Stefan decided to win the lottery.
Not by following the “play and pray” method employed by dreamers the world over. Each paying an idiot tax to purchase a vanishingly small chance that all their money problems will be instantly cured by magic.
Hope is not a sound financial plan.
Stefan approached winning the lottery as a business.
His business plan was simple. Identify occasions when the total prize pool exceeded the cost of purchasing all the number combinations by a factor of three.
One for the prize.
Two for the taxes.
Three for contingency.
Assemble a syndicate of investors to finance those purchases.
Hire legions of temporary staff to purchase each of the millions of potential number combinations at local convenience stores, gas stations, and supermarkets.
Coordinate the process. Ensure no combination was missed. No ticket damaged, lost, or stolen.
Manage the claims for prizes won. The first division jackpot, plus hundreds of lower-division wins.
Fight the inevitable lawsuits that would follow the win, amidst claims of “cheating” and not playing fair.
Distribute the profits to his investors, after deducting a handsome performance bonus for himself.
Stefan understood that no business endeavour is without risk. The jackpot may be split with other players who also happened to choose the winning combination. He felt it was a risk worth taking.
After all, it required not one but two people winning the lottery, and what were the odds of that?
Stefan’s syndicate did win the lottery. A total prize pool worth almost £40,000,000 in today’s money.
An achievement worthy of celebration. But winning was only the beginning of the story.
Repeatable
Doing business is the repeatable act of two parties exchanging something of perceived value for mutual benefit.
On one side of the equation is the seller of goods or services.
On the other is the customer who wishes to purchase those goods or services.
Sounds simple, right? Except it isn’t always immediately obvious who the customer actually is.
In Stefan’s case, the customers were his investors.
His business was not winning the lottery itself. It was selling shares in a potential lottery win.
This was a dream he was able to sell repeatably, thousands of times over, to his syndicate members.
If the plan succeeded, each investor would receive a share of the winnings after costs and taxes were deducted.
If it failed, the investors would lose their stake. Stefan would have lost nothing more than his time.
Each investor contributed roughly the equivalent of £4,225 to the endeavour. Supplying the working capital required to hire the temporary staff, purchase the lottery tickets, and manage the process.
After accounting for costs, taxes, and paying Stefan a handsome performance bonus, each syndicate member stood to receive the equivalent of £6,225.
A profit of nearly £2,000. Representing a return on their investment of 47%.
Not a bad result. A return that traditional asset classes such as shares or property would be hard-pressed to match.
If this were a Hollywood movie, at this point the credits would roll over the happy ending. Self-congratulatory pats on the back. High fives all around. A business plan that proved to be both profitable and successful. Creating thousands of satisfied customers, who would each evangelise about Stefan’s repeatable process for generating riches, and undoubtedly line up to do it all again.
But the story doesn’t end there.
Value
It is an exceedingly rare thing for a business deal to genuinely yield a win-win outcome. Equally good for both parties.
More often than not, there is a winner and a loser.
Sounds simple, right? Except it isn’t always immediately obvious who the loser actually is.
Misaligned commercials muddy the waters. Corporate procurement or the awarding of government contracts provide some good examples. Entrusted to use shareholder capital or taxpayer funds wisely, the stewards of those monies go shopping.
Suddenly they find themselves popular and in-demand. Showered with love and attention. Corporate hospitality in all forms, graft and corruption aplenty.
Conventions or courses.
Dinner or drinks.
Jollies or junkets.
Tickets to theatres of all kinds, musical, sporting, or otherwise.
Admission to the cool kids club for networking opportunities and potential future recruitment.
Yet if those stewards were not spending the money like it is their own, then they care little for the value that a deal represents. Something anyone involved in consulting, “enterprise” sales, financial planning, outsourcing, or wealth management knows all too well!
If there is the perception of a good deal then both parties leave the negotiating table happy.
Inflated list prices, which are then liberally discounted to create the impression that the “savvy” buyer has had a victory and secured a good deal. Few stop to consider what would actually represent value. Perceptions subconsciously influenced by the asking price. Satisfaction determined by the discount they were able to achieve from it. Behavioural psychology. A retailer’s trick as old as time.
In Stefan’s case, there was a twist in the tale.
The lottery jackpot the syndicate won did not get paid out as a single lump sum. It consisted of a series of annual fixed payments spread out over twenty years.
His investors would still recoup their investment and receive their profits. Eventually.
This meant the cash flow profile of Stefan’s business was similar to that of an insurance company.
Insurers receive premium amounts from customers upfront and in full at the start of a policy period. They have full use of those funds, interest-free, throughout the life of the policy. Providing the insurer can make good on any claims which might arise, they can invest the premiums however they like.
It is this cash flow profile that explains why Warren Buffett loves the insurance business so much!
Which brings us to the real purpose of Stefan’s business: financial alchemy.
Stefan performed an impressive arbitrage trick.
He sold the cash flow stream from the lottery win to a life insurance company for the equivalent of £20,000,000.
He then purchased a fixed-term annuity to cover the annual payments owed to his investors, at a cost of £15,500,000 in today’s money.
Stefan pocketed the difference. Walking away with the equivalent of more than £4,500,000. In cash.
Stefan’s customers received the product he had sold them: a share of a guaranteed lottery win.
Their profits were unchanged, though the staggered payment schedule of the lottery they won meant their investment timescales had extended from the immediate to a couple of decades long.
Yet, something about the experience left a bad taste in their mouths.
Perception
There was nothing in the arrangement that said Stefan was going to be making millions from the deal.
He had not contributed any capital.
He had no skin in the game.
He had taken no risk.
Of course, there was nothing in the arrangement that said Stefan couldn’t do what he did either!
That outcome influenced the investor’s perception of the value proposition.
They hadn’t made millions, but Stefan had.
They had to wait for decades to see all of their profits realised, but Stefan didn’t.
It wasn’t fair. It wasn’t just. It didn’t seem right.
Many of the investors experienced buyer’s remorse. No longer willing to shout from the rooftops about their 47% returns. Cool on the prospect of lining up again for another guaranteed lottery win.
The investors hadn’t realised that they were the customers. That Stefan was like an active fund manager, selling the customer’s own hopes, dreams, and greed back to them.
None had understood that the lottery win was incidental to Stefan’s business. His money was made from finding gullible folks who were willing to buy into his claims of having a foolproof path to riches.
They failed to notice the misaligned commercials, where what was good for Stefan differed from what was good for them.
In hindsight, they should have asked what was in it for Stefan? Why would he be content with a nominal performance bonus, when he could have won the entire lottery prize for himself?
They misunderstood the difference between a one-off windfall gain and a sustainable repeatable revenue stream. Their lottery win was an example of the former. Stefan’s business selling shares in the potential lottery win was an example of the latter.
Know Your Customer
The doubt and confusion experienced by Stefan’s investors were far from unique. It can often be difficult to determine who is the customer, and how the commercial interests of each party align.
If we follow the money, then it becomes apparent how a business extracts revenue from us, and which of our behaviours they rely upon to maximise their profits.
Sometimes we’re not even customers of the businesses we thought we were doing business with!
Airbnb’s customers are the landlords. Charging between 3% and 16% of the accommodation tariff for use of their portal, payment processing, and customer support services.
We are the customer of the landlord.
Amazon’s customers are often third-party sellers. Levying a collection of fees for using their website, payment processing, customer service, warehouse, and distribution network.
In those cases, we are the customer of the third-party sellers.
Deliveroo’s customers are the restaurants. Hitting them with a fee of up to 35% of the food bill for access to their ordering, payment processing, and delivery driver network.
We are the customer of the restaurant.
Google’s customers are the advertisers. Charging them a fee to have their adverts appear amongst or alongside the results of our internet searches.
We are (occasionally) the customer of the advertiser.
Uber’s customers are the drivers. Stinging them for 25%+ of each fare for using the rideshare booking platform and payment processing.
We are the customer of the driver.
In a stock market IPO, Venture Capital firms and the financiers who provided seed capital to the company being listed seek a major payday exit from their investment by selling shares at inflated prices.
As retail investors, we are the customer of those profiting from the IPO sale.
Mutual benefit
Take a moment to think about the current relationships you have with financial service providers.
Do you understand how they make money? Is it from you? If not, are you really the customer?
Are their recommendations made with your best interests in mind? Or their own?
What conflicts of interests exist? How might the commercials be misaligned?
Is your financial planner, mortgage broker, private banker, or wealth manager providing good quality advice that is appropriate to your circumstances?
Or are they motivated by performance bonuses and trying to hit sales targets?
Stefan was able to retire to a beach house on the island paradise of Vanuatu. None of his investors were able to do the same.
References
- Airbnb (2020), ‘What are Airbnb service fees?‘
- Amazon (2020), ‘Let’s talk numbers‘
- Crockett, Z. (2018), ‘The man who won the lottery 14 times’, The Hustle
- Elkins, K. (2016), ‘Why the strategy one man used to win the lottery 14 times won’t work for you today’, Business Insider
- Federal Reserve Bank of Minneapolis (2020), ‘Inflation Calculator‘
- Google (2020), ‘Pricing at a glance‘
- Harris, J.F. (1992), ‘Australians luck out in VA. lottery’, The Washington Post
- Helling, B. (2020), ‘Uber fees: how much does Uber pay, actually? (with case studies)’, Ridester
- New York Times (1992), ‘Group Invests $5 Million To Hedge Bets in Lottery‘
- OFX (2020), ‘Historical Exchange Rates‘
- Shead, S. (2020), ‘Restaurant owners in Britain call on Deliveroo to drop commission fees’, CNBC
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Steveark 11 September 2020
One of my engineers only played the lottery when the odds were in his favor. He explained the story you told so well, to me. It always confounded me that a one in a million chance makes sense if the payout is high enough. To me it felt like buying lightning strike insurance. No payout felt right if the odds of attaining it are infinitesimal. But math says he was right.
{in·deed·a·bly} 11 September 2020 — Post author
Thanks Steveark.
I think many people have a poor grasp of probability.
When they hear “one in a million” they think it is an infinitesimally small chance of occurring. What they fail to realise is that in a country with a population the size of the United States, it means that at least 300 people are likely to be experiencing that exceedingly rare event at that very moment!
I’ve done enough work with clients in the insurance sector to have learned their businesses exist to trade on this ignorance, their profit margin exists in that space between how likely we believe an event to be and how likely it will actually occur.
When it comes to the lottery, playing with only one ticket is only ever foolhardy. The chances of choosing the correct numbers in a specific draw can be 1 in 139,838,160. Playing all the numbers, like Stefan did, does make sense. It was for this reasons that all the US state lotteries subsequently changed their rules to outlaw systematic ticket purchases on an industrial scale. They rely on the idiot tax as a source of revenue, so paying out the full prize pool in every draw would be bad for business.
Bob 14 September 2020
I had not heard the term “idiot tax” referred to lotteries before. Personally I would use the term “desperation tax”, if I had to use the term at all.
There are vast swathes of the populace for who opportunities are thin. A small tithe every month gives some tiny hope. I recall in the sixties, when betting was illegal, the jute mill workers placing small bets with the illegal street touts. The loss was small but a win was a family fish supper.
Having said that, I would ban all gambling, bingo, tombola ads on TV. It feels like the target market is lonely, insecure or mentally ill people.
{in·deed·a·bly} 14 September 2020 — Post author
Thanks Bob.
Banning gambling is an interesting idea, though it raises the question of what constitutes “gambling“?
Is day trading gambling?
Options, futures, or FX trading?
Property speculation? Buying gold?
Running for electoral office?
Acquiring collectibles, such as antiques, art, cars, memorabilia, whiskey, or wine?
How about incurring student debt studying a liberal arts or Earth sciences degree, in the hope of securing employment as a management consultant upon graduation?
At their heart, without inside information or the ability to manipulate the market, all of these activities involve taking a punt on an uncertain outcome. Then hoping that the gods of chance smile upon the player.
Fundamentally none of these activities are all that much different from backing a horse or hoping that a specific set of lottery numbers are drawn.
Bob 14 September 2020
It was just the gambling ads I was thinking of. Not the whole industry. The ones where attractive people seem to be in happy social gatherings playing some crap game for money . Whereas in reality they are alone on their phones spending the rent money.
{in·deed·a·bly} 14 September 2020 — Post author
Fair enough.
The last time I watched the cricket at Lords, most of the fans had betting apps open on their smartphones. They appeared to spend more time staring at their screens than watching the play or enjoying an excuse to drink beer in the sun with their mates. A shame really, noticeably changed the atmosphere in the stands. More tension. Less fun.