A Tax on Stupidity?

Like going to the casino, if one analyzes the probability of success on the purchase of a lottery ticket the expected outcome is negative. Or so a self-styled rational being like me thinks. This simple view of the world was upset recently by a fascinating article in the Huffington Post that was brought to our attention by our friends at Northwood Family Office. It’s the story of Jerry and Marge Selbee.

It may surprise some, but lotteries have been around for centuries (as the sarcastic comment from Voltaire suggests). In Colonial America churches, universities and even government bodies sold lottery tickets as a means of generating revenue to pay for roads, schools, or the military. Despite the fact that most players understand that buying a lottery ticket is a “sucker’s bet”, the thrill of the game spurs them on, just as the slot machine does in a casino. As early as 1762, however, lawmakers in Pennsylvania noticed that poor people bought lottery tickets more frequently than the rich. It was apparent, even then, that in many ways the lottery was a tax on the poor.

Today, 44 U.S. states conduct lotteries that generate a staggering $80 billion in ticket sales. By comparison, the U.S. movie industry sells about $11 billion in movie tickets. Eleven states generate more revenue from lottery ticket sales than they do from corporate income tax. And the ugly truth of the lottery remains: it is a regressive form of taxation. Lower income households are disproportionately active lottery players. Yet it is easy for governments to generate revenue through lotteries, and the revenue is impossible to resist.

The story of Jerry and Marge Selbee, however, is that buying a lottery ticket is not necessarily a tax on stupidity. It turns out that in certain circumstances it can be financially rewarding.

Jerry Selbee was a Kellogg’s factory worker and, later, a convenience store owner who had a knack and passion for puzzles and math problems. In 2003, a new lottery in Michigan called “Winfall” caught his eye. It was a game where a player picked six numbers. If you got all six correct you won the jackpot, which was guaranteed at least to be $2 million. You got a lesser prize if you picked five, four, three or two of the numbers. If no one won the jackpot for a few draws then money available for the jackpot swelled. When it crossed the $5 million mark there was a “roll down” where, if no one picked the six correct numbers at the next draw, the payouts increased to those with five, four, three, or two of the correct numbers. What Jerry noticed was that in a roll down, the odds of winning changed dramatically. So long as no one hit the jackpot with six correct numbers in the roll down, playing the lottery in this special circumstance was not a “suckers bet”. It was an investment with a positive expected return! (See the article for more details.)

It took more than Jerry’s mathematical insight to push this story along. In order to benefit from the odds that were in their favour, Jerry and Marge needed to buy lottery tickets in large volume. A single ticket produced a random event. In fact, several statisticians had observed anomalies in various lottery formats in the past. But most were not interested in the grunt work that would be required to exploit it. In order to turn Jerry’s mathematical insight into profit, the effort Jerry and Marge put into their scheme was extraordinary.

At the end of their run, Jerry and Marge were going to separate convenience stores and spending 12 straight hours per day printing out $2 lottery tickets. They spent as much as $720,000 buying 360,000 individual tickets. After each lottery draw it took a full 10 days of 10 hours a day to sort through their tickets and figure out their winnings. But Jerry’s insight proved to be correct. The only time they didn’t profit was when another player claimed the jackpot with six correct numbers. When they stopped playing in 2012 they had grossed nearly $27 million over nine years, and netted $7.5 million before taxes.

The full Huffington Post article is long, but we think it is worth the read. The larger question to ponder is whether there was anything ethically wrong with what Jerry and Marge did? There is little evidence they harmed anyone. And as Jerry said, “if you figured it out and you could do it, would you do it?”

Jerry and Marge were brilliant rather than stupid, but their brilliance could only be rewarded through extraordinary effort. For most of us, lotteries and casinos must remain in the category of entertainment, with a cost attached to it. For reward, most will be better served by entrusting their excess funds with Nexus!