The Powerball lottery drawing for Wednesday evening has an estimated jackpot prize of $US500 million.
While that’s a huge amount of money, buying a ticket is still probably a losing proposition.
Consider the expected value
When trying to evaluate the outcome of a risky, probabilistic event like the lottery, one of the first things to look at is “expected value“. The expected value of a randomly decided process is found by taking all of the possible outcomes of the process, multiplying each outcome by its probability, and adding all of these numbers up. This gives us a long-run average value for our random process.
Expected value is helpful for assessing gambling outcomes: If my expected value for playing the game, based on the cost of playing and the probabilities of winning different prizes, is positive, then in the long run, the game will make me money. If expected value is negative, then this game is a net loser for me.
Powerball and similar lotteries are a wonderful example of this kind of random process. In Powerball, five white balls are drawn from a drum with 59 balls, and one red ball is drawn from a drum with 35 balls. Prizes are then given out based on how many of a player’s chosen numbers match the numbers written on the balls. Match all five white balls and the red power ball, and you win the jackpot. In addition to the jackpot, there are several smaller prizes won for matching some subset of the drawn numbers.
Powerball’s website helpfully provides a list of the odds and prizes for each of the possible outcomes. We can use those probabilities and prize sizes to evaluate the expected value of a $US2 Powerball ticket. Take each prize, subtract the price of our ticket, multiply the net return by the probability of winning, and add all those values up to get our expected value:
At first glance, we seem to be in good shape: We get an expected value of $US1.21 for our $US2 ticket, nice and positive. This seems to indicate that a Powerball ticket might be a good investment.
Annuity vs the lump sum
Of course, that is a vast oversimplification. First, the headline $US500 million prize is paid out as an annuity: Rather than getting the whole half billion all at once, you get the $US500 million spread out in smaller (but still multi-million dollar) annual payments over the course of 30 years. If you choose to take the entire cash prize at one time instead, you get much less money up front: the cash payout value at the time of writing is $US337.8 million.
Despite that much lower value, it turns out that, at a first glance, the one-time cash payment still has a positive expected value:
The question of whether to take the annuity or the cash is somewhat nuanced. Powerball points out on their FAQ site that in the case of the annuity, the state lottery commission invests the cash sum tax-free, and you only pay taxes as you receive your annual payments, whereas with the cash payment, you have to pay the entirety of taxes all at once.
On the other hand, the state is investing the cash somewhat conservatively, in a mix of various US government and agency securities. It’s quite possible, although risky, to get a larger return on the cash sum if it’s invested wisely. Further, having more money today is frequently better than taking in money over a long period of time, since a larger investment today will accumulate compound interest more quickly than smaller investments made over time. This is referred to as the “time value of money“.
Taxes make things much worse
As mentioned above, there’s the important caveat of taxes. While state income taxes vary, it’s possible that combined state, federal, and in some jurisdictions local taxes could take as much as half of the money. Factoring this in, if we’re only taking home $US250 million, we move into negative expected value territory, making our Powerball “investment” a bad idea:
The hit to halving the cash one-time prize is equally devastating:
Factoring in taxes, then, buying a Powerball ticket becomes a losing proposition.