The Hope Premium

It is a strange fact that for many professions, the odds of success are extremely low, and so is the average pay.  For example, many people have dreams about getting into acting, but I’ve seen estimates that only 5% of people who call themselves actors make a living acting, as opposed waiting tables and whatnot.  Similar odds exist for would-be novelists, musicians.  There are the high profile people one thinks of for the categories that act like lotto jackpots, a focal point that overwhelms objective odds. It is somewhat unrealistic, if not cruel, to tell people that chasing their dreams is a waste of time.  People like to dream, and after all, ‘the experts’ are often wrong.  Yet I think this phenomenon suggests that perhaps people accept low average ‘return’, in exchange for the dreams these professions present. 

The inequality in these fields, where incomes have a power law distribution, is not bug, it’s a feature.  The presence of superstars, whose income and status is so high, is the offsetting basis of the dreams for those in the industry, why they are willing to accept less ‘on average’.  In dreams without such opportunities, you need security, or some other offset to compensate. If this is true, it suggests there is a general hope premium in industries, and even assets.  Many financial assets that have the highest volatilities have below average returns, if not negative returns: out-of-the-money call options, Junk bonds, highly volatile stocks, extreme-odds at the racetrack.  We pay to dream, and it can be frivolous, as with the $1 I recently spent on a $206MM lotto ticket Saturday (odds: 1 in 130 million, I did not win), but it can also be a significant part of one’s investment portfolio (not wise, in my opinion, but real). 

People take risk based on hope, and hope is a function of one’s dreams.  In 1961 Walter Gutman wrote a book You only have to get rich once, and noted that "growth stocks might better be called dream stocks", and that ‘dreams are real–we have them every day.  It’s a big mistake to think dreams are unreal and what is called real life is real’.   This is a simple, profound, model of the value effect, where stodgy, low beta firms without much upside generate a higher return than stocks that can be classified by some as the next ‘Yahoo!’ Dreams, in moderation of course, are paradoxically as real as anything, and assets that embolden dreams have extra value for investors, and they are willing to accept a lower ‘average’ return because in taking risk, because they are already ignoring the skepticism of the consensus.

Jonathan Alter recently wrote that we should perhaps pay teachers more, and pay their superstars a lot.  I think the data suggest that if we start paying really large salaries for superstar teachers, we could pay a few of them more, but pay them in aggregate less.  That is, we would have just as much supply if we offered them the hope of become very wealthy, with a lower average pay, than our current system, which pays them a rather solid pay but with very limited upside.  No one with really large ambitions goes into education precisely because they top has a low ceiling.  Hope is worth something, in terms of a higher price, and thus lower  return.

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