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Signs display the jackpots for Tuesday's Mega Millions and Wednesday's Powerball lottery drawings in New York City. Photo by Brendan McDermid/Reuters

What the Mega Millions can teach you about investing

If you are one of the thousands of people trying to cash in on this week’s Mega Millions drawing, it’s easy to think, even just for a second, that you could win the $1.6 billion jackpot.

In reality, you know you have an extremely low chance—1 in 302.5 million to be exact—but that doesn’t stop you from buying a ticket anyway.

That’s because we tend to overestimate the likelihood of events that have a low probability, like winning the Mega Millions, or, in the case of our finances, investing in the next Apple or Google.

And that has big implications for our investments, according to research published by the National Bureau of Economic Research.

People who overestimate the chance of a rare event “tend to over-concentrate their stock holdings in a single company, the one they feel will make them rich,” said Olivia Mitchell, an economist at the Wharton School and one of the study’s authors.

This tendency often leads to a less diverse financial portfolio and costs the average investor about $2,500 per year in lower returns, according to the study.

Others are likely missing out on investing altogether because they also overestimate the chances that a rare negative event, like a stock market crash, will occur. They see investing in stocks as a huge risk and decide not to invest at all, the study found.

The research should serve as a warning, said Nicholas Barberis, a professor of finance at the Yale School of Management who was not involved in the report but has conducted similar studies.

“We should realize we are going to be excessively drawn to lottery-type investments, so we should be cautious,” Barberis said.

If you are thinking about investing in a company that is going public, think twice: It’s likely that people are overweighting their odds that the company will do well, and that makes the stock price overvalued, Barberis said.

On the other hand, if you are too scared to invest, it might be worth taking a moment to reconsider. The chances that you will lose all of your money, if you have a diverse portfolio, are extremely rare.

Financial advisors can help steer people away from bad investments or encourage them toward good investment practices.

But financial advisers aren’t immune to this either. Even financially literate people who understand concepts like interest rates, diversification, and inflation still tend to think they can beat the odds, the study said.

It’s less about what people know than how they feel, said Stephen Dimmock, a co-author of the study and associate professor of finance at Nanyang Technological University.

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