INVESTOR BEHAVIOUR AND LOTTERY STOCKS
There are certain stocks with similar characteristics to lottery tickets, though with a very small chance of winning and a negative average return, why would any investor choose to purchase such “lottery stocks”? This paper investigates investor behaviour, in particular whether they seek out risky investments and the impact this has on investor wealth. We find that certain investors exhibit risk-seeking tendencies, contradictory to the assumption of classical financial theory which assumes that investors are more likely to accept an investment with a certain payoff vis-à-vis an investment with a uncertain but larger payoff, more formally they are risk averse. From an examination of account level information from a leading Australian retail broker, our research finds stocks with lottery-like payoffs underperform, and consequently investors who are risk-seeking earn lower portfolio returns. Furthermore, both risk-seeking investors and risk-averse investors are more likely to make risk-seeking decisions following an earlier portfolio gain. This result supports the ‘house-money’ effect in the behavioural finance literature. In their research, CMCRC PhD candidate Grace Gong and Dr Danika Wright test various definitions of lottery stocks and develop three different approaches to identify such stocks. The first approach identifies lottery stocks as those with high idiosyncratic volatility, high idiosyncratic skewness and low price. The second approach defines lottery stocks for each calendar month as those whose maximum daily returns in the previous calendar month rank in the top 10%. The third approach, developed by the authors, defines lottery stocks for each trading day as those whose maximum daily return over the preceding 20 trading days rank in the top 10%. Findings from all the three methods identify consistent features of lottery stocks: low market capitalisations, low book-to-market ratio, low stock price, and importantly, lower returns than non-lottery stocks. During the 2-year sample period starting February 2010, value-adjusted return differences between lottery stocks and non-lottery stocks are as high as 9% annually, with lottery stocks being the loser. Some investors are more attracted to lottery stocks which have historically provided through–the-roof returns vis-à-vis slow-burners that steadily build in value. Gong and Wright find that many investors forget or ignore the reality that extreme past “wins” are unlikely to repeat. At the same time, their low price makes lottery stocks a “cheap bet”. We find that this bias of risk-seeking behaviour persists even after we control for over-confidence bias. In our sample, some investors allocate a large proportion of their portfolio into lottery stocks. We classify investors with an average lottery-stock holding weight in the top 10% of all investors as risk-seeking. While these risk-seeking investors are more likely to hold lottery stocks, risk-averse investors avoid them. Our analysis shows that following a profit on an existing portfolio, both categories of investors are more likely to purchase lottery stocks. What’s more, a prior gain affects risk-averse investors even more than it does risk-seeking investors. In other words, no one is completely exempt from the lottery-seeking bias. So why does it matter? The analysis of investor behaviour is an emerging area for research and industry practice. Given lottery-stocks’ poor performance, it follows that investors who prefer lottery stocks have poor portfolio performance. Our analysis of portfolio returns supports this hypothesis: risk-seeking investors underperform by 3% a year when compared to investors who do not have such a bias. This has implications for portfolio analysis and financial advice. In the stock market it is not the case of “he who dares wins” gambling with lottery stocks does not bring better fortune than rolling the dice.