Does retail investor preference for stocks with skewed return distributions explain stock return anomalies? In their April 2018 paper entitled “Skewness Preference and Market Anomalies”, Alok Kumar, Mehrshad Motahari and Richard Taffler investigate whether investor preference for positively-skewed payoffs is a common driver of mispricing as indicated by a wide range of market anomalies. They each month measure the skewness of each stock via four metrics: (1) jackpot probability (probability of a return greater than 100% the next 12 months); (2) lottery index (with high relating to low price, high volatility and high skewness; (3) maximum daily return the past month; and, (4) expected idiosyncratic skewness. They also each month measure aggregate mispricing of each stock as its average decile rank when sorting all stocks into tenths on each of 11 widely used anomaly variables. They assess the role of retail investors based on 1991-1996 portfolio holdings data from a large U.S. discount broker. Using a broad sample of U.S. common stocks (excluding financial stocks, firms with negative book value and stocks priced less than $1) during January 1963 through December 2015, they find that:
- Regarding hedge portfolios that are each month long (short) the value-weighted stocks in the fifth, or quintile, that are most underpriced with lowest skewness (most overpriced with highest skewness):
- Monthly gross abnormal returns across the four skewness metrics range from 1.22% to 1.71%.
- The effect concentrates in short sides of the four hedge portfolios (monthly gross abnormal return contributions 0.98% to 1.40%). More generally, returns of long-side stocks do not vary significantly with skewness, and short-side stocks with low skewness do not significantly underperform.
- Long-only institutional (retail) investors tend to hold more long-side (short-side) than short-side (long-side) stocks. The retail tendency concentrates among investors who also overweight high-skewness stocks.
- A factor that captures skewness-related mispricing significantly improves the power of conventional linear factor models to explain stock return anomalies, particularly those related to financial distress.
- Main findings are robust to controlling for variables that relate to implementation frictions.
In summary, evidence indicates that preference for jackpot-lottery-jumpy stocks among some retail investors drives stock mispricings that underlie many widely cited stock return anomalies.
In other words, stock investors may want to include return skewness sorts as a means to enhance performance of smart beta portfolios.
Cautions regarding findings include:
- Return calculations are gross, not net. Accounting for monthly portfolio reformation and shorting costs would reduce returns. Shorting may not always be feasible as specified due to lack of shares to borrow. Costs may vary across anomalies and skewness metrics.
- Stock selection analyses outlined above may be beyond the reach of some investors, who would bear fees for delegating to an investment/fund manager.
- The investor portfolio holdings sample is stale and may not be representative of current retail investor practices.
- Testing multiple skewness metrics on the same sample introduces data snooping bias, such that the best-performing metric overstates expectations.
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