Is investor attraction to high-reward/high-risk (lottery) stocks a crucial contributor to stock return anomalies? In their May 2020 paper entitled “Lottery Preference and Anomalies”, Lei Jiang, Quan Wen, Guofu Zhou and Yifeng Zhu aggregate 16 measures of lottery preference into a single long-short factor via time-varying linear combination. Examples of the 16 measures are: maximum daily return last month; average of the five highest daily returns last month; difference between maximum and minimum daily returns last month; and, skewness of daily returns the past three months. They then test the ability of this lottery preference factor to help explain a set of 19 stock return anomalies previously unexplained by a widely used 4-factor (market, size, investment and profitability) model of stock returns. They further study interactions between the lottery preference factor and 11 well-known anomalies by each month during 1980-2018 double-sorting stocks first into fifths (quintiles) based on lottery preference and then within each lottery preference quintile into sub-quintiles based on each anomaly characteristic. Using firm/stock data for a broad sample of U.S. common stocks priced over $1 during January 1962 through December 2018, they find that:
- The 16 individual measures of lottery preference significantly explain differences in returns across stocks throughout the sample period.
- During July 1978 through December 2018, average monthly gross lottery preference factor return is 1.81%, with standard deviation 2.08% and gross Sharpe ratio an impressive 0.87.
- Appending the lottery preference factor to the specified 4-factor model of stock returns significantly improves the power of the model to explain major anomaly returns. Specifically, the 5-factor model explains 12 of 19 anomalies unexplained by the 4-factor model.
- Economic significance of 11 well-known anomalies depends crucially upon lottery stocks. Specifically, momentum, idiosyncratic volatility, beta, financial distress, asset growth and profitability factor returns are much stronger among lottery stocks than other stocks.
- The strengthening of anomaly returns by lottery stocks concentrates in short sides of long-short factor portfolios. In other words, average returns of short sides are much lower for lottery stocks than other stocks, apparently because investors are reluctant to short lottery stocks due to risk of large price jumps. Average returns for long sides are not significantly different for lottery stocks versus other stocks.
In summary, evidence indicates that stocks exhibiting lottery-like behaviors are important in explaining many widely accepted long-short stock return factors, because investors are wary of shorting them.
Cautions regarding findings include:
- Return data are gross, not net. Accounting for monthly portfolio reformation frictions and shorting costs would reduce all returns. Lottery stocks may be especially costly to trade/short because of wide bid-ask spreads and lack of shares to borrow.
- Calculating aggregate lottery preference is beyond the reach of most investors, who would bear fees for delegating the work to a fund manager.
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