might go wrong, and you become tempted to buy the warranty.

Of course, most of these goods have at least a year-long manufacturer’s warranty. Odds are that if something does go wrong, it will happen in the first year. And the price of extending the warranty to 3 years usually vastly overstates the odds that something will go wrong. Thus, the warranty price is almost pure profit. But, these facts carry little weight with people who become nervous and imagine their new purchase breaking.

Online poker sites offer “free rolls,” which are tournaments that require no money to enter, but have prizes. The idea is to draw players in and ultimately get a fraction of them depositing some of their money to play.

One free roll I’ve tried takes 9000 players and gives the top 72 players a ticket to a second level tournament (with about 5000 players) that pays a total of $2000 in prizes. The average player in the first level tournament gets only about one-third of a cent. However, the tournament has $2000 written at the top, and players imagine winning that money.

Even financial advisors use the power of imagination to steer prospective clients. They start with gloomy projections about government old-age programs that leave you imagining being homeless and eating cat food. Then your new plan has a nice chart showing you retiring a millionaire, which conjures up images of an affluent lifestyle.

Much of the advertising we see is designed to get us to imagine something that suits the advertiser. We would do well to focus on the numbers instead of our imaginations when it comes to big financial choices in life.


  1. Or, are we sometimes risk takers instead of risk averse, with a positive taste for risk when the reward is beyond what is thought ever to be possible?

  2. Canadian Investor: Having an appetite for risk explains some behaviour, but I don't think that applies to the situations I describe. People don't buy lottery tickets because they feel like doing something risky; they dream of winning the big prize. Buying an extended warranty isn't what one does to add more risk to life. Playing poker without committing any money isn't risk-loving behaviour.

  3. Sometimes a warranty is warranted (like if you are buying a poorer quality vehicle), however, it is rare that the "gamble" on buying a longe term warranty pays off.

    As for lottery tickets, they rely on the "Shark bite" phenomenon, where everybody knows of somebody or some friend of a friend who was bitten by a shark, but not that many people get bitten by sharks (same is true for the lottery).

    The most interesting game is KENO, maybe a post on those odds would make people think a bit more?

  4. Big Cajun Man: Of course, you have to wonder why someone would buy a poorer quality vehicle on purpose :-)
    I agree with you about the friend of a friend phenomenon when it comes to lotteries, but I think that just reinforces the mental image of winning. I'd like to think that explaining how bad the odds are in KENO would steer more people away from it, but I think it would only be understood by those who wouldn't play anyway.