The Lottery Mindset: Investors, Gambling and

the Stock Market

DOI: 10.1057/9781137381736.0001
Other Titles by the Author

Wai Mun Fong and Benedict Koh, Personal Financial Planning (Prentice Hall), 4th ed, 2011
Wai Mun Fong and Benedict Koh, Personal Investments (Prentice Hall), 4th ed, 2011

DOI: 10.1057/9781137381736.0001
 The Lottery Mindset:
Investors, Gambling
and the Stock Market
Wai Mun Fong
Associate Professor, National University of Singapore,
Singapore

DOI: 10.1057/9781137381736.0001
© Wai Mun Fong 2014
Softcover reprint of the hardcover 1st edition 2014 978-1-137-38172-9
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www.palgrave.com/pivot
doi: 10.1057/9781137381736
 Contents

List of Figures viii

List of Tables x
Preface xii
About the Author xiv

1 A Survey of Behavioral Finance 1

1.1 The behavioral finance paradigm 2
1.2 Investor preferences 5
1.2.1 Mental accounting 5
1.2.2 Preference for concentrated
portfolios 6
1.2.3 Preference for the familiar 7
1.2.4 Preference for lottery-type stocks 8
1.2.5 Preference for active trading 9
1.3 Heuristics 10
1.3.1 The availability heuristic 10
1.3.2 The anchoring heuristic 11
1.3.3 The representativeness heuristic 12
Categorical predictions 12
The “law of small numbers” 14
1.4 Beliefs 15
1.5 Emotions 18
1.5.1 Gains and losses: Prospect Theory 18
1.5.2 Rejoicing and regret 21
1.5.3 Optimism 21
1.5.4 The social psychology of emotions 23
1.6 Conclusion 24

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vi Contents

2 Overtrading 25
2.1 Introduction 26
2.2 Turnover on equity markets 26
2.3 The profitability of individual investor trades 28
2.3.1 US studies 28
2.3.2 Non-US studies 32
2.4 Learning from trading 34
2.5 Do smart investors outsmart the market? 36
2.6 Why do individual investors trade so much? 37
2.6.1 Risk preferences 38
2.6.2 Sensation-seeking 39
2.6.3 Stocks as lotteries 40
2.6.4 Beliefs and sentiment 42
2.6.5 Heuristics 44
2.7 Conclusion 45
3 Trend-Chasing 46
3.1 Introduction 47
3.2 The “hot-hand” fallacy and the gambler’s fallacy 48
3.3 Trend-chasing in stock markets 51
3.3.1 Experimental evidence 51
3.3.2 Survey evidence 52
3.4 Trend-chasing: mutual fund investors 54
3.5 Behavioral biases of mutual fund investors 60
3.6 Trend-chasing behavior in the aggregate stock market 66
3.7 Conclusion 72
Appendix: Dollar-weighted returns and institutional
ownership 72
4 Growth Stocks 77
4.1 Introduction 78
4.2 The value premium revisited 78
4.2.1 The US value premium 79
4.2.2 The international value premium 81
4.3 Lottery stock preference, arbitrage risk, and the
value premium 85
4.4 The Persistence of lottery-stock preferences 87
4.5 Earnings extrapolation and the value premium 92
4.6 Conclusion 94

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 Contents vii

Appendix 4.1: Lottery factors 95

Appendix 4.2: Earnings growth persistence: is it there? 97
5 The Beta Anomaly 101
5.1 Introduction 102
5.2 The beta anomaly around the world 103
5.2.1 US evidence 103
5.2.2 International evidence 105
5.3 The beta anomaly: long-run consequences 108
5.4 Omitted risks 110
5.4.1 Financial distress 110
5.4.2 Liquidity risk 113
5.5 Explaining the beta anomaly 114
5.6 Conclusion 117
Appendix 5.1: Distress and liquidity measures 118
Appendix 5.2: Institutional ownership and the
beta anomaly 120
6 The IVOL Puzzle 122
6.1 Introduction 123
6.2 The IVOL anomaly revisited 123
6.3 Who invest in high-IVOL stocks? 128
6.4 Does idiosyncratic skewness drive the IVOL effect? 131
6.5 IVOL and beta 133
6.6 Conclusion 137
7 The MAX Effect 138
7.1 Introduction 139
7.2 Sizing up the MAX anomaly 140
7.3 Investor sentiment and the MAX effect 143
7.4 Institutional ownership and the MAX effect 148
7.5 Sentiment or fundamentals? 150
7.6 Explaining the MAX effect: salience and lottery
stock preference 153
7.7 Conclusion 155
8 Conclusion 156

Bibliography 159
Index 178

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 List of Figures
1.1 Portfolio pyramid 5
1.2 Prospect theory value function 20
2.1 NYSE average holding period: 1960–2012 27
2.2 Average holding period in Asian stock markets:
2003–2012 28
2.3 Net risk-adjusted returns by turnover quintiles 30
2.4 FF3 factor loadings by turnover quintiles 31
2.5 Alphas of individual investors’ buy-and-sell
trades in Taiwan 33
2.6 Net daily CAPM alphas of day traders: 1992–2006 35
2.7 Percentage of day trading volume among
unprofitable day traders: 1995–2006 36
2.8 FF4 alphas of individual investors by smartness
quintiles 37
2.9 FF4 alphas of portfolios sorted by buyer-initiated
trades and IVOL: small trades 41
2.10 FF4 alphas of portfolios sorted by buyer-initiated
trades and IVOL: large trades 41
3.1 Probability of attributing sequences to basketball
or coin toss 50
3.2 Stylized plot of cumulative average returns:
long-short portfolios formed on three-Month
FLOW 55
3.3 Average excess returns of quintile portfolios
formed on past FLOW 56
3.4 Average excess returns of quintile portfolios
formed on past three-year FLOW and book-
to-market (BM) ratio 59

viii DOI: 10.1057/9781137381736.0002

 List of Figures ix

3.5 Average return of long-short FLOW strategy: new issues 60

3.6 Regression estimates of trend-chasing behavior: past 12-month
returns and behavioral bias proxies 63
3.7 Regression estimates of trend-chasing behavior: past 24-month
returns and behavioral bias proxies 64
3.8 Impact of a one standard deviation increase in a behavioral
bias proxy on annualized return and alpha 65
3.9 Annual scaled distribution of IO quintile 1: 1980–2011 69
3.10 Annual scaled distribution of IO quintile 5: 1980–2011 69
4.1 Value in December 2012 of $1 invested in July 1981 84
4.2 t-statistics of lottery factor regression coefficients 90
4.3 Subperiod alphas of size-sorted value and growth portfolios 91
4.4 Average run rates for operating income: various categories
of firms and time horizon 99
5.1 Average returns of portfolios sorted by firm size and beta 104
5.2 The beta anomaly in international markets: 1980–2012 106
5.3 Cumulative returns of beta-sorted portfolios: 1972–2012 108
5.4 Cumulative returns of beta-sorted portfolios: 1995–2012 109
5.5 Fama-McBeth regression estimates: coefficients on distress
variables 112
6.1 Fraction of IVOL effect due to overpricing of high-IVOL stocks 127
7.1 Firm characteristics of MAX portfolios 142
7.2 Average returns and alphas of MAX portfolios 143
7.3 Post-formation FF4 alphas of MAX portfolios: 1965–2007 145
7.4 Baker-Wurlger sentiment index and closed-end fund
discount: 1965–2010 147
7.5 Alphas of MAX portfolios conditional on investor
sentiment states 147
7.6 Formation period average returns of high and low-MAX
deciles by institutional ownership 149
7.7 The MAX effect in institutional ownership quintiles following
high and low investor sentiment states 151

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 List of Tables
3.1 Factor analysis of behavioral characteristics of
individual investors 62
3.2 Annual scaled distribution by institutional
ownership quintiles 68
3.3 Predictive regressions: annual returns on lagged
scaled distributions 70
3.4 Buy-and-hold returns, dollar-weighted returns
and correlations between scaled distribution
(SDIST) and past month returns, R(-1) across
IO quintiles 71
3.5 Firm characteristics by institutional ownership
quintiles 75
4.1 The US value premium: 1926–2012 80
4.2 The international value premium: 1981–2012 82
4.3 Returns of value and growth portfolios by
firm size 86
4.4 Excess returns and alphas of size-sorted value and
growth stocks by sub-periods 88
5.1 Returns and alphas of beta quintiles: 1972–2012 105
5.2 Contribution of high-beta stocks mispricing
to the beta anomaly 107
5.3 Returns on beta-sorted portfolios controlling
for firm distress 111
5.4 Returns on beta-sorted portfolios controlling for
illiquidity 113
5.5 Firm characteristics of beta-sorted portfolios 116
5.6 Alphas of portfolios sorted by institutional
ownership and beta 121
6.1 Returns and alphas of IVOL-sorted portfolios 125

x DOI: 10.1057/9781137381736.0003
 List of Tables xi

6.2 Returns and alphas of IVOL-sorted portfolios: longer

holding periods 126
6.3 Characteristics of IVOL-sorted portfolios 129
6.4 IVOL effect by institutional ownership 130
6.5 IVOL effect controlling for idiosyncratic skewness 132
6.6 Cross-sectional regressions with IVOL and ISKEW factors 135
6.7 Time series regressions: returns of high-minus-low beta
portfolio on IVOL factor 136
7.1 Descriptive statistics of MAX portfolios 145
7.2 The MAX effect by institutional ownership quintiles 150
7.3 FF4 alphas of MAX portfolios: sentiment and economic states 152
7.4 Predictive regressions: returns of the long-short MAX
portfolio on lagged sentiment macroeconomic variables 153

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 Preface
Individual investors have a striking ability to lose money
in myriad ways. This book catalogues these money-losing
methods, summarizes the research evidence on how badly
individual investors perform, provides new research
evidence, and examines the motivations that lead indi-
viduals to invest in ways which are detrimental to their
wealth.
More than ever, individual investors need help to plan
their finances, and grow their wealth. People today are
living longer than their predecessors. Pension systems
are shifting away from defined benefits plans to defined
contribution plans where individuals make the call on
what to invest, when to buy and when to sell. Financial
markets are growing in complexity, increasing the risk that
investors may be led to investment products and strategies
they poorly understand. Meanwhile, the crisis-ridden
decade of the 2000s is a stark reminder of how the primal
forces of greed and fear can wreak havoc on household
finances.
Where do individual investors stand in the midst of
these dramas? Not on very solid grounds, unfortunately.
Behavioral finance research shows that individuals
systematically make poor investment decisions by under
diversifying, overtrading, chasing past performance, and
gambling in securities with lottery-like payoffs. At the
same time, thanks to advances in psychology and neuro-
science, behavioral scientists now have a much better
understanding of the mental shortcuts used by individuals
to make investment decisions.

xii DOI: 10.1057/9781137381736.0004

 Preface xiii

This book examines common mental shortcuts that influence the

investment decisions of individual investors. Drawing on existing and
new research, it summarizes the behavioral motivations and detrimental
impact of investment strategies that are popular with individual inves-
tors. My hope is that readers of this book will become more cognizant
of their own behavioral biases, avoid serious investment missteps, and
learn to become more successful investors.
Reforming one’s behavior is never easy because many of our decisions
are made subconsciously by what Nobel laureate Daniel Kahenman
calls System I. System I is the source of intuitive thinking. System I is
quick, automatic, and effortless but as Kahneman puts it, it is also “the
origin of much that we do wrong.” Yet there is hope because each of us
is also endowed with System II. Slow, deliberate, and effortful, System II
is the very essence of rational thinking. Reading this book is a System
II activity. Hopefully, doing so will put us on the road to making better
investment decisions.

DOI: 10.1057/9781137381736.0004
 About the Author
Wai Mun Fong is associate professor of Finance in the
National University of Singapore (NUS). Having graduated
with a PhD in 1992 from the Manchester Business School,
he spent several years in institutional portfolio manage-
ment before joining NUS, where has taught Corporate
Finance, Research Methods and currently teaches a course
in Personal Finance and Private Wealth Management.
Wai Mun has written as two textbooks, Personal Investing
and Personal Financial Planning (Prentice-Hall) and also
published widely in leading journals in areas such as
applied econometrics, empirical asset pricing, investments
and behavioral finance. He has extensive experience in
advising many organizations in Singapore including ANZ
Bank, CapitaLand, Citibank, DBS Bank, Ernst and Young,
and United Overseas Bank.

xiv DOI: 10.1057/9781137381736.0005

 1
A Survey of Behavioral Finance
Abstract: This chapter presents the core ideas of behavioral
finance. We provide a glossary of terms used in the field
which will be referred to extensively in later chapters. We
also provide a brief survey of the literature on important
behavioral drivers of investment choice: investor preferences,
beliefs, heuristics, and emotions. Lastly, drawing on the
research findings of neuroeconomics, the neural basis of
rewards, beliefs, heuristics, and emotions that affect investor
behavior will be discussed.

Keywords: beliefs; emotions; heuristics; preferences;

utility maximization

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. Basingstoke: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0006.

DOI: 10.1057/9781137381736.0006 
 The Lottery Mindset

1.1 The behavioral finance paradigm

Much of academic research in finance is built on the idea that inves-

tors are rational. Investors in these models maximize utility using all
relevant information to construct “optimal” portfolios to balance risk
and returns. These rational investors hold well-diversified portfolios to
eliminate idiosyncratic risks that are not rewarded in efficient markets.
They eschew active trading and follow buy-and-hold strategies that
economize on trading costs.
Psychology research shows that real investors do not behave this
way. Behavioral finance, which borrows heavily from psychology, has
produced considerable evidence that most individual investors under-
diversify (Barber and Odean, 2000; Goetzmann and Kumar, 2008),
exhibit a “home bias” in their portfolios (French, 2008; Solnick and
Zuo, 2012), trade excessively (Odean, 1999; Barber and Odean, 2000),
and show a strong preference for speculative (“lottery-type”) securities
such as those with high idiosyncratic volatility and high idiosyncratic
skewness (Kumar, 2009; Mitton and Vorkink, 2007). There is also
evidence that individual investors chase returns both directly and via
mutual funds (Ippolito, 1992; Chevalier and Ellison, 1997; Bange, 2000;
Frazzini and Lamont, 2008; Barber, Zhu and Odean, 2009a, b; Fong,
2014). Importantly, the average individual investor does all of these to
his detriment.
In light of the growing body of evidence that investors are not
completely rational, finance is evolving a new paradigm featuring inves-
tors who often act under the influence of behavioral biases, who trade
on noise as if it were information, and who are sometimes driven by
emotions and sentiment.
Behavioral finance is a big part of this new paradigm. The first
behavioral finance paper published in a top-ranking journal appeared
only in 1972 (Slovic, 1972). Since then, behavioral finance research
has gradually gained momentum. Two decades later, the profession
was confident enough to present an edited volume of collected
papers with the title, Advances in Behavioral Finance. The editor was
Richard Thaler, a pioneer in behavioral finance research. About the
same time, two psychologists, Daniel Kahneman and Amos Tversky,
made seminal contributions to the study of individual behavioral
biases which inspired a large volume of research in both theoretical
and behavioral finance.

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 A Survey of Behavioral Finance 

Kahneman and Tversky (1979) gave the world, Prospect Theory and
its offshoot, Cumulative Prospect Theory (Tversky and Kahneman,
1992) as alternative models of how people actually make decisions as
opposed to how they are supposed to act. In a series of path-breaking
papers, they provide convincing evidence that the carriers of utility are
gains and losses rather than final wealth, and that people’s judgment
is heavily influenced by how a problem is framed (whether as gains or
losses), their point of reference, and a host of other mental heuristics
such as the availability heuristic, the representativeness heuristic, and
anchoring (see Kahneman, 2011). These heuristics are mental short-
cuts that produce quick solutions to the problems people face. While
heuristics can lead to accurate decisions when the environment is
predictable and the decision-maker has true expertise (think doctors
and engineers), they can also lead to errors of judgment outside these
domains. Moreover, due to deep-seated cognitive biases, these errors of
judgment may become systematic: people may repeat these mistakes
over and over again.
This is not a textbook on behavioral finance nor does it provide an
in-depth survey of behavioral finance research. For readers who wish to
get acquainted with the seminal ideas of Kahneman and Tversky, I recom-
mend Kahneman’s (2003) insightful essay, “Maps of bounded rationality.”
Kahneman’s recent book, Thinking Fast and Slow (2011) gives an authoritative
and engaging account of the self-delusions that people fall prey to. There
are also many excellent surveys of behavioral economics and finance. Early
surveys include Thaler (1993), Rabin (1998), and Daniel, Hirschleifer, and
Teoh (2002). Subrahmanyam (2008), Debondt et al. (2008), and Barber
and Odean (2013) are more recent reviews of the literature.
This book is primarily about how individual investors reduce their
wealth through suboptimal investment strategies. As we will show in the
subsequent chapters, behavioral biases play a big role in explaining why
individual investors persistently engage in money-losing strategies.
In general, people’s investment decisions are shaped by four factors:
preferences, beliefs, mental heuristics, and emotions. An investors’ pref-
erence for one type of investment over others is driven by his goals and
risk tolerance. While the traditional view is that all investors are risk-
averse, in reality, people can be both risk-averse and risk-seeking. As
Friedman and Savage (1948) pointed out long ago, people may purchase
both insurance and lotteries. Shefrin and Statman (2000) developed
behavioral portfolio theory to account for this behavior.

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 The Lottery Mindset

Investors’ investment choices also depend on their beliefs about

financial markets and about their investment skills. A robust finding
from psychology is that people are overconfident about their abilities to
perform a variety of tasks such as driving, forecasting election outcomes
and picking stocks (see, e.g., Alpert and Raiffa, 1982; Lichenstein,
Fischhoff and Phillips, 1982; Odean, 1999). In experiments, overcon-
fidence is manifested by subjects expressing overly narrow confidence
intervals. Overconfidence is a powerful explanation of why investors
prefer undiversified portfolios despite their patchy record of earning
positive alphas from stock picking.
Investors’ beliefs are influenced by what others think. When most
investors become overly optimistic or pessimistic about the market,
sentiment-driven trading results. Keynes (1936) points out the possibil-
ity that significant numbers of sentiment-driven traders in the market
can cause asset prices to deviate from their fundamental values. Shiller
(2008) argues that investor sentiment, mediated by social contagion or
herd behavior, accounts for some of the most spectacular episodes of
stock market booms and crashes.
As noted, mental heuristics are rules of thumb that people use to find
adequate but often imperfect solutions to complex problems. We use
heuristics because it is mentally taxing to work out the ideal solution
especially under the pressure of time. According to Kahneman (2011),
the human brain operates at two levels in making judgments: System I
and System II. System I provides quick and automatic solutions to a
problem, while System II is slow, deliberate, and thoughtful. Heuristics
are invoked when System I is in action. The many cognitive biases that
influence individual investors indicate that people often rely on heuris-
tics to make investment decisions, perhaps to a greater extent than they
realize.
Finally, our investment decisions are also influenced by emotions,
particularly, pleasure from gains, pain from losses, pride, and regret.
While scientists still do not have a complete theory of how emotions
govern risk-taking activities, evidence from brain imaging studies clearly
show that brain areas that govern emotional states significantly influence
people’s attitude toward risk and rewards.
The rest of this chapter summarizes research findings from psychol-
ogy, neuroscience, and behavioral finance concerning the key factors
that drive investors’ preferences, beliefs, use of heuristics, and sensitivity
to emotions.

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 A Survey of Behavioral Finance 

1.2 Investor preferences

1.2.1 Mental accounting

Modern portfolio theory (Markowitz, 1952; Sharpe, 1964) prescribes
that investors should diversify optimally by taking into account the
expected returns and correlation of assets. In reality, few individual
investors follow this prescription. Shefrin and Statman (2000) argue that
real investors apply mental accounting to organize their investments.
Specifically, these investors think about their investment goals, then
compartmentalize their goals using mental accounts where each account
comprise assets whose return and risk characteristics match a specific
goal. This approach leads to a pyramid-like structure of investments as
shown in Figure 1.1.
At the bottom of the pyramid is a “safety account” where money
is invested in risk-free assets such as cash, Treasury bills, and other
money market securities. This layer serves as a liquidity fund and also
as “insurance policy” against potential losses from investing in riskier
assets.
Above the safety layer are other investment accounts aimed at achiev-
ing higher returns. As we move up the pyramid, the risk level increases.
For example, the layer above the safety account might be invested in
large-cap stocks and investment-grade corporate bonds. The next layer

Speculative
assets

Small-caps and
stocks emerging
market stocks

Large-cap stocks and

corporate bonds

Cash, money market and

short-term bonds

figure 1.1 Portfolio pyramid

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 The Lottery Mindset

might consist of riskier securities such as small-cap stocks, below-

investment grade bonds, emerging market stocks, and so on.
The top layer of the pyramid is essentially a gambling account.
Securities held here include high-beta stocks, extremely volatile stocks,
stocks with low book-to-market ratios (growth stocks), stocks with
positively skewed returns, and those that have very high maximum daily
returns in recent months. These stocks grab investors’ attention because
of their large price movements and because they tend to attract more
media attention than “boring stocks.”
Stocks with the above characteristics may also be termed lottery-type
stocks. As argued by Barberis and Huang (2008), Barberis and Xiong
(2012) and others, investors buy such stocks despite their low average
returns for the chance of realizing extremely positive (“jackpot”) returns.
Whereas lottery-type stocks have no special place in classical finance
because investors are supposed to diversify broadly, research evidence
shows that individual investors overweight these stocks relative to their
market weights while institutional investors do the opposite. Lottery-
type stocks fit rather naturally under the multiple account framework of
behavioral portfolio theory.
One consequence of structuring investments using the pyramid model
is that one does not explicitly factor in correlations between asset returns
in the way that modern portfolio theory recommends. As such, the over-
all portfolio is unlikely to be mean–variance efficient. Nonetheless, the
pyramid model is popular in real life. For example, contrary to the two-
fund separation theorem, financial advisors often advise risk-tolerant
clients to hold a higher ratio of stocks to cash and bonds compared to
conservative investors (Canner, Mankiw and Weil, 1997). Rare is the
financial adviser who proposes mean–variance efficient portfolios to
his clients. Rarer still is an individual investor who structures his invest-
ments according to the principles of modern portfolio theory.

1.2.2 Preference for concentrated portfolios

A fundamental insight of modern finance is that it is difficult to consist-
ently outperform the market. Diversification is therefore a sensible
investment strategy. The average investor does not follow this prescrip-
tion. Barber and Odean (2000) find that the average US household owns
just four stocks. Goetzmann and Kumar (2008) report that even among
professionals, the mean number of stocks owned is 4.86, while the

DOI: 10.1057/9781137381736.0006
 A Survey of Behavioral Finance 

mean number of stocks owned by experienced investors is less than 6.

Of course, investors can and do diversify in other ways such as through
mutual funds (Polkovnichenko, 2005). Still, US household data shows
that the fraction of directly held equity holdings is significant. Consistent
with other studies, Polkovnichenko (2005) find that about 80% of the
direct investors hold fewer than five companies. The evidence indicates
investors are not unaware of the importance of diversification. Rather,
they choose to hold concentrated portfolios, mostly likely motivated by
a desire for a shot at riches based on the stocks they choose.

1.2.3 Preference for the familiar

People prefer things they are familiar with. There is overwhelming
evidence that investors prefer local stocks to foreign stocks because
companies from their own country are more familiar to them than those
overseas. This home bias leads to portfolios that are less diversified and
more exposed to systematic risk than is warranted. The home bias is not
confined to individual investors. Investment managers too fall under the
spell of the familiar (Coval and Moskowitz, 1999).
Why do investors exhibit such a bias? Kilka and Weber (2000) study
how German and American investors perceive their respective stock
markets. Consistent with the home bias, German investors believe that
the German stock market will perform better than the US stock market,
while American investors express the opposite view. Each side feels
that they are more competent in judging the future returns of domestic
stocks than foreign stocks. This presumed competence may reflect inves-
tor overconfidence in their ability to forecast. Moreover, the persistence
of the home bias could be due to the well-known confirmation bias.
This bias refers to the fact that once people made up their minds about
something, they tend to overweight evidence that confirms their views
and suppress evidence that contradicts them (Nickerson, 1998).
The familiarity bias extends to the choice of stocks locally (Coval and
Moskowitz, 1999). For example, American investors display a bias for
US companies while Japanese investors prefer Japanese companies. In
addition, investors prefer companies with known brands (Frieder and
Subrahmanyam, 2005), most likely because such stocks receive more
media attention. Consistent with this view, there is substantial evidence
that investors prefer to buy stocks that are in the news (Barber and
Odean, 2008; Fang and Peress, 2009).

DOI: 10.1057/9781137381736.0006
 The Lottery Mindset

Perhaps the most dangerous form of familiarity bias is when inves-

tors put all of their pension money in one stock: that of their employer.
According to a 1996 Wall Street Journal report (Schultz, 1996), employees
at 246 of America’s largest invested 42% of overall 401(k) plan funds in the
shares of the firms they work for. A recent Businessweek report (Moore,
2012) revealed that employees at some of Wall Street’s largest banks lost
US$2 billion in their 401(k) accounts in 2011, losses that were amplified
due to narrow diversification. Although ownership of company stock
has decreased over time, as late as 2011, company stock still represents a
sizeable proportion (at least 40%) of 401(k) plan assets in many large US
firms (Blanchett, 2013).
Bertnazi (2001) surveys more than 1,000 401(k) Plan investors to find
out why 401(k) investors put so much of their money on the line. He finds
that 84% of respondents thought that their company is less risky than the
overall stock market. Such confidence is clearly misplaced because no
single stock can be less risky than the market, a fully diversified portfo-
lio. Investors who hold concentrated portfolios are inadvertently treating
their investments as lotteries.

1.2.4 Preference for lottery-type stocks

Kumar (2009) finds that individual investors overweight stocks that have
low prices, high idiosyncratic volatility, and high idiosyncratic skewness
relative to their market weights. Stocks with such features generate occa-
sional large gains but have low average returns compared to nonlottery-
type stocks. Similar to buyers of state lotteries, investors of lottery-type
stocks are willing to accept low average returns for the small chance of
receiving windfalls.
Barberis and Huang (2008) and Barberis and Xiong (2012) develop
behavioral theories to explain investors’ preferences for lottery-type
securities. Using Cumulative Prospect Theory (Tversky and Kahneman
1992), Barberis and Huang (2008) argue that people evaluate risk
subjectively rather than objectively, which leads to distortion of prob-
ability beliefs. In particular, when investors subjectively overweight
the probability of extremely large gains, they will prefer stocks with
positively skewed returns.
Barberis and Xiong (2012) argue that in contrast to standard utility
models, people narrowly frame their investment history as a series of
gains and loss episodes. Investors derive positive realization utility when

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 A Survey of Behavioral Finance 

they sell at a gain and disutility when they sell at a loss. Owing to the
disposition effect, they will hang on to losers. The resulting asymmet-
ric response to gains and losses encourages investors to trade actively
in highly volatile stocks. The more volatile a stock is, the greater is the
perceived chance of realizing jackpot returns.

1.2.5 Preference for active trading

There is substantial evidence that the average individual investor
underperforms market benchmarks. One reason for this sub-par
performance is excessive trading. Barber and Odean (2000) report that
the average US household turnovers over stocks at a rate of more than
75% a year. The top 20% of households that trade most actively earn an
annual return that is 7% less than the return of buy-and-hold investors.
Barber et al. (2009) report even higher turnover rates for Taiwanese
retail investors. Like their US counterparts, Taiwanese investors
who trade actively earn inferior returns compared to buy-and-hold
investors.
Four factors help to explain the poor performance of active investors.
First, these investors may be uninformed but trade as if they are well
informed. In other words, individual investors are likely to be “noise
traders” (DeLong et al., 1990). Second, investors may be informed but
overrate their ability to earn positive returns after costs. This is the over-
confidence hypothesis. Odean (1999) finds evidence that supports both
the noise trader and overconfidence hypotheses.
Third, investors who trade actively could be sensation-seekers. Using
Finnish data, Grinblatt and Keloharju (2009) find that individuals who
are issued traffic speeding tickets are more likely to be sensation-seekers.
They are also more likely to trade stocks actively. Using a questionnaire
approach, Dorn and Sengmueller (2009) report that respondents who
find investing enjoyable tend to trade more.
Fourth, individuals may trade actively to gamble. Dorn and
Sengmueller (2009) find that investors who enjoy gambling are more
likely to trade than other investors. Knutson et al. (2008), Kuhnen and
Knutson (2005, 2011) find that positive emotional states raise people’s
confidence and willingness to take risk. This may explain why aggregate
trading volume is higher during market booms (Baker and Stein, 2004)
and why stocks with high valuation ratios such as growth stocks are
more heavily traded than value stocks, as was the case during the tech

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 The Lottery Mindset

bubble period of the late 1990s (Ofek and Richardson, 2003; Hong and
Stein, 2007).
The desire for active trading appears to wane with age and investment
experience. Korniotis and Kumar (2011) find that turnover rates are lower
among older, more experienced investors. Older investors not only trade
less, they also own less risky stocks and show a greater preference for
diversification. Consistent with the findings of Barber and Odean (2001),
women trade less often than men.

1.3 Heuristics

1.3.1 The availability heuristic

One of the most common mental shortcuts that investors use to
simplify their investment decisions is the availability heuristic. This
heuristic refers to the tendency for people to judge the frequency of
something occurring with the ease with which they can recall the
event. Daniel Kahneman gives a nice illustration of this heuristic in his
book, Thinking Fast and Slow (Kahneman, 2011) in which he and Amos
Tversky once asked participants to imagine which of the following is
more common: (a) an English word that begins with the letter k, or (b)
an English word with k as the third letter. The correct answer is (b) as
there are twice as many English words with k as their third letter than
k as their first letter. Most participants however gave (a) as the answer.
The error arises because we find it easier to recall words beginning
with k and hence, such words are more available to our memory. In
contrast, most people struggle to bring to mind words with k as their
third letter.
Events that are salient, recent, and personal are more “available” from
our memory than events that are mundane, happened long ago, or
happened to others. This is why on hearing a news report about a plane
crash, people have second thoughts about flying until the memory of the
crash fades. Neuroimaging studies have identified several brain areas
where salience is mediated (Litt et al., 2011). Interestingly, this includes
the ventral striatum, a region known to be active during reward anticipa-
tion (Knutson et al., 2001; Knutson and Cooper, 2005).
The availability heuristic can lead to biased thinking because the
ease with which one can recall an event does not make the event more

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likely to happen in the future. Yet investors routinely act as if it does. For
example, investors are less likely to buy stocks immediately after a crash
even if the crash was not precipitated by any obvious bad news about the
economy (see e.g., Kirilenko et al., 2011). The salience of a recent crash is
enough to trigger an irrational risk-averse response. Conversely, salience
may induce investors to buy stocks that have experienced a large price
run-up the previous month even if this price increase is not justified by
fundamentals (Bali, Cakici, and Whitelaw, 2011). Consistent with the
noise trading hypothesis, Bali et al. (2011) show that such stocks have
poor subsequent returns.
More generally, attention-grabbing stocks such as those with high
trading volume, extreme returns, and high media coverage are likely to
cause investors to succumb to the availability bias (Barber and Odean,
2008). Fang and Peress (2009) show that on average, stocks with high
media coverage have returns that are 0.2% per month lower than those
not featured in the media after accounting for standard risk factors such
as market, size, book-to-market ratio, and momentum. Consistent with
the findings of Barber and Odean (2008), individual investors exhibit
more attention-buying behavior than institutions.

1.3.2 The anchoring heuristic

Is the average price of a Korean car more or less than the price of the
Mercedes E-Class, currently selling at $70,000? The price of the Mercedes
has no relevance to the question but if you use it anyway to arrive at your
price estimate for the Korean car, you have fallen into the anchoring bias
trap of clutching at straws.
A dramatic case of anchoring was reported in an experiment
conducted by Tversky and Kahneman (1974). They recruited a group of
students to play a wheel of fortune game in which the wheel was rigged
to stop at either 10 or 65. After the wheel was spun, the students were
asked to write down the number on which the wheel stopped. They were
then asked two questions: (a) is the percentage of African nations among
UN members larger or smaller than the number you just wrote? And
(2) what is your best guess of the percentage of African nations in the
UN? Of course, the numbers on which the wheel stopped has nothing
to do with the answers to either question. Yet, the answers that students
gave were systematically influenced by the spin of the wheel. On average,
those who saw the number 10 answered 25%, while those who saw the

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 The Lottery Mindset

number 65, answered 45%. Other researchers have replicated the wheel
of fortune experiment, obtaining similar results.
The anchoring effect is related to priming, where something that is
irrelevant to the problem at hand somehow has a disproportionately large
influence on our thinking. Not surprisingly, anchors abound in daily
life. For example, the recommended book list generated by Amazon.
com is an anchor, as is the suggested amount a charity encourages you
to contribute. The high asking price for a house is also an anchor that the
seller uses to induce the potential buyer to think highly of his property.
Advertisers are of course especially adept in exploiting the priming effect
to promote their products.
Interestingly, the more uncertain is the value of something, the more
one tends to resort to anchors. For example, because it is hard to value
a technology company, stock analysts resort to vague valuation metrics
such as “eyeballs” and price-to-sales ratios. This implies that experts are
not immune to the anchoring bias. Anchors vary in degrees of informa-
tiveness but investors will find it often hard to separate useful anchors
from useless ones. Because of that, using noisy anchors in investment
can lead to detrimental outcomes. The poor performance of stocks with
recent extreme high returns documented by Bali et al. (2011) may be an
example of straw clutching.

1.3.3 The representativeness heuristic

People often judge the likelihood of something based on how similar it
is to the population. This is known as the representativeness heuristic.
Common manifestations of the representativeness heuristic are: categori-
cal predictions and belief in the law of small numbers.

Categorical predictions
Humans have a penchant of classifying things into categories and
forming stereotypes of these categories. “Humanities students are more
sociable than those in the sciences,” or “people with MBAs are very
career-driven” are examples of such stereotypical thinking. Investors
also think in terms of stereotypes when they classify stocks into distinct
“styles” such as small caps versus large caps, winners versus losers,
growth stocks versus value stocks, and so on.
Stereotyping allows a quick assessment of people, objects, and events
and is the product of System I thinking. To be sure, some stereotypes

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can be accurate. People with PhDs are more likely to subscribe to the
Economist than the general population. Bankers are more likely to be at
ease conversing about money matters than artists. But there are just as
many situations where stereotypes can mislead. One situation is where
people overrate an object because of its similarity to certain cherished
stereotypes. For example, books that gush about excellent companies
and CEOs are popular because they appeal to our intuition that there
is systematic pattern to their success, while often ignoring the role that
luck plays in these successes. People are also frequently dazzled by fast-
growing companies and accord them high valuations compared to value
firms. However, the halo effect of growth firms ignores the fact that very
few growth firms can sustain their past high growth rates for more than a
few years (see Lakonishok, Shleifer and Vishny, 1994). In virtually every
stock market, the average growth firm is overpriced and underperforms
the average value firm.
Another situation where the representativeness heuristic leads to
errors of judgment is when people ignore the base rate. The base rate is
the frequency at which an event or object occurs in the population. Base
rates for some events can be very low (e.g., the probability of contracting
a rare disease), but people will tend to overestimate such frequencies due
to the availability bias.
As an example of the base rate fallacy, consider the following descrip-
tion: Tim is good in math, and loves tinkering with computers; he also
enjoys jazz. Tom won a couple of prizes as a band member in school.
Which of the following mostly likely fits Tim’s profile? (A) Tim is a
banker (B) Tom is a sound engineer (C) Tim is a sound engineer and a
member of a jazz band.
If you are like most people, you will choose B or C as your answer. B
is plausible given Tim’s appreciation of music, but A is more probable
because there are far more bankers than sound engineers in the popula-
tion (i.e., the base rate for bankers is much higher than that for sound
engineers). You may also find C intuitive, perhaps reasoning that Tim
cannot be just an engineer, given his love of jazz. But C is clearly wrong
because the conjunction of two events cannot be more probable than
one event.
The use of a wrong base rate can lead to poor investment decisions.
Consider the following example. A mutual fund (let’s call it Fund X)
has caught your attention because of its impressive performance. As a
result, you believe that this fund is twice as likely to be a “star fund” than

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 The Lottery Mindset

an average fund (technically, the likelihood ratio for Fund X is 2). You
also believe that on average each year, 60% of mutual funds outperform
the benchmark. This is your estimate of the outperformance base rate
or background probability. The question is: what is the probability that
Fund X is indeed a star fund?
Two important pieces of information are given here: (a) the likelihood
ratio and (b) your estimate of the base rate. Bayes’s rule, named after the
18th-century English statistician, Thomas Bayes, can be used to combine
these two pieces of information to arrive at a rational estimate of the
probability of Fund X as a star fund. This is done by computing the
so-called posterior probability.
The posterior probability is simply the ratio of A to B, where A is the
likelihood ratio times the prior odds and B is 1 plus A. The prior odds
in this example is 0.6/0.4 =1.5. Thus, the posterior probability that X is a
star fund is (2 × 1.5)/(1+3) × 100% = 75%. This high posterior probability
is a reflection of your high opinion of mutual fund managers in general,
and the skills of the people managing Fund X in particular.
But what if your base rate is wrong? Indeed, empirical evidence shows
that most funds underperform the index each year (see, e.g., www.
spindices.com). Suppose the true base rate 0.45 instead of 0.6. Using the
same likelihood ratio as before, the posterior probability that Fund X
is a star fund is now 0.62. If the true likelihood ratio is 1 and not 2, the
posterior probability is reduced to just 0.45.
This example highlights the importance of using an accurate base rate
in arriving at sensible investment decisions. Problems arise when inves-
tors do not know what is the correct base rate and resort to guess work
or “facts” that come easily to mind (the representativeness bias).

The “Law of Small Numbers”

People have difficulties dealing with random events that somehow do
not look like they are random. Imagine you were a spectator at the
roulette game in a casino. Over the past ten minutes, you witnessed
something extraordinary. The ball has landed on white in each of the last
ten throws! If you bet that the next throw must land on black, you have
committed the gambler’s fallacy. This fallacy occurs because people have
an intuitive but wrong notion of what randomness implies. In particular,
many people expect a random sequence “look random” even in small
samples. In investment, this fallacy encourages contrarian trading (buy
on lows and sell on highs).

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The opposite of the gambler’s fallacy is the belief in hot hands. The
“hot-hand” fallacy is a common notion in sports, where after observing
a player score a sequence of successful hits, one begins to think that the
player is on “on a roll” and is more likely to continue to score. Gilovich,
Vallone, and Tversky (1985) were the first researchers to debunk the hot-
fallacy phenomenon. Their findings have since been confirmed by many
other studies. Nonetheless, belief in hot hands continues, not only in
sports but also in investments where it manifests in returns-chasing (in
particular, buying stocks that have performed well recently). As we shall
see in later chapters, investors’ attempts to time the market using these
strategies have proved to be futile.

1.4 Beliefs

Economic models traditionally assume that investors’ beliefs and predic-

tions are unbiased. In contrast, the psychology literature has long shown
that individuals are prone to biased beliefs and that they make systematic
errors when processing information. One of the most common biases
is that of overconfidence. Overconfidence has many facets. In general,
people tend to (a) exaggerate the precision of their knowledge, (b) think
that they are better than the average person in knowledge and skills, and
(c) think that they have better control over events than is warranted. The
classic psychology papers on overconfidence are Fischhoff et al. (1977),
Alpert and Raiffa (1982), and Lichtenstein et al. (1982). Moore and Healy
(2008) provide an excellent review of this literature.
A classic sign of overconfidence in predictions is overly narrow confi-
dence intervals. Ben-David, Graham, and Harvey (2007) examine the
stock market forecasts of Chief Financial Officers over a six-year period
to investigate whether CFOs exhibit overconfidence. If forecasts are well
calibrated, 80% confidence intervals should contain actual returns 8
out of 10 times. Graham et al. (2007) find that this happens only 40%
of the time, implying that forecast surprises are three times higher than
expected.
Malmendier and Tate (2008) identify overconfident CEOs as those
who own significant stakes in their company’s stock. They find that
overconfident CEOs are more likely to issue debt than equity. The odds
of making an acquisition are much higher if the CEO is overconfident.
Acquisitions undertaken by overconfident CEOs are associated with

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 The Lottery Mindset

more negative market reactions at the announcement date than those

undertaken by non-over-confident CEOs.
Overconfidence is also prevalent among investors and portfolio
managers. Research shows that people tend to be more overconfident
in tasks that are highly subjective and hard to predict (see Griffin and
Tversky, 1992). Finding the right stock to buy or predicting the future
returns of stocks is a difficult task for most investors. Financial markets
are also slow places to learn to calibrate one’s confidence accurately due
to noise in asset prices. Therefore, one can expect investors in general
to be overconfident. Overconfident investors will not fully diversify
systematic risks, preferring to bet on idiosyncratic risks. They will also
trade actively to exploit their presumed skills (Odean, 1998).
Barber and Odean (2000) find evidence for both these traits in a
study of over 60,000 US households who trade with a large discount
brokerage firm. Consistent with under-diversification, the average
household owns just 4.3 stocks. Despite high trading costs, the average
household turns over its portfolio at a rate of 75% a year. Those who
trade most earn the lowest average return (trailing the market’s return
by 6.5% a year). Overall, Barber and Odean (2000) conclude that
overconfidence leads investors to trade too much. In a follow-up study,
Barber and Odean (2001) show that men trade more and perform
worse than women, consistent with men being more overconfident
than women.
An illusion of control can bolster one’s overconfidence. The internet is
an important source of the illusion of control given the wealth of infor-
mation available to ordinary investors at a click of the mouse. Barber and
Odean (2002) study the behavior of over 1600 stock market investors
before and after switching from telephone to Internet trading. The mean
annual turnover rate jumped from 70% to 120% after the switch, and
remained high (90%) two years later. Choi, Laibson, and Metrick (2002)
obtain similar results using a large sample of investors in two corporate
401(k) plans. After 18 months of migrating to the Internet, the turnover
rate doubled compared to a control group of investors. Consistent with
investor overconfidence, there is no evidence that online trades were
more successful than those executed in the traditional way. In a different
context, Russo and Schoemaker (2002) find that horse race punters who
have more information about each horse fail to make better predictions
than punters who are less informed.

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Reinforcement learning can foster overconfidence. Because investors

feel good after winning, they are repeat behaviors that are associated
with winning episodes and avoid behaviors that are associated with
losses. Consistent with reinforcement learning, empirical evidence
shows that investors are more willing to take risk after experiencing
higher returns than their savings rates (Choi et al., 2009; Pütz and
Ruenzi, 2008) and more likely to subscribe to initial public offerings
(IPOs) if their previous IPO experience has been profitable (Kaustia
and Knupfer, 2008).
Other forms of reinforcement learning that contributes to overcon-
fidence are the self-attribution bias and confirmation bias. Langer and
Roth (1975) argue that self-attribution bias leads people to take credit
for their successes and blame bad luck for their failures. Lord, Ross,
and Lepper (1979) argue that people process information in ways that
confirm their initial views even if these views are unfounded. Nisbett
and Ross (1980) and Nickerson (1998) point out that the confirma-
tion bias contributes to the persistence of mistaken beliefs. Rabin and
Shrag (1999) show that the confirmation bias slows down the speed of
learning. In the investment context, Gervais and Odean (2001) show
that investors learn to be overconfident by taking more credit for their
success compared to a Bayesian agent. Owing to the self-attribution
bias, even unsuccessful traders may persist in trading actively.
In summary, research shows that:

 The more difficult a task is, the more overconfident people tend to
be.
 Experts such as chief financial officers and fund managers are also
affected by overconfidence.
 Overconfidence is an important reason why investors trade
excessively.
 More overconfident traders perform worse than less overconfident
traders.
 In general, men are more overconfident than women.
 Investors are more overconfident after market gains and less
overconfident after market losses.
 Reinforcement learning, illusion of control, and confirmation bias
contribute to the persistence of overconfidence.

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 The Lottery Mindset

1.5 Emotions

1.5.1 Gains and losses: Prospect Theory

Standard economic theories assume that people make decisions solely
by maximizing their utility. It is also assumed that individuals only
care about final wealth, not gains or losses in their wealth. Thus, gain-
ing one dollar gives the same utility as losing the same dollar. Prospect
Theory (Kahneman and Tversky, 1979) challenges these assumptions. In
Prospect Theory, how a problem is framed has important consequences
for behavior.
To see the idea of framing, consider the following poser. You are
presented with two types of chocolate chips. One is marketed as “95% fat
free”, and the other as “5% fat”. Which is healthier? The two statements
are logically the same but our brains do not always see it that way. For
most people, bad outcomes loom larger than good outcomes. As a result,
the “95% fat free” option seems healthier.
Here’s another scenario. Suppose you need to undergo treatment for
heart failure. Your doctor suggests two treatment options: heart bypass
or medication using beta-blockers. You are told that medication is a slow
form of treatment, but heart bypass has short-term risks. That risk is
described in two ways:
A. There is a 90% chance that the operation will not lead to serious
complications.
B. There is a 10% chance that the operation will lead to serious
complications.
If you are like most people, your choice of treatment will be influenced
by the risk description. A 90% chance of no serious complications
will register as good news, whereas a 10% chance of serious complica-
tions induces distraught. To use the language of Prospect Theory, you
are likely to perceive the first description as a gain and the second as
a loss. Since you dislike losses more than you like gains, the result is
predictable.
This example is hypothetical but real experiments carried out in
clinical settings have produced similar results with regards to people’s
preferences (see McNeil, Pauker, and Tversky, 1982; 1988). Interestingly,
these experiments also reveal that physicians have the same perception
bias as patients and students.

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The gist of Prospect Theory is that choices are highly dependent on

whether they are framed as gains or losses relative to a reference point.
Consider the following statements.
A: You have saved $10,000 and are choosing to invest this sum either
in an investment that has a 50% chance of gaining $10,000 or one
that guarantees $5,000 for sure.
B: You have saved $20,000, and are choosing to invest this sum either
in an investment that has a 50% chance of losing $10,000 or one
that loses $5,000 for sure.
The expected value of final wealth for both problems is the same. Hence,
people who behave according to standard utility theory should be indif-
ferent between the sure option and the probabilistic option. This is not
the case. In many experiments of this type, most people prefer the safe
option with regards to gains, and prefer to gamble with regards to losses.
Why is that so? For problem A the reference point is $10,000. Choosing
the safe option increases your wealth to $15,000 for sure, which is very
attractive compared to the probabilistic option. For Problem B, choos-
ing the sure loss option leads to final wealth that is subjectively less than
$15,000 due to loss aversion. So, the gambling option is more attractive.
These results are in accordance with the predictions of Prospect Theory
that people dislike losing more than they like winning.
The key elements of Prospect Theory are as follows:
 The carriers of utility are changes in financial outcomes rather than
the final value of the outcome.
 People evaluate decisions using a reference point. The reference
point is usually the current position with respect to income, wealth
etc. But it could also be an outcome that you expect.
 Outcomes that are above (below) the reference point represent
gains (losses).
 People are risk averse in the domain of gains but risk seeking in the
domain of losses.
These principles are illustrated in the famous S-shaped value function of
Prospect Theory (Figure 1.2). The vertical axis is the psychological value
of gains and losses, and the horizontal axis measures outcomes. The
reference point is at the intersection of the two axes. The value function
is concave to the right of the reference point, indicating risk aversion
and convex to the left of the reference point, indicating risk-seeking.

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 The Lottery Mindset

Value

Outcome
Losses Gains

Reference point

figure 1.2 Prospect Theory value function

These differences in risk preferences are due to diminishing sensitivity

to gains and losses. Concavity of the value function implies that an extra
dollar gained yields a smaller increase in utility than a previous dollar
gained. Convexity implies that an extra dollar lost is less painful than
a previous dollar lost. Lastly, the slope of the value function is steeper
when we transition from gains to losses than the other way around. This
asymmetry reflects loss aversion.
Prospect Theory can explain seemingly contradictory aspects of
investors’ behavior. Suppose an investment has a 50–50 chance of losing
$1,000 or gaining $2,000. A loss-averse investor is likely to reject this
gamble even though its expected value is positive. This example is
not merely hypothetical. Think of it a metaphor for the stock market.
Investing in stocks is generally a positive-sum game in the long run, but
loss-averse investors may underweight stocks because prospective losses
loom larger in their minds than the prospective gains.
Loss aversion in the investor population could be one explanation
of the well-known equity premium puzzle (Mehra and Prescott, 1985;
Barberis, Huang, and Santos, 2001). Loss aversion has also been impli-
cated in studies of people who invest very conservatively after having
lived through difficult economic times as shown by Malmendier and
Nagel (2011).
Framing provides an elegant explanation as to why people sometimes
avoid risk while at other times they embrace it. Consider a gamble with
a 90% chance of losing $10 and a 1% chance of winning $2,000. The

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 A Survey of Behavioral Finance 

expected value of the gamble is $11 but a loss-averse person is likely to

reject the gamble. Now suppose we frame the gamble as a lottery ticket
where pay $9 for a 90% chance of winning nothing and a 1% chance of
winning $2,000. This gamble now looks very attractive even though its
expected value is the same as the first. More generally, framing a lottery
as a shot at riches makes the price of the lottery ticket much more palat-
able. Framing effects explains why many investors find highly volatile
stocks attractive despite their low average returns (Kumar, 2009; Barberis
and Xiong, 2012).

1.5.2 Rejoicing and regret

Investors often make decisions based on strong emotions linked to
reward anticipation and regret. Neuroscience research identifies the
ventral striatum in the midbrain as responsible for encoding informa-
tion about reward stimuli (see, e.g., Schultz, Dayan, and Montague,
1997; McClure, Berns, and Montague, 2003; Platt and Huettel, 2008).
Excitation of neurons in the ventral striatum helps explain why inves-
tors are attracted to lottery-type stocks and the tendency for them to
sell stocks that have gained, and hold on to stocks that incurred losses
(Shefrin and Statman, 1985; Frydman et al., 2014).
Regret is the pain of realizing that you could have taken a different
decision that has a better outcome. Bell (1982) and Loomes and Sugden
(1982) analyze the influence of regret on decision-making. Coricelli
et al. (2007) discuss the neural basis of regret. Delaying selling a losing
stock counters regret since investors can rationalize that they have
only suffered “paper losses”. Such tactics, combined with the desire for
riches encourage active trading of stocks that appeal to risk-seekers and
sensation-seekers.

1.5.3 Optimism
On the first day of his MBA class, behavioral economist Richard Thaler
wanted to know how many students thought they will get an above-
median grade. It turned out that every single one of them did. Bertnazi,
Kahneman, and Thaler (1999) designed a questionnaire to test how
optimistic investors are. Altogether, they collected 1,053 responses. One
question was “When you think about your financial investment, do you
spend more time thinking about potential gain or potential loss?” The
responses were as follows:

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 The Lottery Mindset

 Much more time thinking about potential gain (39%)

 A little more time about potential gain (35%)
 About the same time on both (19%)
 A little more time about potential loss (6%)
 Much more time about potential loss (1%)
Almost three in four respondents focused on gains than losses. In
another question, people were asked to indicate the probability that
stocks will outperform bonds in the long term (20 years). One in three
of the respondents believed that stocks are a sure thing. Nearly one in
two believe that there is a greater than 90% chance of stocks outperform-
ing bonds over 20 years. Both responses represent an astonishing show
of confidence that is difficult to reconcile with the fact that investors
face huge parameter uncertainty in long-range forecasting (Pastor and
Stambaugh, 2012).
Misplaced optimism leads to overly aggressive investments in riskier
assets, especially lottery-type stocks. In the optimal beliefs theory of
Brunnermeier, Gollier, and Parker (2009), investors are happier if they
are optimistic about the states of the world in which their investments
will pay off. They show that this leads them to under-diversify and to
overinvest in stocks that are have positively skewed returns.
When investors in general are too optimistic, sentiment-driven
buying may lead to overpricing of stocks, especially those that are diffi-
cult to arbitrage. Baker and Wurgler (2006) show that major episodes
of booms and crashes in the US stock market mirror market-wide
sentiment swings. Small firms, young firms, firms with extreme book-
to-market ratios and highly volatile firms are more sensitive to changes
in sentiment than other firms, consistent with the fact that these firms
are difficult to value and hard to arbitrage. Yu and Yuan (2011) find that
the trades of sentiment-driven investors undermine the mean–variance
relationship for the market portfolio. Stambaugh, Yu, and Yuan (2012)
show that sentiment explains many stock market anomalies. Fong and
Toh (2014) find that the MAX effect documented by Bali, Cakici, and
Whitelaw (2011) is concentrated in high sentiment periods, suggesting
that investors are particularly prone to behavioral biases when market
optimism is high.
Similar to other cognitive biases, brain scan studies show that opti-
mism has a neurobiological basis. Positive emotions activate the nucleus
accumbens (NAcc) region of the ventral striatum, which in turn predicts

DOI: 10.1057/9781137381736.0006
 A Survey of Behavioral Finance 

greater risk-taking (Knutson et al., 2001; Kuhnen and Knutson 2005;

Kuhnen and Knutson 2011). Recent psychology research has identified
an “optimism gene” that significantly predicts depression, optimism,
self-esteem, and mastery (Saphire-Bernstein et al., 2011).

1.5.4 The social psychology of emotions

As social animals, humans have a natural propensity to behave in the
same manner as others. The desire to conform may be a powerful reason
why people often “herd.” The classic experiment on conformity is Asch
(1940, 1952).
Male college students (subjects) were seated in a room with other
participants and asked to perform a simple visual test. They were shown
a line segment and individually asked to choose a matching line segment
from a group of three different lengths. Unbeknown to the subjects,
all the other participants were ‘confederates’ whose role was to give
correct answers at times and incorrect answers at other times in order
to test whether subjects conform. Initially, all confederates gave correct
answers, but later switched to giving incorrect answers. The results were
startling. Subjects conformed to incorrect answers more than one third
of the time, even though a separate test shows almost all subjects were
able to identify the correct match. Since subjects and confederates were
strangers, peer pressure is unlikely to be the reason why so many subjects
conform to the wrong answers given by the confederates. The Asch
experiment is not a fluke. Asch-type experiments have been replicated
many times in different countries with similar results.
Herd behavior is also prevalent in financial markets. Barber, Odean,
and Zhu (2009a) find that individual investors buy and sell predomi-
nantly the same stocks as each other at the same time. Kumar and Lee
(2006) report similar results. Herding affects stock returns, particularly
those that are favored by individual investors such as small firms, low-
price firms, and value firms. Herding hurts performance. Barber and
Odean (2009b) find that stocks that are heavily bought underperform
those that are heavily sold by over four percentage points the following
year. This result also indicates that individual investors do not herd to
gather more accurate information.
Herding may be hard-wired in the brain. Berns (2005) shows that the
tendency to conform is associated with the brain’s perceptual features
rather than a conscious decision that is modulated by the prefrontal

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 The Lottery Mindset

cortex. Burke et al. (2010) document increased activity in the ventral

striatum region when subjects buy stocks after observing the buying
decisions of others. Bickart et al. (2010) find that the volume of the
amygdala (an almond-shaped set of neurons located deep in the brain’s
temporal lobe and which play a key role in regulating emotions) is
positively correlated with the size and complexity of social networks in
adult humans. Thus, investors may also herd for the comfort of safety in
numbers, which may be why there tends to be widespread selling follow-
ing a sudden sharp decline in stock prices.

1.6 Conclusion

The behavior of real world investors often differs systematically from

textbook models of rationality. Individuals hold concentrated portfolios,
speculate in securities with low average returns, trade excessively, chase
trends, and are prone to the influence of market sentiment and fads. The
survey in this chapter shows that people rarely make decisions based on
maximizing utility over final wealth. Instead, their decisions are driven
by a complex interplay of risk preferences, beliefs, mental heuristics,
and emotions. This chapter also provides a glossary of the core ideas of
behavioral economics. In the following chapters, we will see how these
behavioral elements help to explain the lottery mindset of individual
investors.

DOI: 10.1057/9781137381736.0006
 2
Overtrading
Abstract: A standard prescription of modern portfolio theory
is that uninformed investors should follow a buy-and-hold
investment strategy to minimize the cost of active trading.
Individual investors deviate systematically from this
prescription. This chapter surveys empirical evidence on the
trading behavior of individual investors around the world. An
unambiguous finding from the literature is that individual
investors trade too much and to their detriment. Losses from
trading are amplified due to investors’ preference for lottery-
type stocks such as those with high idiosyncratic volatility.
Losses of individual investors are gains to institutional
investors. Contrary to the predictions of rational learning
theories, investors with a history of losses persist in trading
actively. Explanations for active trading based on psychology
and behavioral finance research are discussed.

Keywords: overconfidence; sensation-seeking; turnover

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. Basingstoke: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0007.

DOI: 10.1057/9781137381736.0007 
 The Lottery Mindset

2.1 Introduction

Standard portfolio theory prescribes that investors who are relatively

uninformed should simply buy and hold the market portfolio to mini-
mize trading costs. One does not have to look far to see that this advice
is routinely violated in the real world. For example, while the global
market for passively managed exchange traded funds (ETFs) is worth
US$2.5 trillion, this amount pales in comparison with the US$27 tril-
lion mutual fund industry where professional fund managers actively
managed investments on behalf of individual investors (Economist,
2014). Like individual investors, equity mutual fund managers trade
very actively, with an average turnover of over 80% a year according to
Edelen, Evans, and Kadlec (2013). The propensity for active trading is not
limited to stocks. The average daily trading volume on currency markets
is about $5 trillion, far in excess of what is needed to settle trade and real
investment transactions.
High trading volume implies short holding periods. In the US stock
market, the average holding period for New York Stock Exchange
(NYSE) stocks has fallen sharply from seven years in 1940 to just seven
months in 2007 (Haldane, 2010). While average holding periods have
risen somewhat in recent years, they remain well below the long-term
average in all major markets. Overall, high security turnover is still a
pervasive phenomenon across many asset classes.
This chapter focuses on the trading behavior and performance of
individual investors in stock markets. Many financial models depict
individual investors as less informed and sophisticated than institutional
investors (see, e.g., Kyle, 1985; DeLong et al., 1990; Shleifer, 2000). We
present evidence that despite being relatively uninformed, individual
investors trade too much and to their detriment. We examine the reasons
for the high turnover rate, the type of stocks that individual investors
trade most actively, and the financial consequences of overtrading.

2.2 Turnover on equity markets

How actively an investor trades is measured by the rate at which he

turns over the securities in his portfolio. Equity turnover is the sum of
all stock purchases or sales (whichever is lower) over a period divided by
the average value of shares traded over the same period. The reciprocal

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 Overtrading 

of turnover is the average duration with which the portfolio is passively

held. If the annual turnover rate is 50%, the average holding period is
two years. A short average holding period indicates that investors are
trading actively.
Figure 2.1 charts the average holding period for common stocks
traded on the NYSE from 1960 to 2005. In 1960, investors held US
stocks for an average of about eight years. This declined almost contin-
uously to about one year from 2003 to 2012. Over the same period, the
average holding period in the Deutsche bourse and Euronext was also
about one year.
Figure 2.2 shows average holding periods for several Asian stock
markets for the decade to 2012. Stock markets were generally bullish
between 2003 and 2007. Reflecting investor optimism during this period,
average holding periods fell to less than one year in some markets, but
increased following the onset of the global financial crisis in 2008.
Overall, trading activity in equity markets appears to be inversely related
to market sentiment.
Haldane (2010) points out that the secular trend of higher equity
turnover is partly a result of increased market liquidity. Interestingly,

8
Average Holding Period (Years)

0
60
63
66
69
72
75
78
81
84
87
90
93
96
99
02
05
08
11
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20

figure 2.1 NYSE average holding period: 1960–2012

Source: NYSE Statistics Archive (www.nyse.com).

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 The Lottery Mindset

2.5
Average Holding Period (Years)

1.5

0.5

0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Australia Hong Kong Japan
Taiwan Shanghai Singapore

figure 2.2 Average holding period in Asian stock markets: 2003–2012

Source: World Federation of Exchanges.

rising turnover rates also occurred in tandem with an increase in the

level of institutional ownership in the United States and other developed
markets (Blume and Keim, 2012). Mutual funds, an important class of
institutional investors, are known to trade actively (Cahart, 1997; Odean,
1999; Edelen, Evans, and Kadlec, 2013). Thus, the propensity to trade
actively is not restricted to “dumb” individual investors.

2.3 The profitability of individual investor trades

2.3.1 US studies
This section surveys research findings on the trading behavior and
investment performance of individual investors. Most of these studies
pertain to the US stock market. We begin by reviewing a series of papers

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 Overtrading 

by economists Brad Barber and Terrence Odean whose studies are based
on a unique database containing the trading records of thousands of US
households.
Odean (1999) analyzes the trading records of 10,000 investors with a
large discount brokerage firm over the period from 1987 to 1993. Because
these trading accounts are self-directed rather than broker-assisted, his
study provides a unique opportunity to test whether investors exhibit
trading skills. Odean finds that stocks that investors buy subsequently
underperform those they sell. For example, over a two-year horizon, the
average difference between the returns of stocks bought and stocks sold
was –3.32% per annum. The corresponding number for a four-month
and one-year holding periods are –1.36% and –3.31%. As these numbers
are before transaction costs, average net returns are even lower.
Odean (1999) finds that his results are very similar after accounting
for trades that are not motivated by profits (e.g., trades executed to
meet liquidity or rebalancing needs). Risk-adjusted returns or alphas
using the three-factor (FF3) model of Fama and French (1992, 1993) are
also significantly negative (alphas range from –0.137% to –0.291% per
month).
A popular explanation for overtrading is that investors exaggerate
their abilities or the precision of their information (Odean, 1998; Gervais
and Odean, 2001). That is, overconfidence leads to overtrading. While
overconfidence may explain why investors persist in trading even though
they earn negative net returns, the fact that their gross returns are insuf-
ficient to cover trading cost indicates that these investors also lack the
skills to trade rationally (i.e., to the point where the marginal benefit of a
trade is equal to the marginal cost).
Barber and Odean (2000) examine the trade positions of a larger
sample of 66,465 investors with the same large discount brokerage firm
as in Odean (1999). The sample period for the study is 1991–1996. Each
month, they sort investors into quintiles by turnover. The mean return
for each turnover quintile is then measured in five ways over the sample
period: raw return and four measures of risk-adjusted returns. Barber
and Odean (2000) find that investors in their sample trade frequently.
The average turnover is 75% a year (implying an average holding period
of 1.3 years). The average turnover for the highest quintile is over 250% a
year. Performance-wise, the average investor earns a mean gross return
that is nearly equal to that of the market, thus providing no evidence of

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 The Lottery Mindset

superior investment skills. After accounting for brokerage commissions

and bid-ask spreads, the average investor performs poorly.
Figure 2.3 shows two measures of risk-adjusted returns from Table
5 of Barber and Odean (2000). The first measure (black bars) is the
own-benchmark abnormal return. This measure uses as benchmark, the
month t return of the beginning-of-year portfolio for each household.
If the household did not trade during the year, the own-benchmark
abnormal return would be zero for all 12 months in that year. The second
measure (white bars) is the FF3 alpha.
Figure 2.3 shows that investors in the highest turnover quintile (Q5)
underperform those in the lowest turnover quintile (Q1) by an average
own-benchmark-adjusted return of 0.566% a month (6.8% annual-
ized). Q5 also underperform Q1 in FF3 alpha with a performance gap
of 0.80% per month (9.6% annualized). Both measures of net returns
decline monotonically with turnover, consistent with the hypothesis that
overconfidence explain high trading levels and poor performance after
costs.
Stocks with lottery features are those with low average returns but
occasionally produce huge positive returns. A strong preference for such
stocks combined with active trading can also explain the return patterns

–0.1

–0.2
Net Average Monthly Return

–0.3

–0.4

–0.5

–0.6

–0.7
Own-benchmark abnormal return
–0.8
FF3 alpha
–0.9

–1
Q1 Q2 Q3 Q4 Q5
Turnover Quintile

figure 2.3 Net risk-adjusted returns by turnover quintiles

Source: Barber and Odean (2000), Table 5.

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 Overtrading 

in Figure 2.3. To see whether active traders display such a preference,

Figure 2.4 plots the factor loadings for the three risk factors in the FF3
model.
Figure 2.4 shows that loadings for the market (MKT) and the small-
minus-big (SMB) risk factor increase monotonically with turnover
level, while the loadings for the high-minus-low (HML) risk factor are
quite similar across the turnover quintiles except for Q1 and Q5. The
loading patterns in Figure 2.4 implies that compared to Q1 investors,
the portfolios of Q5 investors are tilted toward smaller stocks, high-beta
stocks, and growth stocks. One way to interpret these style tilts is to see
their resemblance to so-called lottery-type stocks, as defined by Kumar
(2009) in his study of the gambling preferences of individual investors.
Kumar defines lottery stocks as those with low price, high idiosyncratic
volatility, and high idiosyncratic skewness, characteristics that provide
investors with cheap bets on potentially huge (“jackpot”) returns. Similar
to real lotteries, the average returns of these stocks are significantly nega-
tive. It would appear then that overconfident investors not only trade
too much, but may also be trading in highly speculative stocks that yield

1.3

1.1

0.9
Factor Loadings

0.7

0.5

0.3

0.1

1 2 3 4 5
–0.1
Turnover Quintile
SMB HML MKT

figure 2.4 FF3 factor loadings by turnover quintiles

Source: Barber and Odean (2000), Table 5.

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 The Lottery Mindset

poor returns on average. More formal evidence in support of this view

comes from a recent study by Bailey, Kumar, and Ng (2011). Using factor
analysis, they find that investors who exhibit a high propensity to trade
also display a strong orientation toward lottery-type stocks.

2.3.2 Non-US studies

The trading behavior of individual investors has also been studied using
data from other markets. Grinblatt and Keloharju (2000) examine the
trading record of individual investors on the Helsinki Stock Exchange
using two years of data. Consistent with the results of Odean (1999),
individual investors in Finland are net buyers of stocks that subsequently
perform poorly.
Dorn, Huberman, and Sengmueller (2008) examine the daily trade
records of over 37,000 individual investors with a large German discount
brokerage firm between February 1998 and May 2000. They show that:
(a) investors are positive feedback traders in that past returns positively
predict current net order imbalance, (b) this effect is stronger for specu-
lative market orders than nonspeculative market orders such as those
dictated by regular investment plans, (c), informed trading does not
appear to play an important role in driving speculative trades, and (d)
speculative trades are highly correlated across investors on a given day.
Their results suggest that individual investors’ trades are highly corre-
lated, and sentiment-driven rather than information-driven.
Barber et al. (2009) study the trading behavior of Taiwanese investors
over the period from 1995 to 1999. The Taiwan Stock Exchange (TSE)
is a particularly interesting market to study the behavior of individual
investors for a number of reasons. First, in contrast to the US stock
market, the TSE is dominated by individual investors. Over the sample
period studied by Barber et al. (2009), individual investors own about
60% of outstanding stock and account for nearly 90% of all trades by
value. Second, trading cost is low, with brokerage commissions capped
at 0.1425% of the value of a trade. In addition, investors only pay a
transaction tax on stock sales of just 0.3%, and there is no capital gains
tax. Third, perhaps due to low trading costs, equity turnover on the TSE
is extremely high, averaging 294% per annum over the sample period.
This high turnover strongly suggests that individual investors are mainly
short-term speculators. Consistent with this view, 23% of all trades on
the TSE are “day trades” in which the same stock is bought and sold

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 Overtrading 

on the same day by the same investor. Finally, 64% of all trades on the
TSE are aggressive limit orders, which include buy limit orders with
high prices and sell limit orders with low prices. While the proportion
of aggressive orders among individual and institutional investors are
roughly the same, most of the losses of individual investors (and gains of
institutional investors) are traceable to these order types, which provides
further evidence that individual investors are uninformed.
Do individual investors on the TSE profit from all this activity? Barber
et al. (2009) show that the answer is clearly no. As a group, individual
investors suffer a performance penalty of 3.8 percentage points a year
after trading costs, which implies an economically large wealth trans-
fer from these investors to institutional investors. A total of 61% of the
annual performance penalty stems from trading losses and market
timing, with trading costs accounting for the remainder. Thus, similar to
the findings of Odean (1999), the average individual TSE investor lacks
the skill to trade profitably.
Figure 2.5 plots monthly four-factor (FF4) alphas for the buy-and-sell
trades of individual investors in Taiwan for holding periods of 1–140

4
FF4 Alphas (percent per month)

–2

Buys
–4
Sells

–6

–8
1 day 10 days 25 days 140 days

figure 2.5 Alphas of individual investors’ buy-and-sell trades in Taiwan

Source: Barber et al. (2009c), Table 6.

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 The Lottery Mindset

days. The risk factors in the FF4 model are the three risk factors of Fama
and French (1992, 1993) plus the Cahart (1997) momentum factor. For
all holding periods, stocks that individual investors buy earn negative
alphas while stocks they sell earn positive alphas. Most alphas are statis-
tically significant and they range from –0.76% a month (for the 140-day
horizon) to a huge –11% a month (for 1 day).
In summary, the evidence from Finland, Germany, and Taiwan
corroborate the results of US studies by Odean (1999) and Barber and
Odean (2000). When individual investors trade solely for profits, they
end up trading too much and performing poorly compared to a buy-
and-hold strategy.

2.4 Learning from trading

Do individual investors learn from their mistakes? Models of rational

learning argue that investors with poor performance are likely to quit.
For example, in the learning model of Mahani and Bernhardt (2007),
investors are Bayesians. Novice investors rationally choose to trade
against smart traders to learn about their abilities. Successful traders
continue to trade, increasing their wealth while unsuccessful ones
leave the market. In contrast, Gervais and Odean (2000) argue that
unsuccessful traders persist in trading because of a self-attribution
bias. Investors affected by this bias tend to attribute profitable trades
to their skill and unprofitable trades to bad luck, thus exaggerat-
ing their ability as a trader. Over time, these investors learn to be
overconfident.
Rational learning models predict that although novice traders lose to
experienced traders, in the aggregate, the average returns of all traders
should be positive. Otherwise, there is no incentive for risk-neutral or
risk-averse novice traders to “trade to learn.”
Barber et al. (2010) test these predictions using data from Taiwan over
the 15-year period from 1992 to 2006. As noted earlier, a significant share
of trading on the Taiwan stock market comes from day traders. Barber
et al. (2010) focus on day traders as these traders are more likely to trade
for speculative than nonspeculative reasons. They find that contrary to
the predictions of rational learning models, in each of the 15 years, the
aggregate net return of day traders is negative, and after adjusting for

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 Overtrading 

10.0
CAPM Alpha
8.0
t statistic
6.0
Daily CAPM Alphas (in Basis Points)

4.0

2.0

0.0
1991 1993 1995 1997 1999 2001 2003 2005
–2.0

–4.0

–6.0

–8.0

–10.0

figure 2.6 Net daily CAPM alphas of day traders: 1992–2006

Source: Barber et al. (2010), Table 1.

market risk, day traders lose an economically large 9.4% per year after
costs. Figure 2.6 plots net CAPM alphas (daily basis points) for all years
in the sample (bold line). The t-statistics for the alphas are shown as
dotted lines.
Rational learning models also predict that traders with a history of
losses should stop trading. Barber et al. (2010) find that this is not the
case. Unsuccessful traders make up a quarter of all day traders and more
than half of all day trading dollar volume. Figure 2.7 shows these results
graphically. This figure plots the proportion of day trading volume each
year that is accounted for by unprofitable day traders. A trader is clas-
sified as unprofitable if he/she has at least 20 days of day trading and a
negative mean daily net return through each prior year. Figure 2.7 starts
from 1995 to allow traders to build up a history of day trading. On aver-
age, unprofitable day trades represent over half (54%) of all day trading
volume in the decade to 2006. All in all, Taiwanese day traders appear to
be a remarkably persistent lot.

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 The Lottery Mindset

80

70

60
Percentage of Day Trading Volume

50

40

30

20

10

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

figure 2.7 Percentage of day trading volume among unprofitable day traders:
1995–2006
Source: Barber et al. (2010), Table 4.

2.5 Do smart investors outsmart the market?

The evidence so far relates to the average investor. Average returns may
mask substantial performance variations across individuals. Smarter and
more experienced investors may achieve better performance outcomes
than other investors. Research evidence indicates that some individual
investors are indeed able to earn significant abnormal returns, though
they are in the minority. For example, using Finnish data, Grinblatt,
Keloharju, and Linnainmaa (2012) find that investors with high intel-
ligence quotients (IQ) earn higher gross returns after purchases than low
IQ investors. These investors however form only 8% of the sample. Using
the same dataset as Barber and Odean (2000), Korniotis and Kumar
(2013) classify investors into five groups based on standardized measures
of verbal ability, quantitative ability, and memory. They find that smart
investors significantly outperform dumb investors by an average of

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 Overtrading 

–0.05

–0.1
Monthly Abnormal Returns

–0.15

–0.2

–0.25

–0.3

–0.35

–0.4
Q1 Q2 Q3 Q4 Q5
Smartness Quintile

figure 2.8 FF4 alphas of individual investors by smartness quintiles

Source: Korniotis and Kumar (2012), Table 3.

0.315% a month, which translates to an economically impressive 3.78%.

This performance gap is net of trading costs and adjusted for risks using
the FF4 model. Figure 2.8 plots net FF4 alphas (in percent per month) for
each smartness quintile, showing the wide gap in performance between
the extreme groups. Note that all the alphas are negative, which implies
that none of the investor groups are able to beat the passive benchmarks.
Thus, being smart is an advantage but only in a relative sense. When
they analyze net risk-adjusted returns of a sub-sample of investors who
trade actively, they find that smart investors show marginally significant
superior returns while dumb investors show inferior performance. These
results suggest that beating the benchmark is challenging even for smart
investors.

2.6 Why do individual investors trade so much?

Individual investors may trade for reasons other than to make money.
For example, they may trade to shift some of their savings to stocks,
rebalance their portfolios, hedge risks, or meet liquidity demands (e.g.,

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 The Lottery Mindset

pay taxes or realize tax losses). However, the high equity turnover in
many markets suggests that these cannot be the main reasons why indi-
vidual investors trade so much. Odean (1999) finds that the investors in
his sample actually performed worse after accounting for nonspeculative
motives for trading. In Taiwan, where turnover is much higher than the
United States it is even less plausible to attribute most of this turnover to
nonspeculative trades. A rational speculator will trade to the point when
the marginal benefit of trading equals the marginal cost. The empiri-
cal evidence clearly indicates that as a group, individual investors have
crossed this line. Why do they do it?
Many studies suggest overconfidence as an important contributor
to excessive trading. While overconfidence may explain why investors
trade even though their gross profits cannot cover trading costs, the
fact that on average, gross return is negative in many cases suggest that
there are other explanations for the high turnover. In particular, inves-
tors may be misinformed or misled by behavioral biases and heuristics.
It is also possible that investors trade because they find it thrilling
(sensation-seeking) or because they view trading as a form of gambling
(risk-seeking). We elaborate on these trading motives below.

2.6.1 Risk preferences

Economists like to view the world through the lens of utility functions,
and in classical economics, utility is always defined using end-of-period
wealth. Moreover investors are always modeled as globally risk-averse,
which implies that they never gamble. Might it be possible that people
derive utility from changes in their wealth as Kahneman and Tversky
(1979) posit? Furthermore, what if investors actually do not mind
allocating part of their overall portfolio to lotteries as in the Behavioral
Portfolio Theory of Shefrin and Statman (2000)?
If people attach high importance to changes in wealth, they may want
to trade actively because realizing a gain gives the trader a burst of util-
ity. Moreover, due to the disposition effect (Shefrin and Statman, 1985),
investors can mitigate the pain of a loss by not selling the stock until its
price recovers to the purchase price.
Barberis and Xiong (2012) propose a “realization utility model” to
capture the idea that investors care about changes in wealth. Their model
assumes that investors are affected by “narrow framing” in that they view
their investments not in terms of overall portfolio returns but as a series of
trading episodes defined by gains and losses. Narrow framing is a form of

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 Overtrading 

mental accounting (Thaler, 1999). A realization utility investor is eager to

realize profits since every realized gain is recorded as a positive experience
in his mental account. Similarly, by not selling a loss-making stock, the
investor can console himself that his “loss account” is merely paper loss.
The realization utility model leads to three implications for trading:
first, an investor will like to trade frequently since doing so gives them
many chances of experiencing positive realized utility. Second, the
investor will prefer more volatile stocks to less volatile stocks since the
probability of realizing gains increases with volatility. Third, an inves-
tor will tend to defer realizing losses unless he has important liquidity
needs. Recent neural research by Frydman et al. (2014) have confirmed
these predictions. An innovative aspect of the Frydman et al. (2014)
study is that it uses functional magnetic resonance imaging to measure
brain activity while subjects trade in an experimental stock market.
Brain regions known to encode information about the value of rewards
(specifically, the ventromedial frontal cortex and the ventral striatum)
were found to exhibit a positive response when subjects realized capital
gains. Moreover, all subjects were found to exhibit a strong disposition
effect following trading losses.

2.6.2 Sensation-seeking
A noncompeting explanation for active trading is that investors are
sensation-seekers. That is, they simply enjoy the “thrill of the chase”. Not
surprisingly, sensation-seeking has been implicated in a large number
of neural studies. These studies indicate that certain regions of the brain
are activated when people anticipate excitement from experiencing both
monetary rewards as well as nonmonetary pleasures such as humor and
attractive images (Aharon et al., 2001; Breiter et al., 2001, Azim et al.,
2005; Lohrenz et al., 2007; Linnet et al., 2011).
Using survey data, Dorn and Sengmueller (2009) find that investors
who report that they enjoy investing or gambling trade more frequently.
Using personality and risk appraisal tests, Horvath and Zuckerman
(1993) find that sensation-seekers are prone to risky behavior in four
areas: sports, gambling, criminal activities, and minor violations of
the law such as traffic offenses. Grinblatt and Keloharju (2009) show
that controlling for a host of other variables, stock investors who were
recently issued speeding tickets (and face potentially large fines) trade
more frequently.

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 The Lottery Mindset

2.6.3 Stocks as lotteries

The realization utility model predicts that investors who trade actively
will prefer to trade highly volatile stocks. Volatile stocks in turn attract
high trading volume because they catch speculators’ attention more than
do stable stocks.
A large literature shows that stocks with high total or idiosyncratic
volatility have lottery-like payoffs in that they earn negative risk-adjusted
returns (see, e.g., Ang, Hodrick, Xing, and Zhang, 2006; Baker and Haugen,
2012; Fong, 2013). Kumar (2009) shows that individual investors are the
main clienteles of such stocks, and thus infer that individuals, rather than
institutional investors are the ones who gamble in the stock market.
Barber, Odean, and Zhu (2009b) quantify the effects of trading high-
volatility stocks by individual and institutional investors. They use small
trades (trade size < $5,000) to proxy for the trades of individual investors
and large trades (trade size > $50,000) to proxy for the trades of institutions.
For each trade size, they form value-weighed portfolios by double sorting
stocks based on the proportion of buyer-initiated trades and idiosyncratic
volatility. Specifically, each year-end from 1983 to 2002, they sort stocks into
quintiles based on the proportion of buyer-initiated trades during that year.
Then, within each quintile, they short stocks into three groups (low 30%,
medium 40%, and high 30%) by idiosyncratic volatility. The idiosyncratic
volatility of a stock in month t is calculated as the standard deviation of
the monthly residual from a regression of the stock’s excess return on the
market’s excess return over the previous 48 months. FF4 alphas are then
computed for all 20 portfolios: 15 for small trades, and 15 for large trades.
Figure 2.9 plots monthly FF4 alphas for small trades. Q1 (Q5) denotes
the portfolio with the lowest (highest) proportion of buyer-initiated
trades. The thick line shows alphas for the high idiosyncratic volatility
portfolio, and the dash and dotted lines show alphas for the medium
and low idiosyncratic volatility portfolios respectively. Alphas gener-
ally decline with buy intensity, but this much more pronounced for the
high idiosyncratic volatility portfolio. Individual investors who chase
these volatile stocks aggressively incur a significantly negative alpha of
nearly 0.6% a month or 7.2% a year. This loss is before trading costs.
Results for large trades are shown in Figure 2.10. In contrast to indi-
vidual investors, none of the alphas for institutional investors is signifi-
cantly negative, and one is significantly positive. A take-away from these
findings is that when individual investors are most eager to trade volatile
stocks, their performance gets worse.

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 0.8
High IVOL
0.6 Medium IVOL
Low IVOL
0.4
Monthly Percentage Alpha

0.2

0.0
Q1 Q2 Q3 Q4 Q5

–0.2

–0.4

–0.6

Proportion of Buyer-initiated Trades Quintiles

–0.8

figure 2.9 FF4 alphas of portfolios sorted by buyer-initiated trades and IVOL:
small trades
Source: Barber et al. (2009b), Table 5.

0.8
Medium IVOL
0.6 Low IVOL
High IVOL

0.4
Monthly Percentage Alpha

0.2

0.0
Q1 Q2 Q3 Q4 Q5

–0.2

–0.4

Proportion of Buyer-initiated Trades Quintiles

–0.6

figure 2.10 FF4 alphas of portfolios sorted by buyer-initiated trades and IVOL:
large trades
Source: Barber et al. (2009b), Table 5.

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 The Lottery Mindset

2.6.4 Beliefs and sentiment

Investors are more likely to buy stocks when they are optimistic about
stocks in general. Optimism may be justified by a belief that stock
fundamentals are improving, but they could also be driven by irrational
sentiments. Historically, periods of high investor sentiment are associ-
ated with high trading volume and stock bubbles (Ofek and Richardson,
2003; Baker and Stein, 2004; Baker and Wurgler, 2006). The realization
utility model offers one possible explanation for this association: in a
rising market, speculators trade more because they believe they are more
likely to realize capital gains.
Baker and Wurgler (2006) develop an index of market-wide investor
sentiment and show that fluctuations in this index lines up well with bull
and bear market episodes in the United States. Using cross-sectional
regressions, they find that sentiment affects some types of stocks more
than others. Specifically, stocks that are hard to arbitrage, such as small
firms, young firms, unprofitable firms, and firms with very volatile
returns, have higher sentiment loadings. Importantly, these stocks earn
lower average returns following high sentiment than stocks with low
sentiment loadings, suggesting that hard-to-arbitrage stocks become
overpriced when investors are overoptimistic or show increased propen-
sity to speculate. It is interesting to note that hard-to-arbitrage stocks
share many similar characteristics with lottery-type stocks as defined by
Kumar (2009). Baker and Wurgler’s results therefore provide indirect
evidence that individual investors are most willing to gamble when high
sentiment is high and lottery-type stocks are overvalued.
If individual investors are the prime examples of sentiment-driven
investors, then order imbalance of individual investors should be a
useful indicator of market sentiment. Barber, Odean, and Zhu (2009a)
and Hvidkjaer (2008) use order imbalance of small trades as a proxy for
sentiment-driven trades. Defining small trades as those with a contract
value of $5,000 or less, and using data from 1983 to 2000, Barber et al.
(2009a) find that stocks that are heavily bought by individuals exhibit
higher returns in the short term (up to 4 weeks), after which returns
reverse. Over a one-year holding period, stocks heavily bought under-
perform stocks heavily sold by 4.4%. Moreover, underperformance
increases to 13% for stocks that are hardest to arbitrage such as highly
volatile stocks. Their findings support the view that individual investors
are noise traders who lose from sentiment-driven trades.

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 Overtrading 

Investor optimism may be reinforced by other behavioral biases such

as overconfidence and self-attribution (see Chapter 1). Consider a stock
whose abnormal return is normally distributed N(0,1). Suppose an inves-
tor believes that the mean abnormal return is positive, not zero, and also
thinks that the standard deviation is less than one. This investor is both
overoptimistic and overconfident. Benos (1998) and Odean (1998) argue
that due to overconfidence, investors will trade too much. Moreover, the
self-attribution bias can sustain the inclination to overtrade. Owing to
this bias, an investor will attribute losses to bad luck and success to his
stock-picking skill. Langer and Roth (1975) call this type of reasoning,
“heads I win, tails it’s chance.”
Dorn and Huberman (2003) test the self-attribution bias hypothesis
by surveying more than 1,000 German individual investors who trade
actively. Among the questions asked are the following that are aimed at
detecting whether respondents show the self-attribution bias:
 Losses in my investments have frequently been caused by external
circumstances such as macroeconomic developments.
 Gains in my investment must above all be attributed to my
competence as an investor.
 My failed investments have often been the result of unfavorable
circumstances.
 My instinct has often helped me to make good investment
decisions.
Respondents are asked to indicate the extent to which they disagree or
agree with the above statements (the response scale ranges from 1 for
completely disagree to 4 for completely agree). Dorn and Huberman
(2003) find that 68% of respondents suffer from the self-attribution bias,
with about one in five respondents showing a strong bias.
Gervais and Odean (2001) argue that investors tend to be more optimis-
tic and overconfident after a period of market gains. This is because most
investors hold net long positions, which means they become wealthier
in a bullish market. Overconfident investors erroneously attribute the
wealth increase to their investment acumen while rationalizing poor
outcomes as due to bad luck. Barber et al. (2001) and Korniostis and
Kumar (2011) show that men are more overconfident and trade more
frequently than women. The latter study also finds that turnover is higher
among younger, less experienced, and more risk-seeking investors (those
who prefer stocks with low dividend yields).

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 The Lottery Mindset

2.6.5 Heuristics
Investors face a huge search problem when deciding what stocks to buy
given that there are hundreds or thousands of stocks to choose from.
Selling is a much easier decision since investors already own the stocks.
To simplify buying and selling decisions, investors often resort to heuris-
tics, whether deliberately or unconsciously.
Mental accounting is a common heuristic for dealing with gains and
losses. For example, the disposition effect leads investors to sell stocks
that are winners (specifically, those which yield capital gains) and to
hang on to losers. The first decision locks in gains, which gives investors
a jolt in realization utility, while the second decision is a mechanism
to mitigate the pain of losses. As discussed earlier, realization theory
predicts that such behavior can lead to excessive trading, especially in
volatile stocks.
Conditioning on past returns is another way to simplify trading deci-
sions. Odean (1999) and Dorn, Huberman and Sengmueller (2008) show
that individual investors behave like momentum traders in that they tend
to buy stocks after strong performance. Psychologically, this behavior is
consistent with the “hot hand” phenomenon in sports (Gilovich, Vallone,
and Tversky (1985), which will be further discussed in the next chapter.
In hot hand experiments, people often mistake a chance sequence with
real trends after seeing a long streak of outcomes (Ayton and Fischer,
2004) as if observing a long streak causes one to overturn the belief
that the outcomes are truly random. Similarly, in market experiments,
Andreassen and Kraus (1990) find that with modest stock price fluctua-
tions, subjects fall into the hot-hand fallacy when presented with a strong
trend. Rabin and Vayanos (2010) formalize this type of perception in a
broader economic setting. Overall, the hot-hand belief helps to explain
why the stocks that investors buy tend to be those that have appreciated
more than the stocks they sell.
The availability heuristic is useful in explaining why traders are
attracted to certain types of stocks. In psychology parlance, availability
refers to the tendency for people to form judgments based on events
or information that they can easily recall. Vivid and salient events are
more available than mundane events. Stocks with high media coverage
and those with high daily trading volume generate more buying interest
because they are more attention-grabbing (Barber and Odean, 2008;
Fang and Peress, 2009). Similar to lottery-type stocks, stocks in the
media spotlight earn lower returns than those with no media coverage.

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 Overtrading 

2.7 Conclusion

Finance theory assumes that investors are rational, making invest-

ment decisions based on optimal trade-offs between risk and expected
returns. Real-world investors behave very differently from this norma-
tive prescription. Individuals under-diversify and prefer stocks with
lottery-type characteristics that earn low average returns. Individual
investors also trade actively, against the prescription that uninformed
investors should follow a buy-and-hold strategy. The empirical evidence
surveyed in this chapter shows that (a) individual generally trade too
much, (b) lose money even before trading costs, (c) lose money to
institutions, (d) lose money trading highly volatile stocks that have low
average returns, (e) persist in trading despite a history of losses, and (f)
exert short-term price pressures through herding and trend chasing,
but suffer losses over typical holding periods. Reasons for overtrading
include the use of cognitive heuristics, preferences for lottery-type
stocks, sensation-seeking, and misjudgments about the nature of asset
prices due to erroneous probability beliefs. The buy-and-hold approach
to investing remains a compelling one for most individual investors to
avoid the “traders’ curse”.

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 3
Trend-Chasing
Abstract: The human brain is hard-wired to look for patterns
even in randomness. A common bias in investing is the
extrapolation bias or the tendency to buy assets that have
high past returns and sell assets that have low past returns.
Trend-chasing is particularly common among individual
and inexperienced investors. This chapter analyzes the
psychological biases that precipitate trend-chasing, surveys
the research evidence on trend-chasing from psychology,
economics, and finance, and examines the short- and long-
term consequences of this form of behavior.

Keywords: pattern-seeking; representativeness heuristic;

trend-chasing

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. Basingstoke: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0008.

 DOI: 10.1057/9781137381736.0008
 Trend-Chasing 

3.1 Introduction

This chapter is about return-chasing or trend-chasing behavior in the

stock market. Investors who chase returns buy assets after they have
risen and sell assets after they have fallen. Trend-chasing can be based
on a single asset such as a stock or a mutual fund, or across assets as
in momentum strategies where one buys recent winners (stocks which
have performed well recently) and shorts recent losers (stocks that have
performed poorly recently). For reasons still unclear, momentum strate-
gies have been extremely profitable across a variety of asset types and
markets (see e.g., Asness, Frazzini, and Pedersen, 2013). This is not the
case for single asset trend-chasing strategies, which implies that they
have more of a lottery flavor than momentum strategies.
This chapter focuses on trend-chasing behavior of individual inves-
tors. Individual investors are usually characterized as uninformed “noise
traders” who trade on sentiment or nonfundamental factors (DeLong
et al., 1990; Baker and Wurgler, 2006; Frazzini and Lamont, 2008). Being
less sophisticated than institutions, individual investors are also thought
to be more prone to the influence of psychological biases (e.g., Bailey,
Kumar, and Ng, 2011).
An important bias with regards to trend-chasing behavior is the belief
that what has happened will continue to do so. Various scientific disci-
plines have studied this form of extrapolative thinking, albeit calling it by
different names, such as the “hot hands” belief in psychology, or positive
feedback behavior and adaptive expectations in economics and finance.
Other cognitive biases such as overconfidence and the self-attribution
bias may also reinforce trend-chasing behavior by causing investors to
exaggerate the role of skills and downplay the role of luck in predicting
essentially random events.
This chapter proceeds as follows. Section 3.2 discusses two common
errors in people’s perceptions of random events (the gambler’s fallacy
and “hot-hand” fallacy) and the effects they have on people’s beliefs.
Section 3.3 reviews experimental and survey-based studies of trend-
chasing behavior. Sections 3.4 and 3.5 review recent research on the
trend-chasing behavior of mutual fund investors. Section 3.6 takes a
broader look at trend-chasing behavior in the overall stock market based
on my study of capital flows across portfolios with different levels of
institutional ownership. The key result of that study is that trend-chasing
behavior is pronounced among stocks with low institutional ownership,

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 The Lottery Mindset

consistent with behavioral theories which predict that individual inves-

tors are more likely to chase returns than sophisticated institutional
investors. The study also shows that individual investors in aggregate are
poor market timers.

3.2 The “hot-hand” fallacy and the gambler’s fallacy

Human beings have an innate desire to seek patterns. Kahneman (2011)

attributes this tendency to our desire for coherence in the world. He
argues that pattern-seeking is an activity of System I, that part of our
cognitive system which performs automatic and effortless thinking. An
unquestioned reliance on System I leads people to be quick in inferring
causal connections where none exists. As a result, an illusion of pattern
prevails in daily life. Two of the most glaring mistakes are the “hot-hand”
fallacy and the gambler’s fallacy.
Few people watching a basketball game will not be impressed with
a player who scores several times in a row. This player will be viewed
as a “hot hand,” and if asked to place on bet on his next throw, most
people will bet on another throw in. Yet, scores of studies have shown
that no hot-hand phenomenon in sports and games exist. In an early
study, Gilovich, Vallone, and Tversky (1985) tracked the performance
of several professional basketball teams against a controlled group
that comprises university basketball players. They find no evidence
to support the hot-hand hypothesis. Subsequent studies have also
confirmed the fallacy of the hot-hand belief in a variety of sports (see
Camerer, 1989; Tversky and Gilovich, 1989; Albright, 1993; Ayton, 1998;
Bar-Eli, Avugos, and Raab, 2006).
Despite the evidence, the hot-hand belief is hard to dispel because
the desire to seek patterns is hard-wired in the brain. As Gilovich and
Tversky explain, the persistence of the hot-hand belief may be due to the
fact that long sequences of hits and misses loom larger in people’s minds
than alternating sequences.
The gambler’s fallacy is the belief that runs of a particular outcome will
reverse (Jarvick, 1951, Rabin, 2002). To illustrate this fallacy, consider the
outcome of three consecutive coin tosses, “TTT”, where T stands for tail.
If one reasons that after a TTT sequence, a head is overdue, and the next
coin toss is more likely to show a head, one has committed the gambler’s
fallacy.

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 Trend-Chasing 

The gambler’s and hot-hand fallacy are opposites. In the investment

context, the gambler’s fallacy is akin to taking a contrarian view, while
the hot-hand fallacy leads to an extrapolation bias, for example, a belief
that a stock which has risen on most days last week is more likely to
continue rising this week.
Kahneman and Tversky (1972) and Gilovich, Vallone, and Tversky
(1985) propose that a single psychological bias – the representativeness
heuristic – drives both fallacies. Their argument goes like this. People
expect a chance process to look like one even in small samples (the
so-called “law of small numbers” reasoning). At the same time, they also
believe that a chance process is very unlikely to exhibit long streaks, and
if it does, it is probably not random to begin with. Together, these argu-
ments mislead people to expect short streaks to be balanced by opposite
outcomes, thus committing the gambler’s fallacy, and to refute the
randomness of sequences when they see long streaks, thus succumbing
to the hot-hand fallacy.
The representativeness heuristic argument is incomplete, however,
because it does not clarify the conditions where one fallacy is more likely
to dominate. To better understand the cognitive mechanism behind
the two fallacies, Ayton and Fischer (2004) test the conjecture that the
gambler’s fallacy is more likely to arise in chance events such as coin
tosses or roulette, neither of which involve human performance, while
attribution to hot hands is more likely in tasks that require human effort,
such as sports. Their experimental results provide support for both
conjectures.
Ayton and Fischer (2004) carried out their hot-hand experiment with
the help of 33 students from Ben Gurion University. Each student was
shown binary sequences made up of a string of 21 symbols of # and @.
Some sequences have a high symbol change-over rate (e.g., @##@#@#),
while others are generated to resemble long streaks. A total of 28 such
sequences were generated for the experiment. Subjects were asked to
indicate whether a sequence with a particular change-over rate repre-
sents the shots of a basketball player (representing human performance),
or a coin toss (representing chance). The results showed that subjects
tend to attribute sequences with low change-over rates to a basketball
player, and to attribute sequences with high change-over rates to a coin
toss. For example, more than 70% of subjects attributed the outcome to a
basketball player when the change-over rate is 0.2 (such as the sequence
@@@@@@@@@#@#########@).

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 The Lottery Mindset

I replicated this simple experiment with 70 MBA students from the

NUS Business School and find very similar results, summarized in
Figure 3.1. The vertical axis in Figure 3.1 is the attribution rate, or the
percentage of subjects who attribute sequences to the basketball player
or the coin toss. The horizontal axis is the change-over rate. Similar
to the Ayton-Fischer study, most subjects associated low change-over
rates with the basketball player and high change-over rates with the
coin toss. The percentages who do so are 65% and 78% respectively
(the corresponding numbers obtained by Ayton and Fischer are 74%
for each case). Collectively, these results confirm people’s tendency
to associate long streaks with human skill, and less streaky events to
randomness.
To summarize, experimental results indicate that there is a “tipping
point” in change-over rates such that given a sufficiently long streak,
people start to reject the notion of randomness in favor of “trends.”
As alluded earlier, this result may also have important implications for
investor behavior, especially trend-chasing. In an early study of individ-
ual investors, DeBondt (1998) surveyed a small sample of 45 American
investors on their beliefs about equity risk and returns. These investors

0.8

0.7

0.6
Attribution Rate

Basketball
0.5
Coin toss

0.4

0.3

0.2
0.2 0.3 0.4 0.5 0.6 0.7 0.8
Change-over Rate

figure 3.1 Probability of attributing sequences to basketball player or coin toss

Source: Author’s research.

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 Trend-Chasing 

were asked to indicate the extent to which they agree or disagree with five
statements, one of which has to do with their beliefs about skills versus
chance. The question reads: “Investing in stocks is like buying lottery
tickets. Luck is everything and investment skill plays no role.” None of the
investors in the survey agreed with this statement, suggesting that they
believe that human skills do play an important role in determining stock
market performance. If such thinking is widespread, then so may be the
belief in hot hands. The rest of this chapter reviews research evidence on
whether a belief in hot hands is prevalent in the stock market.

3.3 Trend-chasing in stock markets

3.3.1 Experimental evidence

A large number of laboratory experiments report evidence of extrapo-
lative forecasting among individual investors. In an early experiment
study, Edwards (1968) find that subjects come to believe in a hot hand
after observing a very long binary series even if they are not told how the
data is generated. Andreassen and Kraus (1990) provide experimental
evidence that while subjects exhibit the gambler’s fallacy when stock
price fluctuations are moderate, their beliefs become extrapolative when
there is a strong price trend. This result is consistent with research by
Odean (1999) who finds that individual investors tend to buy stocks that
have appreciated to a greater extent than those they sell.
Smith, Suchanek, and Williams (1988) find that bubbles and crashes
occur often in laboratory markets, and attribute these phenomena to
price pressures caused by adaptive or backward-looking expectations.
Haruvy, Lahav, and Noussair (2007) show that adaptive expectations are
more prevalent among inexperienced individuals. This result is congru-
ent with Greenwood and Nagel (2009)’s finding that young mutual fund
managers were aggressive buyers of technology stocks near the peak of
the Internet stock bubble in 1999 compared to older fund managers.
They also find that young managers failed to profit from trend-chasing.
Palfrey and Wang (2012) experimentally test the predictions of the clas-
sic model of Harrison and Kreps (1978) and Miller (1977) which features
a market where traders have heterogeneous beliefs and face short-sale
constraints. Consistent with the model’s prediction, subjects chase trends
even when they are told that information signals are random. When

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 The Lottery Mindset

short-sale constraints are binding, assets become overpriced as the most

optimistic traders have a disproportionate effect on prices.

3.3.2 Survey evidence

The most direct way of knowing what investors are thinking is to ask
them. Since 1987, the American Association of Individual Investors
(AAII) has been conducting weekly surveys to assess the stock market
predictions of its members. An early study that uses AAII data is
DeBondt (1993). Using survey results from 1987 to 1992, DeBondt finds
that investors’ forecasts of the Dow Jones Index (DJI) for the next six
months are positively correlated with the DJI’s performance in the prior
week. In particular, the average percentage gap between optimists and
pessimists was higher by 1.3% for every percentage point rise in the DJI
in the week prior to the survey. This represents one of the first evidence
of an extrapolative bias in individual investor forecasts.
Bange (2000) uses AAII data from 1987 to 1994 to test whether indi-
vidual investors act on their forecast by changing their asset allocations.
She finds that investors allocate more money to equities when they are
bullish than when they are bearish. To see if these actions were rational,
Bange regressed the market’s excess returns for month t on the change
in equity holdings of individual investors in the previous month. This
regression is also a test of whether individual investors have market
timing skills. If they do, the coefficient on change in equity holdings
should be significantly positive. Controlling for a set of common
information variables, she finds that individual investors are unable to
successfully time the market over a one-month horizon. In fact, when
investors increase their equity holdings by 1%, market excess returns in
the following month was lower by 0.38%. Similar results were obtained
using a three-month and six-month forecasting horizon. In short,
these results indicate that individual investors chase returns to their
detriment.
Vissing-Jorgensen (2003) examines investor expectations using
data from UBS PaineWebber-Gallup polls. Each month, about 1,000
individual investors with at least $10,000 in financial assets were asked
to answer four questions about their past returns and expectations of
future one-year and ten-year market returns. Responses to these ques-
tions were available monthly from February 1999 to December 2002.
Note that this sample covers the late stage of the 1990s bull market

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 Trend-Chasing 

which peaked in 2000. The author finds that even wealthy investors,
who were supposedly more sophisticated than less wealthy investors,
chased trends. Moreover, these investors remained optimistic about
the market even though many thought stock prices were overvalued
at the time. A plausible story for this behavior is that investors became
overoptimistic after a bullish market, and extrapolated past returns into
the future. This interpretation is consistent with the “house money”
effect (see Thaler and Johnson 1991), in reference to gambling parlance
of ‘playing with the house money’ when gamblers are ahead. In effect,
the house money phenomenon leads gamblers to take on more risks as
their wealth increases. Gervais and Odean (2001) argue that increased
wealth boosts people’s overconfidence about their investment skills
through the self-attribution bias. Again, this leads to increased risk
appetite.
Finance professors, portfolio managers and finance academics are
presumably less biased than individuals. Yet, the evidence does not
always exonerate these “smart investors” from the trend-chasing mind-
set. Froot and Ito (1989) find evidence of extrapolative forecasting among
currency traders. In particular, a rise in the exchange rate leads traders
to expect a higher long-run future spot rate, which implies that short-
term expectations overreact relative to long-term expectations (see also
Frankel and Froot, 1990).
Graham and Harvey (2013) find that Chief Financial Officers’ long-
term forecasts of the equity risk premium reached double digits just
before the Internet stock bubble burst in the late 1999s. Brav, Lehavy, and
Michaely (2005) find that First Call sell-side analysts’ issued more opti-
mistic return forecasts across all stocks between 1997 and 2001, a bullish
period. As these forecasts are widely disseminated to both institutional
and individual investors, sell-side analyst opinions are likely to have a
considerable influence on the expectations and investment decisions of
a cross section of investors. Consistent with this view, Womack (1996),
Barber et al. (2001), and Brav and Lehavy (2003) show that analysts’
forecasts affect stock prices.
Are Finance professors more cool-headed than sentiment-driven
individual investors in their market outlook? Surveys by Welch (2009)
indicate a tendency for finance academics’ forecasts to increase after
market highs and decrease after market lows. For example, the average
forecasts of one-year stock market excess returns reached a high of 6%
to 7% in the first of four surveys (conducted between 1997 and 1998),

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 The Lottery Mindset

but fell to only 3% in 2001. The mean forecast recovered to about 5% in

2007, just before the market crashed in 2008. By January 2009 (the latest
survey), 50% of respondents expected the market to go down over the
next 12 months.
Collectively, the above findings from surveys suggest that some
institutions may also have a proclivity to extrapolate from past returns.
For more direct evidence on institutional trend-chasing, see Goyal and
Wahal (2008) on plan sponsors, Grinblatt, Titman, and Russ (1995),
Wermers (1999), Badrinath and Sunil (2002), and Greenwood and Nagel
(2009) on mutual fund managers, and Brunnermeier and Nagel (2004)
and Griffin et al. (2005) on hedge fund managers.

3.4 Trend-chasing: mutual fund investors

Survey data tap directly into the beliefs of investors, but they have
important limitations. First, respondents may not have the incentives to
reveal their true beliefs. Second, a good survey might require substantial
effort by respondents to analyze disparate pieces of information about
their past returns. They may not have the time or incentives to do so.
Third, return expectations differ widely across individuals, making it
difficult to summarize survey results into a single average forecast that
characterizes the “representative investor.” Experimental studies too
have their critics. The most common criticism is that the market settings
in the laboratory are too remote from that of real life. This, and the often
low monetary compensation paid to subjects, may lead subjects to treat
experiments as parlor games, with little to gain or lose.
Mutual fund investors are primarily individuals, and good data on
mutual funds are widely available. This allows researchers to investigate
the behavior of mutual fund investors and fund managers in great detail.
Beginning with Ippolito (1992), studies have documented evidence of
return-chasing by mutual fund investors. In particular, funds that have
strong past returns tend to attract more capital flows (Chevalier and
Ellion 1997; Sirri and Tufano, 1998). Investors who send more money to
such “star funds” may end up with a portfolio that contains stocks that
are overpriced. Frazzini and Lamont (2009) set out to test this hypoth-
esis using data on equity mutual funds’ ownership of individual stocks.
Specifically, they construct a stock-specific variable which they call
FLOW. Stocks with high FLOW are stocks owned by all equity mutual

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 Trend-Chasing 

funds that have experienced high inflows. If mutual investors are “dumb”
and irrationally send more money into funds that recently performed
well, stocks with high FLOW should have low future returns. In this
sense, FLOW is an investor sentiment indicator.
Frazzini and Lamont (2008) find that FLOW indeed captures investor
sentiment in a way that is consistent with irrational trend-chasing. First,
mutual fund investors direct money into funds with high past returns,
which in turn are funds that have high FLOW. This finding is consist-
ent with the results of previous research by Ippolito (1992) and Sirri and
Tufano (1998). Second, mutual fund investors are ‘dumb’ in that mutual
fund inflows are associated with low future returns while outflows are
associated with high future returns.
Figure 3.2, adapted from Frazzini and Lamont (2009), shows the
evidence for trend-chasing. This figure is a stylized plot of event-time
cumulative abnormal returns (CARs) on long-short (L/S) portfolios of
stocks formed every month based on their past three-month FLOWs
in month t. The L/S portfolio longs stocks in the top quintile by
three-month FLOW, and shorts those in the bottom quintile by three-
month FLOW over the same period. All portfolios are value-weighted.

25

20
Cumulative Abnormal Return

15

10

0
–24 –20 –16 –12 –8 –4 –1 0 4 8 12 16 20 24
Month t+k

figure 3.2 Stylized plot of cumulative average returns: long-short portfolios

formed on three-month FLOW
Source: Adapted from Frazzini and Lamont (2008), figure 1.

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 The Lottery Mindset

Figure 3.2 depicts the CAR at return horizons of between –24 months to
24 months. The line on the left of k = 0 captures the effects of past returns
on current FLOW. Since this line is upward sloping, there is evidence of
trend-chasing. That is, flows into a particular stocks increase after they
have performed well in the past.
The line on the right of k = 0 provides evidence of the dumb money
effect. Since the CAR line slopes downwards, high-FLOW stocks have
lower future returns than low-FLOW stocks.
Figure 3.3 shows the impact of high and low FLOW on subsequent
returns. The figure plots average monthly excess returns of the low-
FLOW quintile (Q1) and high-FLOW quintile (Q5) formed each month
t, on the last available FLOW as of t – 1, where FLOW is measured at
horizons of three months to five years. Portfolios are value-weighted and
rebalanced monthly.
For past three-month FLOW (white bars), Q5 slightly outperforms Q1
but the difference is not statistically significant. However, the dumb effect
is clearly evident at longer FLOW horizons, with Q5 underperforming

1.2

0.8
Portfolio Returns

0.6

0.4

0.2

0
Q1 Q2 Q3 Q4 Q5
Flow Quintiles
3 month 6 months 1 year 3 years 5 years

figure 3.3 Average excess returns of quintile portfolios formed on Past FLOW
Source: Frazzini and Lamont (2008), table 2.

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 Trend-Chasing 

Q1 by 0.36% a month for the one-year horizon and up to 0.85% a month

for the three-year horizon. These numbers translate to economically
large underperformances of between 4% and 10% a year before trading
costs. Adjusting for risks using the characteristics benchmark model of
Daniel, Grinblatt, Titman, and Wermers (1997) yields qualitatively simi-
lar results. Alphas are negative for all horizons and they range from 2%
to 5.1% a year. Thus, whichever way one looks at the evidence, the dumb
money effect is pronounced.
In light of Frazzini and Lamont’s (2008) findings, one can imagine that
individual investors will tend to send more money into mutual funds
when the market is bullish. This in turn encourages fund managers to
tilt their portfolios towards high-beta stocks since these stocks can be
expected to perform better than low-beta stocks in up markets. This is
indeed what Karceski (2002) finds in his empirical study of mutual fund
tournaments. Using data on aggregate cash flows into domestic equity
mutual funds between 1984 and 1996, Karceski (2002) estimates that after
a bull market, funds received new net cash flows (NNCFs) amounting to
38 months of average NNCFs over a two-year period. In contrast, after a
bear market, NNCFs was only five months of average NNCFs. Moreover,
investors pour two and half times as much money into aggressive growth
funds per unit of assets under management than into income funds.
Consistent with agency incentives, fund managers respond to investors’
desire for riskier stocks by tilting their portfolios toward high-beta stocks.
While high-beta stocks generally outperform low-beta stocks contempo-
raneously, investor enthusiasm for high-beta stocks may also cause them
to be overpriced, leading to poor future returns as shown by Blitz and van
Pliet (2007), Frazzini and Pedersen (2014), and Fong and Koh (2014).
The above discussion indicates that mutual fund investors who are
strongly influenced by past high returns are likely to end up choosing
funds that own overpriced stocks. Figure 3.4, based on Frazzini and
Lamont (2008, table 4) confirms this prediction. Each of the five graphs
plots average excess returns (percent per month) of value-weighted
quintiles formed by sorting stocks independently based on their past
three-year FLOW and book-to-market (BM) ratios. BM5 is the highest
BM (value) quintile while BM1 is the lowest BM (growth) quintile. Q1 is
the lowest FLOW quintile and Q5 is the highest FLOW quintile. Since
growth firms have higher betas than value firms, the overpricing hypoth-
esis predicts that funds flow will have a more adverse return impact on
BM1 than BM5.

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 1.4
BM5 (Value)

1.2

0.8
Returns

0.6

0.4

0.2

0
Q1 Q2 Q3 Q4 Q5
1.4
BM4

1.2

0.8
Returns

0.6

0.4

0.2

0
Q1 Q2 Q3 Q4 Q5
1.4
BM3

1.2

0.8
Returns

0.6

0.4

0.2

0
Q1 Q2 Q3 Q4 Q5
figure 3.4 Continued
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 Trend-Chasing 

1.4
BM2

1.2

0.8
Returns

0.6

0.4

0.2

0
Q1 Q2 Q3 Q4 Q5

1.4
BM1 (Growth)
1.2

0.8

0.6
Returns

0.4

0.2

0
Q1 Q2 Q3 Q4 Q5
–0.2

–0.4

figure 3.4 Average returns of quintile portfolios formed on past three-year

FLOW and book-to-market (BM) ratio
Source: Frazzini and Lamont (2008), table 4.

Figure 3.4 shows that Q5 underperforms Q1 in all but one BM quin-

tile, confirming that stocks with large FLOW tend to have lower returns
on average than stocks with low FLOW. Capital inflows have relatively
little impact on the returns of value stocks (the average excess return for
BM5 is always positive). In contrast, FLOW has a marked impact on the
performance of growth stocks. Specifically, the average excess return for
BM1 declines monotonically from 1.32% when FLOW is low to –0.18%
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 The Lottery Mindset

0.4

0.2

–0.2

–0.4
Returns

–0.6

–0.8

–1

–1.2

–1.4

–1.6
3 months 6 months 1 year 3 years 5 years

figure 3.5 Average return of long-short FLOW Strategy: new issues

Source: Frazzini and Lamont (2008), table 5.

when FLOW is high. Consistent with the Karceski (2002), the dumb
money effect is concentrated among high-beta growth stocks.
Another category of stocks where inflows might be expected to
result in pronounced overpricing are new issues (Ritter, 1991; Loughran
and Ritter, 1995). The dumb money effect for new issues is shown in
Figure 3.5. This figure plots the average monthly return (in percent) of a
long-short strategy that sort stocks based on their past FLOW, measured
over horizons of three months to five years, and longs (shorts) stocks
with the 20% highest (lowest) FLOW. Figure 3.5 shows that except for the
three-month FLOW horizon, all other average returns are significantly
negative. Overpricing is especially pronounced for horizons of one year
and above.

3.5 Behavioral biases of mutual fund investors

Bailey et al. (2011) study trend-chasing by individual investors who

maintained accounts at a major US discount brokerage firm from

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 Trend-Chasing 

1991 to 1996. Their dataset is same as that analyzed by Odean (1998)

and Barber and Odean (2000), which contains information on the
trades and monthly portfolio positions of over 21,000 investors.
Bailey et al. (2011) use this dataset to test whether proxies of behav-
ioral biases drive trend-chasing behavior in mutual fund investing. I
discuss this study in some detail as it is the first study to link prox-
ies of important behavioral biases to the actual trading behavior of
individual investors.
Bailey et al. (2011) begin their study with a factor analysis of the
observed characteristics of the 21,542 investors in their database. These
observed characteristics fall into two clusters. The first cluster of investor
characteristics captures behavioral biases which are well documented
in the psychology and behavioral finance literature. These include the
disposition effect, narrow framing, overconfidence, and lottery stock
preference. See table A1 in Bailey et al. (2011) for the full list of biases
they examine and details on how each bias is measured.
The second cluster of investor characteristics relate to investors’ demo-
graphic profiles. I highlight only those demographic characteristics that
Bailey et al. (2011) find to be prominently related to individual inves-
tors’ behavioral traits. These are age, income (total annual household
income), a professional dummy variable (equals one for white collar
profession, zero otherwise), a retired dummy (equals one if the inves-
tor is retired, zero otherwise), investment experience (years since the
brokerage account was open), stock portfolio size (the natural log of the
market value of the investor’s stock portfolio over the sample period),
stock portfolio diversification (the negative of normalized portfolio vari-
ance, where the latter is the ratio of the portfolio variance to the aver-
age variance of individual stocks in the portfolio), and stock portfolio
performance (the intercept from a time series regression, with monthly
stock portfolio returns as the dependent variable).
The factor analysis shows that individual investors in their sample can
be described parsimoniously in terms of five behavioral traits or factors
which they label as: (1) Gambler, (2) Smart, (3) Overconfident, (4)
Narrow Framer, and (5) Mature. The raw inputs for the factor analysis
are the two clusters of investor characteristics.
Table 3.1 summarizes the five behavioral factors in terms of (1) the
percentage of the variance of investor characteristics explained,
(2) investor characteristics with large positive loadings, and (3) inves-

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 The Lottery Mindset

table 3.1 Factor analysis of behavioral characteristics of individual investors

Behavioral  Variance
factor explained Positive loadings Negative loadings
Gambler 21.8% Disposition effect, narrow Age, income, retired
framing, overconfidence dummy, investment
dummy, lottery stocks experience, portfolio size,
preference portfolio diversification,
portfolio performance
Smart 18.1% Age, income, professional Disposition effect, narrow
dummy, retired dummy, framing, overconfidence
investment experience, dummy, lottery stocks
short-sale dummy, preference
portfolio diversification,
portfolio performance
Over- 15.3% Disposition effect, narrow Professional dummy,
confidence framing, overconfidence retired dummy, investment
dummy, lottery stock experience, portfolio
preference diversification, portfolio
performance
Narrow 12.3% Disposition effect, narrow Age, income, portfolio
Framer framing, overconfidence diversification, portfolio
dummy, lottery stock size, portfolio performance
preference
Mature 10.2% Age, retired dummy, Disposition, narrow
investment experience, framing, overconfidence
portfolio size, portfolio dummy, lottery stock
diversification preference, income,
professional dummy

Source: Adapted from Bailey et al. (2011), table 3.

tor characteristics with large negative loadings. Loadings with absolute

values below 0.05 are classified as small.
Several features stand out from Table 3.1. The Gambler, Overconfident,
and Narrow Framer factors tend to load positively on the following
biases: disposition effect, narrow framing, overconfidence, and lottery
stock preference. These loadings indicate quite intuitively that inves-
tors with a gambling trait have a high appetite for risky lottery-type
stocks, consistent with the findings of Kumar (2009). In addition,
overconfident investors and narrow framers prefer less diversified
portfolios despite being ineffective investors as evidenced by the nega-
tive loadings on stock portfolio performance. In contrast, “Smart” and
“Mature” investors tend to be older and more prudent as evidenced by

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 Trend-Chasing 

the positive loadings on diversification. Smart investors are also more

likely to be professionals and effective investors compared to other
investors.
Bailey et al. (2011) next used the factorized behavioral traits to see
whether they explain trend-chasing in individual mutual fund port-
folios. To do so, they carried out cross-sectional regressions in which
the dependent variable is the average (across individuals) of the mutual
fund’s k-year return prior to each purchase, where k is set to 1 and 2.
The independent variables are behavioral bias proxies and controls
for investor demographics such as age, income, marital status, and so
on. Bailey et al. (2011) reject the null hypothesis that investors do not
chase trends. Figures 3.6 and 3.7 summarize their regression evidence
graphically.
Figure 3.6 plots the cross-sectional regression estimates and t-statistics
for four selected behavioral bias proxies (DE, NF, OC, and LS) which
play a significant role in identifying the behavioral factors described
earlier, where DE, NF, OC, and LS stand for the disposition effect, narrow

8
R–12
7 t statistic

6
Coefficient Estimates and t Statistics

0
DE DE*High NF OC LS
Income
–1
Behavioral Bias Proxies

figure 3.6 Regression estimates of trend-chasing behavior: past 12-month returns

and behavioral bias proxies
Source: Bailey et al. (2011), table 3.

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 The Lottery Mindset

7
R–24
6 t statistic
Coefficient Estimates and t Statistics

0
DE DE*High NF OC LS
–1 Income
Behavioral Bias Proxies

figure 3.7 Regression estimates of trend-chasing behavior: past 24-Month

returns and behavioral bias proxies.
Source: Bailey et al. (2011), table 3.

framing, overconfidence, and lottery stocks preference respectively. The

variable DE*High Income is explained below.
The results in Figures 3.6 and 3.7 are based on regressions with
k = 1 and 2 respectively. They show that except for DE, coefficients for
all other behavioral biases are positive and statistically significant. The
strongest trend-chasing predictors are the overconfidence dummy and
lottery stocks preference, followed by narrow framing. The disposition
effect proxy per se is not significant, but the interaction between DE
and a high income dummy variable (equals one if an investor’s average
income exceeds US$125,000 and zero otherwise) has better predictor
power. This interaction variable is motivated by the argument that
although selling winners and keeping losers may be rational from a tax
viewpoint, this action is particularly costly for high income individuals.
We have seen from Frazzini and Lamont’s (2008) study that portfolios
of stocks with large FLOW tend to perform poorly relative to portfolios
of stocks with small FLOW. Bailey et al. (2011)’s result show that it is

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 Trend-Chasing 

behaviorally biased investors who are responsible for these trend-

chasing flows. These investors tend to be those who are overconfident
and risk-seeking.
Figure 3.8 plots the consequences of mutual fund trend-chasing in
terms of gross returns, net-of-expenses returns and market model alphas.
To better capture the economic significance of the results, the figure
shows the annualized return impact of a standard deviation increase
in DE, NF, OC, or LS assuming that the top quintile of each behavioral
bias proxy exceeds the bottom quintile by four standard deviations (this
number is close to that reported by Bailey et al., (2011)). The results are
again based on cross-sectional regressions of returns on the same set of
behavioral bias proxies and controls. Figure 3.8 shows that every one
standard deviation increase in NF, OC, and LS preference implies an
annual net return of at least 1% lower for the top bias quintile compared

0.0

–0.5
Annualized Return and Alpha (%)

–1.0

–1.5

–2.0

–2.5

–3.0
DE NF OC LS
Gross Return Net Return Alpha

figure 3.8 Impact of a one standard deviation increase in a behavioral bias

proxy on annualized return and alpha
Source: Bailey et al. (2011), table 7.

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 The Lottery Mindset

to the bottom bias quintile. The impact of behavioral biases on alphas is

noticeably larger.
In sum, the dumb money effect documented by Frazzini and Lamont
(2008) is driven by behavioral biases associated with investors’ propen-
sity to under-diversify, overtrade, and gamble. Investors with strong
behavioral biases also experience poorer returns than less biased inves-
tors. These results suggest that investors chase trends irrationally and
not because they can infer managerial skills from past performance as
argued by some (Gruber, 1996; Sirri and Tufano, 1998; Berk and Green,
2004).

3.6 Trend-chasing behavior in the aggregate

stock market

Many individual investors prefer to own stocks directly than through

mutual funds. Using data from the Survey of Consumer Finances
(SCF), Polkovnichenko (2005) reports that between 1983 and 2001, at
least 40% of all equity portfolios owned by US households was held
directly. The percentage was in fact much higher in the earlier years of
her sample, but declined continuously over the years as mutual funds
gained popularity. Consistent with other studies, individual investors
in the SCF sample held highly concentrated portfolios comprising of
very few stocks. These equity ownership patterns suggest that trend-
chasing is likely to be more pervasive than is captured by mutual
funds data. One way to detect whether trend-chasing behavior exists
in the broader market is to classify stocks by level of institutional
ownership.
Fong and Ahn (2013) use 13F institutional equity holdings data to
sort stocks quarterly into institutional ownership (IO) quintiles, where
Q1 (Q5) denotes the quintile with the lowest (highest) institutional
ownership ratio (IOR). A stock’s IOR is the number of shares held by
13F institutions divided by the total number of shares outstanding.
Over the sample period of the study (1980 to 2011), the three lowest
IO quintiles have mean IOR of less than 25%, indicating that large
institutions generally avoid stocks in these quintiles. Large institutions
show more interest in Q4 (mean IOR: 45.2%) and strong interest in
Q5 (mean IOR: 69.2%). These ownership patterns suggest that stocks
in Q1 to Q3 are predominantly held by individuals rather institutions.

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 Trend-Chasing 

See the Appendix for details on the sample and research methodology
used in this study.
If individual investors are more prone to trend-chasing, this behavior
should manifest more strongly in the bottom three IO quintiles than in
Q4 or Q5. To detect trend-chasing behavior, we follow Dichev (2007) by
calculating scaled distributions representing capital flows into or out of
the stock market. The distribution for a particular IO quintile in month t
is computed as follows:

Distributiont  MVt 1 s (1  rt ) MVt

where rt is the value-weighted return for an IO quintile for month t,

and MVt is the aggregate market capitalization of that quintile at the
end of the month. A negative distribution indicates that investors were
net-buyers of stocks in month t, that is, they sent more money into the
market than capital flowed out of the market. Conversely, a positive
distribution implies that investors were net-sellers.
Table 3.2 presents annual scaled distributions over the sample period.
We compute each year’s scaled distribution by summing monthly distri-
butions within that year and dividing the result by the average of the
beginning and end-of-year market capitalization. We do this for each
the five IO quintiles. In Table 3.2, SDIST1 denotes the scaled distribution
for the bottom IO quintile (Q1), SDIST2 denotes the scaled distribution
for IO quintile 2, and so forth. To relate the demand for stocks with the
performance of the overall market, the second last column of the table
includes MKT, the average return on the market portfolio (the Centre
for Research on Security Prices [CRSP] value-weighted stock index), and
MKT-12, the average return on the market for the previous year. These
average returns are calculated as geometric means of monthly returns
within a particular year.
Table 3.2 shows that Q1 and Q3 were net buyers of stocks over the
sample period. Of particular interest is Q1 which comprises micro-cap
stocks that are predominantly owned by individual investors. Investors
poured substantial sums of money into the stock market throughout the
bullish decade from 1990 to 1999. The average scaled distribution for Q1
during this period is –0.015, about four times its full-sample average. The
average scaled distributions for Q2 to Q4 were also negative but much
smaller than that of Q1, while the average scaled distribution of Q5 (large
institutions) was actually positive.

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 The Lottery Mindset

table 3.2 Annual scaled distribution by institutional ownership quintiles

Year SDIST SDIST SDIST SDIST SDIST MKT MKT-

1980 0.023 –0.006 –0.008 0.005 0.002 0.291 0.220
1981 0.023 –0.021 0.015 0.005 0.002 –0.041 0.291
1982 –0.006 0.019 0.007 0.002 0.004 0.187 –0.041
1983 –0.020 –0.019 –0.011 –0.014 0.005 0.206 0.187
1984 –0.004 –0.010 0.014 0.009 0.001 0.031 0.206
1985 –0.004 0.031 0.006 –0.006 0.008 0.276 0.031
1986 –0.007 0.000 –0.001 –0.003 0.005 0.145 0.276
1987 –0.001 –0.021 0.015 –0.001 0.003 0.018 0.145
1988 –0.010 0.007 –0.010 0.008 0.008 0.163 0.018
1989 –0.009 0.020 0.000 –0.004 0.007 0.253 0.163
1990 –0.026 0.017 0.010 0.004 0.002 –0.063 0.253
1991 –0.015 –0.023 –0.020 –0.010 0.007 0.293 –0.063
1992 –0.016 –0.009 –0.016 –0.005 0.004 0.087 0.293
1993 –0.019 –0.016 –0.021 –0.016 0.012 0.110 0.087
1994 –0.006 –0.007 0.009 –0.003 0.000 –0.008 0.110
1995 –0.019 0.003 –0.007 0.005 –0.001 0.309 –0.008
1996 –0.027 –0.006 0.018 –0.005 0.000 0.194 0.309
1997 –0.008 0.011 0.006 –0.007 0.006 0.268 0.194
1998 0.002 –0.002 0.028 –0.007 0.003 0.203 0.268
1999 –0.019 0.005 –0.036 0.007 –0.002 0.227 0.203
2000 0.025 –0.011 –0.006 –0.013 0.009 –0.117 0.227
2001 –0.052 0.007 –0.012 –0.017 0.032 –0.119 –0.117
2002 0.089 0.002 –0.023 –0.002 0.014 –0.231 –0.119
2003 0.001 –0.005 –0.060 0.016 0.011 0.290 –0.231
2004 –0.002 –0.005 –0.022 0.010 0.015 0.123 0.290
2005 –0.013 –0.032 –0.018 0.020 0.007 0.071 0.123
2006 0.009 –0.017 –0.001 0.005 0.015 0.151 0.071
2007 –0.022 0.003 0.006 –0.002 0.014 0.071 0.151
2008 –0.015 0.005 –0.002 0.011 –0.005 –0.473 0.071
2009 0.027 0.007 0.018 –0.007 –0.014 0.278 –0.473
2010 –0.068 0.010 –0.017 0.015 0.016 0.166 0.278
2011 0.062 0.068 0.081 0.089 0.088 –0.009 0.166
Mean –0.004 0.000 –0.002 0.003 0.009 0.105 0.112
Stdev 0.028 0.018 0.023 0.018 0.016 0.172 0.172

Source: Fong and Ahn (2013).

Figure 3.9 plots the scaled distribution for Q1 over the sample period
along with the market’s average return for the previous year. Figure 3.10
graphs the same information for Q5. In each plot, the thin line depicts
the market’s average return, while the thick line depicts the scaled distri-
bution. The investment behavior of the two extreme IO groups could not
be more different.

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 Trend-Chasing 

1.0

0.8
Scaled Distribution for IO Quintile 1

0.6

0.4

0.2

0.0

–0.2

–0.4

–0.6

–0.8
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
figure 3.9 Annual scaled distribution of IO quintile 1: 1980–2011
Source: Fong and Ahn (2013).

1.0

0.8
Scaled Distribution for IO Quintile 5

0.6

0.4

0.2

0.0

–0.2

–0.4

–0.6
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

figure 3.10 Annual scaled distribution of IO quintile 5: 1980–2011

Source: Fong and Ahn (2013).

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 The Lottery Mindset

The above analysis indicates that individual investors as a group

chased trends, especially during bullish periods. The next question we
address is whether this behavior was a smart move. To do so, we esti-
mated predictive regressions, in which the dependent variable is the
annual return of each IO quintile and the key independent variable is
the lagged scaled distribution, labeled as Scaled Dist(–1). We include in
the regressions, the current year scaled distribution and market returns
as controls. The results are shown in Table 3.3. The coefficient for Scaled
Dist(–1) is significantly positive for Q1 and Q3 (numbers in bold), insig-
nificant for Q2 and Q4 and significantly negative for Q5. Overall, these
results corroborate the evidence from the mutual funds literature that
individual investors represent “dumb money,” sending money into the
market after strong returns and before poor returns.
To examine the long-term consequences of trend-chasing, we
compute two measures of average returns using monthly data for each
IO quintile: dollar-weighted returns (DWR) and buy-and-hold return
(BHR). DWR is the internal rate of return (IRR) that equates an initial
outlay with the discounted values of all subsequent capital flows, while
BHR is the geometric average of compounded portfolio returns over a
holding period. DWR is the correct measure to assess market timing
ability because it incorporates both the timing and magnitude of investor
capital flows. Successful market timing implies that DWR is higher than
BHR. See the Appendix for details on how these two return measures are
computed.

table 3.3 Predictive regressions: annual returns on lagged scaled distributions

IO quintiles

Q Q Q Q Q
Intercept –0.051 –0.014 –0.015 0.003 0.030
(–1.35) (–0.50) (–1.56) (0.73) (1.81)
Scaled Dist 0.126 0.095 –0.118 –0.037 0.052
(1.34) (0.81) (–2.80) (–0.72) (0.75)
Scaled Dist(–1) . –0.120 . 0.005 –0.277
(2.57) (–1.14) (1.90) (0.12) (–2.17)
Mkt 0.845 1.027 0.993 1.020 0.964
(7.69) (6.31) (21.98) (45.51) (11.34)
Adjusted R square 0.55 0.53 0.91 0.97 0.94

Source: Fong and Ahn (2013).

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 Trend-Chasing 

Following Dichev (2007), we use bootstrap simulations to assess

the statistical significance of the difference between DWR and BHR.
Table 3.4 reports the results. The second column of the table shows the
correlation between current month distribution and previous month
portfolio returns, where numbers highlighted in bold are significant
at 10% and below. The table shows that correlations are significantly
negative for Q1 to Q3 and significantly positive for Q5. Similar to the
patterns for annual data, individual investors and perhaps small insti-
tutions tend to buy more stocks after recent gains and sell stocks after
recent losses. There is no evidence that individual investors were able
to profit from trend-chasing. In particular, BHR is larger than DWR
in all but one case (Q5 is the exception), and bootstrap p-values for
the difference between these two returns (BHR-DWR) are significant
for Q1 to Q4. The gap between BHR and DWR is especially large for
Q1 to Q3.
Our findings complement the results of research based on mutual
funds and trading records data (Frazzini and Lamont, 2008; Bailey
et al., 2011). Those studies find that individual investors send money
to funds that invest in overpriced stocks, and that this dumb money
effect is more pronounced with investors who are significantly affected
by behavioral biases. Our study indicates that the dumb money effect
is not confined to mutual fund investors. Individual investors have
a strong propensity to chase past returns, but not the skills to profit
from it.

table 3.4 Buy-and-hold return (BHR), dollar-weighted returns (DWR) and

correlations between scaled distribution (SDIST) with past month returns, R(–1)
across IO quintiles
IO Quintile Corr[S Dist, R(–)] BHR DWR BHR-DWR
Q1 –. –0.006 –0.043 .
(0.061) (0.075)
Q2 –. 0.089 0.055 .
(0.090) (0.067)
Q3 –. 0.087 0.037 .
(0.098) (0.007)
Q4 –0.025 0.113 0.091 .
(0.623) (0.050)
Q5 0.090 0.110 0.144 –0.034
(0.080) (0.506)
Source: Fong and Ahn (2013).

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 The Lottery Mindset

3.7 Conclusion

This chapter has reviewed empirical research on trend-chasing behavior

in stock markets. The studies surveyed offer little evidence that individ-
ual investors are able to systematically profit from trend-chasing. Mutual
fund investors direct more money to funds with high past returns, but
this simply drives up the prices of growth stocks, new issues and past
winners which are disproportionately represented in the holdings of
“successful” funds. Investors who reallocate their capital this way end up
with overpriced stocks but lower wealth compared to those who do not
chase trends.
The dumb money effect manifests more broadly whenever inves-
tors buy stocks after a rising streak and sell them after a falling streak.
There is no evidence that investors in aggregate can successfully time
their trades to their benefit. Indeed, substantial portions of stock
market wealth are destroyed by those who try to do so. This group
includes mainly individual investors and some small institutional
investors. What is lost by these “dumb” investors is gained by large
institutions.
Despite the evidence, trend-chasing is hard to eradicate because the
brain is hard-wired to seek patterns even in randomness. Evolutionary
biologists argue that pattern-seeking is an innate trait of humans
because it confers survival advantages. This makes sense for our early
ancestors since noticing regularities that exist (e.g., where one’s prey
and predators tend to gather) is of much greater value than the cost
of mistaking regularities that don’t exist. However, in contrast to the
primal environment of our ancestors, financial markets deal with
abstract quantities such as fundamental news, market sentiment and
prices, all of which are difficult to predict. The benefits of trading
on presumed trends in financial markets are therefore much more
dubious.

Appendix: Dollar-weighted returns and institutional

ownership

This appendix describes the sample, data sources, and research method-
ology used by Fong and Ahn (2013). Summary statistics of the data are
also presented.

DOI: 10.1057/9781137381736.0008
 Trend-Chasing 

Sample and data

The sample for the study includes all common stocks with share codes 10
or 11 traded on the New York Stock Exchange (NYSE), American Stock
Exchange (Amex), and NASDAQ. The sample period is from January
1980 to December 2011. Data on stock prices and stock returns are from
the Centre for Research on Security Prices (CRSP) database. Data on
firms’ book-to-market data are from COMPUSTAT.
We also obtain information on the equity holdings of “large”
institutions as classified by the Securities Exchange Commission
(SEC) from the Thomson-Reuters Institutional Holdings database.
Under SEC regulations, financial institutions managing investment
portfolios of at least US$100 million on a discretionary basis are
required to report their stock holdings to the SEC quarterly. This
data, commonly known as “13F” is available quarterly beginning
from April 1980.

Institutional ownership quintiles

Each quarter from April 1980, we sort stocks into institutional owner-
ship quintiles based on their institutional ownership ratio (IOR). A
stock’s IOR is the number of shares held by 13F institutions divided by
the total number of shares outstanding. We adjust the timing of hold-
ings for stock splits and other distributions using the CRSP cumulative
adjustment factor.1 Since our return computations use monthly data, we
use IORs for the first quarter to form IO quintiles for April, May, and
June, IORs for the second quarter to form IO quintiles for July, August,
and September and so on. We let Q1 (Q5) denote the quintile with the
lowest (highest) institutional ownership.

Calculating dollar-weighted returns

To measure the ability of investors to time the market, we compare
dollar-weighted returns (DWR) for each IO quintile with the average
return of a buy-and-hold strategy (BHR). DWR is the correct return
concept to assess market timing ability because it incorporates both the
timing and magnitude of investor capital flows into and out of securities.

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 The Lottery Mindset

To illustrate the intuition behind DWR, consider the following example

from Dichev (2007). An investor has a two-month holding period. He
owns a stock whose price at the start of month 1 is $10. The price then
doubles to $20 by the end of the month, before falling back to $10 at the
end of month 2. Suppose the investor purchased 100 shares of the stock
at start of month 1 and added 100 shares at the end of that month. Using
Equation (3.1) below, the buy-and-hold return is zero percent:

R BH  [(1  100%) s (1 50%)]1/ 2 1  0 (3.1)

But this result is counterintuitive. Since the investor purchased $3000

worth of stocks but received only $2000 from selling, his average return
should be negative, not zero. The reason why BHR is incorrect in this
case is because it gives the same weight to the negative return in month
2 as the positive return in month 1 even though the investor has twice as
much capital in the stock in month 2 compared to month 1. The correct
way to capture the effects of capital flows on returns over a period is by
computing DWR as follows:

1,000 2,000(1  DWR) 1  2,000(1  DWR) 2  0 (3.2)

where the minus signs denote capital outlay and the positive sign at the
end of month 2 denotes capital inflow. The DWR is the internal rate of
return (IRR) that equates the initial outlay of $1,000 with the discounted
values of all subsequent capital flows. Solving Equation (3.2) gives a
DWR of –26.8%. Equation (3.2) can be easily extended to more than
two periods, and can be applied to individual securities or portfolios.
Successful market timing implies that DWR is higher than BHR. We
compute the BHR for each IO quintile as the geometric average of the
monthly value-weighted returns for that quintile. The general formula
for BHR is:
1
BHR [(1  r1 ) s (1  r2 ) s ... s (1  rt )]t 1 (3.3)

The computation for DWR is more involved. Following Dichev (2007),

we first collect a time series of monthly net capital flows or ‘distributions’
for each IO quintile:

Distributiont  MVt 1 s (1  rt ) MVt (3.4)

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 Trend-Chasing 

where rt is the value-weighted return for an IO quintile for month t, and

MVt is the aggregate market capitalization of that quintile at the end of the
month. A negative distribution indicates that investors were net-buyers
of stocks in month t, that is., they sent more money into the market than
capital outflows from the market. Conversely, a positive distribution
implies that investors were net-sellers. The DWR for a portfolio is the
IRR computed using the time series of distributions from Equation (3.4).
By construction, the IRR calculation puts more (less) weight on a return
in a particular period when more (less) capital is invested during that
period.

Summary statistics

Table 3.5 presents the time series means of selected characteristics of

each IO quintile. The three lowest IO quintiles have mean IOR of less
than 25%, indicating that large institutions generally avoid stocks in
these quintiles. Large institutions show more interest in Q4 (mean IOR:
45.2%) and strong interest in Q5 (mean IOR: 69.2%). The rest of the
table report averages of the following stock characteristics: stock price,
market capitalization, and idiosyncratic volatility (IVOL). Following
Kumar (2009), a stock’s IVOL in month t is computed as the standard

table 3.5 Firm characteristics by institutional ownership quintiles

Stock characteristics

Firm Book-to-
No. of size (in market Amihud
stocks IOR million ) ratio IVOL ILLIQ Price
Quintile
Mean 1,126 2.73% 75,519 0.843 0.900 12.264 34.83
Q1
Median 1,141 1.35% 53,381 0.589 0.772 2.198 16.02
Mean 1,135 12.88% 322,668 0.910 0.680 7.208 61.25
Q2
Median 1,158 9.68% 230,957 0.663 0.586 0.755 36.87
Mean 1,137 27.56% 1,645,106 0.879 0.543 3.574 22.17
Q3
Median 1,161 22.72% 490,049 0.678 0.473 0.224 15.94
Mean 1,140 45.21% 3,041,679 0.836 0.442 1.567 28.09
Q4
Median 1,163 41.44% 2,272,986 0.633 0.385 0.049 22.25
Mean 1,143 69.23% 2,365,707 0.773 0.390 0.650 156.83
Q5 Median 1,141 66.41% 2,129,246 0.570 0.339 0.011 145.35

Source: Fong and Ahn (2013).

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 The Lottery Mindset

deviation of residuals obtained from regressing the stock’s daily excess

returns on the FF3 model plus the momentum factor over the past one
year. Book-to-market ratios are computed in the same way as Fama and
French (1992). The liquidity measure is that of Amihud (2002).
Stock price, firm size, and liquidity increase monotonically as we go
from Q1 to Q5, consistent with the fact that institutional investors prefer
larger, more liquid stocks (Falkenstein, 1996, Del Guercio, 1996). Blume
and Keim (2012) reach the same conclusion, but they note that since
1980, institutions have gradually shifted their holdings from large-cap
stocks into smaller, riskier stocks, most likely in response to increased
competition for funds. Average book-to-market ratios are fairly similar
across Q1 to Q4, and is somewhat lower in Q5, suggesting that large
institutions have a stronger preference for growth stocks as compared
to individual investors and smaller institutions. Idiosyncratic volatility
declines monotonically as we go from Q1 to Q5, consistent with indi-
vidual investors’ preference for highly volatile stocks as described by
Kumar (2009) and predicted by the realization utility model of Barberis
and Xiong (2012). Finally, Table 3.5 shows that large institutions avoid
the most volatile stocks in direct contrast to individuals. As Del Geurcio
(1996) argues, this could be due to the effects of prudent-man laws
on institutional equity investments. Overall, the stock characteristics
in Table 3.5 suggest that stocks in Q1 to Q3 are generally owned by
individual investors whereas stocks in Q5 are generally owned by large
institutions.

Note
 Adjusted holdings (report date) = reported holdings (reported date) *
CFACSHR (file date) / CFACSHR (report date). CFACSHR refers to CRSP’s
cumulative adjustment factor for common stocks.

DOI: 10.1057/9781137381736.0008
 4
Growth Stocks
Abstract: Growth stocks systematically underperform value
stocks in many markets, especially among small firms that
are primarily owned by individual investors. This chapter
presents updated evidence on the value premium or book-to-
market effect. I show that the value premium has remained
strong since the 1960s, exists globally, is most pronounced
among small firms, and is mainly driven by the overpricing
of growth stocks that have characteristics very similar to
lottery-type stocks. Cognitive biases that lead investors to be
over-optimistic towards growth stocks are examined, along
with empirical evidence on earnings extrapolations. The
role of short-selling constraints and agency issues in fund
management which prevents effective arbitrage of the value
anomaly will also be discussed.

Keywords: book-to-market; earnings extrapolation;

lottery-stock preference; value premium

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. Basingstoke: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0009.

DOI: 10.1057/9781137381736.0009 
 The Lottery Mindset

4.1 Introduction

Stocks with low book-to-market (BM) ratios historically underperform

those with high BM. The difference between the average return of value
stocks and the average return of growth stocks is known as the value
premium or book-to-market effect. The value premium is economi-
cally large, exists in many markets, and has defied standard risk-based
explanations.
This chapter reviews the value premium with a focus on its implica-
tions for individual investors. Section 4.2 presents empirical evidence
on the value premium in global stock markets, beginning with the US
market which has a long history, followed by evidence from the United
Kingdom, Continental Europe, and Japan. Sections 4.3 and 4.4 turn the
spotlight on individual investors and the value premium by looking at
the returns of value and growth portfolios sorted by firm size. Consistent
with previous research, the value premium is concentrated in the small-
est 40% of firms, with overpricing of growth stocks being the main driver
of the value effect. Another take-away from this section is that smaller
institutions may also have contributed to the value premium in recent
years.
Growth investors seek stocks which can achieve rapid earnings
growth. However, attempts to predict long-term earnings growth are
rife with psychological biases. Section 4.5 presents evidence on the
tendency for investors to be over-optimistic in their earnings forecasts
for growth firms and over-pessimistic in their earnings forecasts for
value firms. Behavioral biases that induce such extrapolative beliefs
are discussed.

4.2 The value premium revisited

This section surveys the value premium in international stock markets. I

will begin with the US evidence in subsection 4.2.1, followed by evidence
from other developed markets in subsection 4.2.2. My analysis for the
United States is based on data that are freely provided by Professor
Kenneth French on his website at http://mba.tuck.dartmouth.edu/pages/
faculty/ken.french/data_library.html. The sample period for my analysis
is from July 1926 to December 2012.

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 Growth Stocks 

All returns are analyzed at the portfolio level. While Professor

French has compiled returns for decile and quintile portfolios, I will
focus on quintiles in the interest of space. BM quintiles are formed at
the end of June each year. The sample includes all NYSE, AMEX, and
NASDAQ stocks for which there is available market capitalization data
in December of the previous year (t – 1) and book value data for the
latest fiscal year ending in t – 1. The post-formation returns for each
quintile are calculated monthly but all returns will be presented in
annualized form.
I focus on value-weighted portfolios which are less influenced by
the returns of small firms. However, stocks with high retail concen-
tration tend to small firms (Barber and Odean, 2000; Goetzmann
and Kumar, 2008) and firms with lottery features (Kumar, 2009). To
study the effects of firm size on the value premium, I will examine
the returns of portfolios sorted by size and BM ratio in Sections 4.3
and 4.4.

4.2.1 The US value premium

Table 4.1 shows evidence of the value premium in the US stock market.
Panel A reports annualized average excess returns (over the Treasury bill
rate) of BM quintiles, where BM1 (BM5) consists of stocks with the lowest
(highest) book-to-market ratios. The last row (BM5–BM1) captures the
value premium, the difference in average returns between value stocks
and growth stocks. Numbers highlighted in bold are statistically signifi-
cant at 5% or lower.
Over the 86-year period from 1926 to 2012, value stocks earned an
average excess return of 12% a year compared to 7% for growth stocks.
Investors who chose growth stocks over value stocks thus incurred a
sizeable opportunity cost of 5% a year.
Following Asness, Moskowitz, and Pedersen (2013), Panel B
presents risk-adjusted returns of BM quintiles using the Capital Asset
Pricing Model (CAPM) as the benchmark. The market risk factor is
uncontroversial, at least in a time-series context. In contrast, there is
ongoing debate as to whether the high-minus-low (HML) value factor
in the Fama-French three-factor model really captures firm distress
risk as Fama and French (1993) contend. See Campbell, Hilscher, and
Szilagyi (2008) for evidence on the effects of financial distress and the

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 The Lottery Mindset

cross-section of stock returns. See Lakonishok, Shleifer, and Vishny

(1994) and Fong (2012) for time-series evidence.
Over the full sample period, CAPM was able to price portfolios
sorted on BM. The value-growth alpha of 2.76% per annum is statisti-
cally insignificant (t-statistic: 1.53). This result differs from Fama and
French (1992) who document a significant value premium over the
period from 1963 to 1990. The second column of Panel B confirms this
result. The value premium over this period is large (6.48% per annum)
and highly significant (t-statistic: 2.74). The last column of Panel B
shows that the value premium also exists from 1963 to 2012, although it
is about 1.3 percentage point smaller compared to the value premium
in the earlier subperiod.

table 4.1 The US value premium: 1926–2012

Annualized excess returns ()

Panel A – – –

BM1 7.00 3.52 5.04

BM2 7.43 4.04 6.08
BM3 8.55 5.09 6.40
BM4 9.84 7.63 8.08
BM5 12.01 9.65 9.87
BM5–BM1 5.02 6.13 4.82
CAPM Alphas ()
Panel B – – –
– – –
BM1 3.02 5.45 4.24
(5.10) (5.19) (5.220
BM2 3.79 6.13 5.67
(6.62) (7.19) (7.15)
BM3 4.46 7.68 6.35
(5.31) (8.42) (6.44)
BM4 4.94 10.32 8.23
(4.58) (8.47) (6.50)
BM5 5.79 11.93 9.44
(3.98) (7.45) (6.42)
BM5–BM1 2.76 . .
(1.53) (2.74) (2.60)

Source: Author’s research. Raw data from the website of Professor Kenneth French
at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.

DOI: 10.1057/9781137381736.0009
 Growth Stocks 

The above findings imply that there was no value premium in the
United States before 1963. Separate analysis (not reported) confirms this.
I find that from 1926 to 1962, value and growth stocks had very similar
average returns.
It is not clear why there was no value premium prior to 1963. One
possible explanation is that the US economy performed very poorly in
this period, which led to sustained financial distress among many small
firms during the Great Depression and the Second World War (Bernanke,
1983). By contrast, the economy had remarkably few recessions from
1963. Records from the National Bureau of Economic Research (NBER)
show that while there were an equal number of business cycle troughs
from 1933 to 1962 and 1963 to 2012 (seven in both cases), the two periods
could not be more different in terms of the average duration of economic
expansion: 42 months in the earlier period and 71 months in the later
period. Not surprisingly, the post-1963 period witnessed two of the most
prolonged expansions in US economic history (in the 1960s and 1990s).
See www.nber.cycle.org for details. Therefore, it would appear that the
value premium emerged only after investors were steadily conditioned
to long periods of economic prosperity.

4.2.2 The international value premium

This section presents evidence on the global value premium. Results
are shown for the United Kingdom, Continental Europe, Japan, and the
United States. The sample period is from July 1981 to December 2012. The
raw data are downloaded from the website of Professor Lasse Pedersen
at http://www.lhpedersen.com/data. This data closely overlap with the
dataset analyzed by Asness et al. (2013).
Portfolios are formed in the following manner. Each month, all eligible
stocks are sorted into book-to-market tertiles. Only very liquid stocks
are used to form portfolios. Specifically, stocks with share price below $1
at the start of each month are excluded from the sample. Of the remain-
ing firms, only those that cumulatively account for 90% of the market
capitalization in each stock market are selected. On average, these filters
select portfolios that comprise the largest 20% of stocks in each market.
Table 4.2 reports summary statistics on the performance of value and
growth stocks in each market. Panel A reports average excess returns
(over the US Treasury bill rate), Panel B reports Sharpe ratios, and Panel

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 The Lottery Mindset

table 4.2 The international value premium: 1981–2012

Panel A Excess Returns ()
BM BM BM BM–BM
US 10.67 11.22 12.87 2.20
UK 10.68 12.26 14.60 3.92
EUR 11.63 14.08 15.75 4.13
JP 2.26 7.67 13.56 11.31
Panel B Sharpe Ratios
US 0.36 0.44 0.52 0.19
UK 0.33 0.39 0.49 0.29
EUR 0.39 0.52 0.56 0.36
JP –0.10 0.14 0.42 0.75
Panel C Value of  Invested
US UK EUR JP
Value 38.02 50.79 73.32 34.38
Growth 17.80 16.62 22.50 0.87
Value-Growth 20.22 34.17 50.81 33.51

Source: Author’s research. Raw data are from the website of

Professor Lasse Pedersen at http://www.lhpedersen.com/data.

C reports cumulative return statistics. BM1 (BM3) is the lowest (highest)

BM tertile.
Table 4.2 confirms that the value premium is not confined to the
United States. In fact, the United States has the smallest value premium
(2.2% per annum), while Japan has the largest value premium (11.3% per
annum). A strategy of buying value stocks and shorting growth stocks
generated positive Sharpe ratios of between 0.19 for the United States
and 0.75 for Japan. Given the extremely high Sharpe ratio for Japan, the
Sharpe ratio of an equal-weighted portfolio of the four markets is also
high (0.40). Over the sample period, this portfolio produced a CAPM
alpha of 6% per annum (t-statistic: 2.65).
Due to compounding, a modest value premium can cumulate an
initial amount to a very large sum over the long run. Figure 4.1 plots
the value in December 2012 from investing $1 in either value or growth
stocks in July 1981. The bold line traces the cumulative return from value
stocks (BM3) and the dash line traces the cumulative return from growth
stocks (BM1). Over the 31 year period, a dollar in US value stocks grew to
$38, while a dollar in US growth stocks grew to only $17.80, a difference
of $20.22. This difference is even larger for the other markets: about $34
for United Kingdom and Japan, and $51 for Europe.

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 Value of $1 Invested in 1981

figure 4.1
Value of $1 Invested in 1981

0
10
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0
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198107
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198311
198311

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198501

Continued
198501
198603
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198705
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198807
198807
198909
198909
199011
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199201
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199405
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UK
199711
US

199711
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200411
200411
200601
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200703
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200805
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200907
201009
201009
201111
201111
Growth Stocks

 

Value of $1 Invested in 1981 Value of $1 Invested in 1981

figure 4.1
0
5
10
15
20
25
30
35
40
45
50
0
20
40
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80
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198107 120
198107
198209 198209
198311 198311
198501 198501

www.lhpedersen.com/data
198603 198603
The Lottery Mindset

198705 198705
198807 198807
198909 198909
199011 199011
199201 199201
199303 199303
199405 199405
199507 199507
199609 199609
199711

Japan
199711
Europe

199901 199901
200003 200003
200105 200105
200207 200207
200309 200309
200411 200411

Value in December 2012 of $1 invested in July 1981

200601 200601
200703 200703
200805 200805
200907 200907
201009 201009
201111 201111

Source: Author’s research. Raw data from the website of Professor Lasse Pedersen at http://

DOI: 10.1057/9781137381736.0009
 Growth Stocks 

4.3 Lottery-stock preference, arbitrage risk and

the value premium

In this section, I examine the value premium across firm size. The
interaction between size and the value premium is of interest because
individual investors tend to concentrate in smaller stocks, as well as
stocks with lottery features (Goetzmann and Kumar, 2008; Kumar 2009).
Kumar (2009) define a lottery-type stock as one which has a low price,
high idiosyncratic volatility, and high idiosyncratic skewness. Despite
their low average returns, gambling-motivated investors find these
stocks attractive because of their occasional large (“jackpot”) returns.
This section investigates whether individual investors also view growth
stocks as offering lottery-type payoffs. If they do, small growth stocks
should be more overpriced than large growth stocks.
To study the interaction of firm size and the value effect, I examine the
returns of double sorted portfolios. The data for this analysis is obtained
from Professor Kenneth French’s Data Library. Portfolios (quintiles) are
formed annually, first by sorting stocks on market capitalization using
NYSE breakpoints, then on BM ratio within each size quintile, giving a
total of 25 size-BM quintiles.
Table 4.3 shows return statistics of the 25 size-value portfolios for
the period from 1926 to 2012. All portfolios are value-weighted. Panel
A reports average excess returns and Panel B reports CAPM alphas. As
before, all returns and alphas are in percent per annum. Size 1 (Size 5)
consists of firms in the smallest (largest) size quintile.
Table 4.3 shows that the value premium is concentrated among
small firms. The BM5–BM1 alpha for Size 1 is particularly large (11.97%,
followed by 7.04% for Size 2, and 4.75% for Size 3. These alphas are all
statistically significant. In contrast, there is no value premium for large
firms.
Firms in the lowest three size quintiles are mainly owned by individual
investors and small institutions. Using 13F institutional holdings data
from Thomson Reuters, I find that over the sample period, “large insti-
tutions,” defined by the Securities Exchange Commission as those that
exercise investment discretion over portfolios of at least $100 million,
owned than less 3% of firms in Size 1, about 13% of firms in Size 2, and
28% of firms in Size 3.
That the value premium is more pronounced in small firms
is consistent with previous research by Fama and French (1992),

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 The Lottery Mindset

table 4.3 Returns of value and growth portfolios by firm size

Panel A Excess returns ()
Size  Size  Size  Size  Size 
BM1 6.23 6.80 8.31 8.24 7.06
BM2 8.99 11.06 10.33 8.75 7.15
BM3 12.67 12.03 11.40 10.04 7.79
BM4 13.77 12.83 12.07 11.38 8.22
BM5 16.48 14.92 13.70 12.28 10.33
BM5–BM1 10.25 8.12 5.39 4.04 3.27
Panel B CAPM Alphas ()
BM1 –. –. –1.26 0.12 –0.21
(–2.51) (–1.66) (–1.07) (0.12) (–0.33)
BM2 –2.20 1.74 . 0.52 0.26
(–1.14) (1.37) (2.00) (0.59) (0.44)
BM3 2.31 . . . 0.44
(1.288) (2.42) (2.79) (1.97) (0.47)
BM4 . . . . –0.07
(2.44) (2.72) (3.10) (2.11) (–0.06)
BM5 . . . . 1.45
(3.23) (2.68) (2.09) (1.00) (0.91)
BM5–BM1 . . . 1.56 1.67
(5.66) (3.80) (2.31) (0.73) (0.86)
Panel C Value and Growth Mispricing ()
BM5–BM3 . 1.67 0.62 –0.14 1.02
% mispricing 161% 58% 22% –8% 232%
t-statistics 3.22 1.4 0.51 –0.01 0.58

BM1–BM3 –. –. –. –1.71 –0.65

% mispricing –356% –186% –144% –94% –149%
t-statistics –4.23 –3.94 –2.94 –1.25 –0.48

Source: Author’s research. Raw data from the website of Professor Kenneth
French at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.

Ali, Hwang, and Trombley (2003) and Israel and Moskowitz (2012).
Studies using mutual fund flows data also show evidence consistent with
individual investors’ stock preferences. Karceski (2002) finds that indi-
vidual investors display a strong preference for aggressive growth funds
over income funds. Since growth stocks have higher betas and higher
idiosyncratic volatility than value stocks (see Ali et al., 2003), this prefer-
ence can also be viewed as a desire for lottery-type stocks.
Growth stocks can be overpriced for long periods because high
idiosyncratic risk deters would-be arbitrageurs from exploiting the

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 Growth Stocks 

anomaly (Shleifer and Vishny, 1997). Because mutual fund managers are
agents of individual investors, they too have strong incentives to tilt their
portfolios toward growth stocks in bullish periods. Consistent with the
limits-to-arbitrage hypothesis, Ali et al. (2003) and Nagel (2005) find that
the value premium is largest among stocks that have high idiosyncratic
volatility and low institutional ownership.
The combined effects of lottery-stock preference and limits to arbi-
trage leads to a simple prediction: the value premium is mainly driven by
overpriced growth stocks than underpriced value stocks. In other words,
the profitability of the long-short (BM5–BM1) strategy is mainly due to
the short-leg of the strategy.
Panel C confirms this hypothesis. Using BM3 as the “value-neutral”
portfolio, I report the difference in alphas between BM5 and BM3 and
the difference in alphas between BM1 and BM3. A positive BM5–BM3
implies that value stocks are underpriced, and a negative BM1–BM3
implies that growth stocks are overpriced. Panel C shows that value
stocks are underpriced only among very small firms (Size 1), while
growth stocks are overpriced among firms in Size 1 to Size 3. Relative
to BM3, growth stocks are overpriced to a greater degree than value
stocks are underpriced. These results indicate that the small-firm value
premium is largely due to overpriced growth stocks.

4.4 The persistence of lottery-stock preferences

How persistent is the small-firm value premium? Table 4.4 shows
mean excess returns and alphas for the size-value quintiles over four
subperiods: three 25-year periods (1926 to 1950, 1951 to 1975, and 1976 to
2000) and the remaining 12-year period from 2001 to 2012. In addition
to CAPM alphas, I report alphas based on a two-factor model, which is
simply the FF3 excluding HML. I exclude HML because it is tautological
to explain the value effect with another representation of the same effect.
Moreover, the notion that HML represents a distress risk factor has not
received much empirical support.
Table 4.4 shows that the value premium is largely absent among large
firms (Size 4 and Size 5) across the subperiods. Size 1 firms show the larg-
est and most persistent value premium, which suggests that individual
investors have a robust desire for growth stocks. Figure 4.2 displays
evidence consistent with this view. Shown in this figure are t-statistics

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 table 4.4 Excess returns and alphas of size-sorted value and growth stocks by subperiods

Panel A. Size  (Smallest) Panel D. Size 

– – – – – – – –
BM1 14.17 3.44 3.89 0.73 BM1 10.109 5.434 10.012 6.606
BM2 8.08 7.05 11.97 8.69 BM2 11.747 5.846 9.449 7.232
BM3 20.37 6.64 12.75 9.36 BM3 11.768 9.588 10.696 6.059
BM4 18.73 9.75 14.42 10.66 BM4 14.766 9.468 12.495 6.254
BM5 24.36 11.51 14.68 14.50 BM5 17.888 9.468 12.495 6.254
BM5-BM1 10.20 . . . Value-Growth 7.779 4.034 2.482 –0.352
t-statistic (1.12) (2.94) (3.50) (3.27) t-statistic (1.28) (.) (0.78) (–0.09)
CAPM Alpha . . . . CAPM Alpha 0.996 4.080 5.580 1.656
t-statistic (1.88) (3.66) (4.08) (3.00) t-statistic (0.20) (1.40) (1.63) (0.319)
2-Factor Alpha . . . . 2-Factor Alpha –0.18 4.2 . 5.424
t-statistic (1.74) (3.77) (4.50) (3.59) t-statistic (–0.04) (1.44) (1.81) (1.05)

Panel B. Size  Panel E. Size  (Largest)

– – – – – – – –
BM1 10.23 3.56 7.15 5.82 BM1 8.96 6.61 8.34 1.45
BM2 16.59 7.08 10.77 8.68 BM2 7.92 5.41 9.49 4.35
BM3 14.88 9.13 12.61 11.05 BM3 8.71 8.17 8.87 2.85
DOI: 10.1057/9781137381736.0009

BM4 17.12 9.20 14.10 8.96 BM4 10.70 7.60 9.55 1.70
BM5 21.62 11.87 13.70 10.14 BM5 15.54 8.23 10.68 3.33
BM5-BM1 . . . 4.32 Value-Growth 6.58 1.62 2.34 1.89
t-statistic (2.19) (3.58) (2.20) (1.02) t-statistic (1.24) (0.62) (0.84) (0.47)
CAPM Alpha . . . 7.34 CAPM Alpha 2.34 1.79 4.60 1.39
t-statistic (1.75) (3.55) (3.18) (1.43) t-statistic (0.47) (0.71) (1.53) (0.35)
2-Factor Alpha . . . 4.12 2-Factor Alpha 1.42 1.94 4.70 4.76
t-statistic (1.70) (3.84) (3.36) (0.84) t-statistic (0.30) (0.77) (1.55) (1.10)
DOI: 10.1057/9781137381736.0009

Panel C. Size  Panel F. Size  (Small minus Big)

– – – – – – – –
BM1 12.41 5.31 8.52 5.75 BM1 5.202 –3.163 –4.456 –0.713
BM2 12.35 7.89 11.71 8.38 BM2 0.160 1.644 2.483 4.341
BM3 16.06 7.99 11.18 9.48 BM3 11.661 –1.533 3.877 6.513
BM4 15.29 10.49 11.82 9.31 BM4 8.029 2.151 4.871 8.957
BM5 17.91 8.84 15.18 12.16 BM5 8.823 3.286 3.996 11.168
BM5-BM1 5.49 3.53 6.65 6.42 Value-Growth 3.621 6.449 8.452 11.881
t-statistic (1.18) (1.53) (.) (1.64)
CAPM Alpha 1.98 . . .
t-statistic (0.47) (1.76) (2.80) (2.11)
2-Factor Alpha 2.14 . . .
t-statistic (0.53) (1.73) (2.90) (2.42)

Source: Author’s research.

 The Lottery Mindset

of regressions coefficients for four for lottery factors: TSKEW, ISKEW,

IVOL, and MAX. The coefficients are estimated based on time-series
regressions of the monthly value premium on the market excess return
(MKT) and each lottery factor. The black bars denote t-statistics based
on firms in Size 1, the grey bars, t-statistics based on the average value
premium of firms in Size 1 and Size 2, and the white bars t-statistics
based on the average value premium of firms in Size 1 to Size 3.
The lottery factor TSKEW captures the returns of an investment strat-
egy that longs low-total skewness stocks and shorts high-total skewness
stocks. The other lottery factors are defined similarly based on idiosyn-
cratic skewness (ISKEW), idiosyncratic volatility (IVOL) and maximum
daily returns in the previous month (MAX). Past research shows that such
strategies yield positive alphas, indicating that stocks with lottery features
are overpriced. Details on the construction of the lottery factors are given
in Appendix 4.1.
Figure 4.2 shows that the t-statistics for all the indicated portfolios are
positive and most are significant. This implies that overpricing of growth
stocks is positively correlated with the overpricing of lottery-type stocks.

2.5

1.5
T–statistic

Size 1
Size 1–2
Size 1–3
1

0.5

0
TSKEW ISKEW IVOL MAX

figure 4.2 t-statistics of lottery factor regression coefficients

Source: Author’s research.

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 Growth Stocks 

1.8

1.6

1.4
Monthly Alphas (Percent)

1.2
Size1
1.0 Size2
Size3
0.8 Size4
Size5
0.6

0.4

0.2

0.0
1 2 3 4
Subperiod

figure 4.3 Subperiod alphas of size-sorted value and growth portfolios

Source: Author’s research.

Figure 4.3 provides a visual summary of the changes in two-factor

alphas over the four subperiods analyzed earlier. These alphas are
expressed as monthly percentages. Note the sharp increase in alpha for
Size 3 firms from the third subperiod.
The rise in the alpha for Size 3 is interesting because it suggests
that smaller institutions may have contributed to the value premium.
Blume and Keim (2012) and Lewellen (2011) note that since 1980,
institutional investors have increased their portfolio allocations to
smaller stocks. Among institutions, mutual funds’ ownership of US
equities increased very significantly over this period (Bailey, Kumar,
and Ng, 2011). Karceski (2002) find that in aggregate, equity mutual
funds overweight high-beta growth stocks relative to their market
weights. In terms of fund styles, aggressive growth funds manage
more than twice the amount of money as income funds. Hao (2010)
shows that the value premium is partly due to the tendency for
institutions to trade concurrently or herd in the direction of intan-
gible information. Daniel and Titman (2006) find that intangible

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 The Lottery Mindset

information negatively predicts future returns. It is plausible that

these forces explain a portion of the value premium for Size 3
stocks.

4.5 Earnings extrapolation and the value premium

Why do individual investors overpay for growth stocks? We have

argued that a desire for lottery payoffs can partly account for the value
premium among small firms. In this section, we argue that investors
are also misled by the belief that growth firms can sustain rapid earn-
ings growth. In particular, the tendency to extrapolate past earnings
growth leads to biased predictions in the form of over-optimistic earn-
ings forecasts for growth firms and over-pessimistic earnings forecasts
for value firms.
There is little doubt that earnings are viewed by investors and senior
company executives as one of the most important measures of a firm’s
performance (see e.g., Graham, Harvey, and Rajgopal, 2006; Federick W.
Cook & Co, 2013). Research shows that a cross-section of people, includ-
ing stock analysts, corporate executives, and investors, tend to extrapo-
late past earnings growth into the future. Bain & Company’s Consultant
Chris Zook surveys firms that have achieved sustained growth in the
1990s (Zook, 2001). He finds that two-thirds of these firms continued
to project double-digit earnings growth rates in their long-term plans.
Graham et al. (2006) report that corporate executives were willing to
defer value-creating projects and cut R&D budgets to meet short-term
earnings expectations.
Brav, Lehavy, and Michaely (2005) study the earnings forecasts of sell-
side stock analysts using data from the First Call database. Controlling
for beta, firm size, and momentum, expected returns implied by analysts’
earnings forecasts vary inversely with BM ratios. That is, analysts expect
higher returns for growth firms than value firms. This contradicts the
predictions of rational asset pricing models that value firms should have
higher expected returns because they are riskier.
One way to interpret Brav et al.’s finding is that a low BM ratio reflects
a large dose of good news that a growth firm has enjoyed, and analysts
tend to predict more good times ahead. Consistent with this view, Zhang
(2006) shows that among firms with a high degree of information

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 Growth Stocks 

uncertainty, such as growth firms, good news tend to be followed by

higher stock returns the following month, while bad news tend to be
followed by lower returns over the same period. Again, this news-return
pattern contradicts the predictions of standard asset pricing models.
Greenwood and Shleifer (2014) analyze expectations of stock market
returns from five survey sources: Gallup, Investors’ Intelligence, the
American Association of Individual Investors, surveys of chief financial
officers conducted by economists John Graham and Campbell Harvey,
and surveys of wealthy individual investors conducted by economist
Robert Shiller.
To see what factors drive these stock market return expectations, they
estimate the following time-series regression:

E (Rt )  a  bRt k  cPt  dZ t  ut (4.1)

where E (Rt ) is the expected return on the S&P 500 index over the next
12 months, Rt 12 is the past k-month cumulative raw return on the S&P
index, P is the price level (either the log of the S&P index or the log
price-dividend ratio), and Z is a vector of fundamental variables such as
aggregate stock market earnings growth, the unemployment rate and the
risk-free rate. They report results using k = 3, 12, and 24 months and find
them to be very similar. Below, I focus on their results for k = 12.
The main variable of interest is earnings growth. If investors forecast
returns by extrapolating from past  earnings growth, the coefficient on
this variable, which I denote by d e will be positive. Their results show

that d e is positive in all cases though it is statistically significant in only
two cases (surveys conducted by Gallup and the American Association
of Individual Investors).
The Gallup results are of particular interest for two reasons. First,
this survey has a large respondent pool which reduces statistical noise.
Second, a sentiment indicator constructed using Gallup survey responses
is highly and positively correlated with inflows into equity mutual funds
as well as the return expectations of chief financial officers. Greenwood
and Shleifer’s findings therefore suggest that a large cross-section of
investors extrapolate past earnings growth into the future when form-
ing return forecasts. In line with the findings of Brav et al. (2005), these
forecasts are not consistent with expected returns implied by rational
risk-based models.

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 The Lottery Mindset

In sum, research suggests that when investors say they expect higher
returns, they are in fact extrapolating prices in the direction of recent
good news, and not because they expect returns to compensate for risk.
Extrapolative forecasts are of little use if good news show little persist-
ence. Fama and French (2002) find that even short-term earnings growth
is highly unpredictable. Novy-Marx (2013) point out that Fama and
French’s findings are not surprising because earnings are a highly noisy
measure of a firm’s true economic profitability. He also finds that instead
of showing persistence, current-year earnings growth negatively predict
earnings growth over the next three-years, and have no predictive power
for earnings growth over the next ten years. His result is consistent with
a comprehensive study by Chan, Karceski, and Lakonishok (2003) who
find that there is “no persistence in long-term earnings growth beyond
chance” (Chan et al., 2003, p. 643). Appendix 4.2 summarizes the main
findings of this seminal study.

4.6 Conclusion
Investors do not only chase returns. They also chase earnings, with
unsophisticated individual investors more likely to do so than informed
institutional investors. Return-chasing and earnings-chasing are inti-
mately related. Growth stocks reach lofty valuations due to their strong
past returns. In turn, a rising stock price becomes the market’s endorse-
ment of a firm’s rapid earnings growth which investors continue to
expect but are more likely to be disappointed. Trend chasing in either
form are aided by a range of cognitive biases which includes investors’
predilection for stereotyping growth stocks as great investments (the
representativeness heuristic), the tendency to overlook the low base rate
of consistently profitable firms, and to ignore mean reversion in operat-
ing performance. Furthermore, gambling-motivated investors also seek
growth stocks for potential jackpot returns associated with these stocks’
high idiosyncratic volatility and high idiosyncratic skewness.
The good news is that growth investors are not doomed to dismal
returns. As Novy-Marx (2013) shows, companies that rank highly
in gross profitability are good growth stocks which are less prone to
distress and have longer cash flow durations. Investors can benefit from
the anomalous way the market prices such stocks. Like firms with low
financial distress (Campbell et al. 2008), good growth firms have higher

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 Growth Stocks 

average returns and alphas than firms that simply carry the growth label
by virtue of their low BM ratios. In some sense, growth investors have
been barking up the wrong tree.

Appendix 4.1: Lottery factors

The construction of lottery factors follows George and Hwang (2010)

and Palazzo (2012). We use four measures of stock lottery character-
istics commonly examined in the literature: total skewness (TSKEW),
idiosyncratic skewness (ISKEW), idiosyncratic volatility (IVOL), and
maximum daily returns in the previous month (MAX). The definition of
these lottery measures are as follows:

Total skewness (TSKEW)

TSKEW for a stock is defined as the third moment of the stock’s daily
returns in the past month For stock i in month t, this is given by:

Dt
Dt ¥ Ri , d * i ,t ´
TSKEWi ,t  ¤
D t 1 D t 2 d 1 ¦§ m i ,t µ¶ (4.2)

where D t is the number daily observations in month t; Ri ,d is the return of

stock i on day d; * i ,t is the mean daily return of stock i in month t; and m i ,t
is the standard deviation of the daily stock returns of stock i in month t.

Idiosyncratic volatility (IVOL)

Following Ang et al. (2006), we estimate a stock’s IVOL using the Fama
and French (1992, 1993) three-factor model by regressing a stock’s daily
excess returns in month t against excess returns of the CRSP market
index, the Small-minus-Big (SMB) factor and the High-minus-Low
(HML) factor over the same month. The regression is:

Ri ,d rf d  ] i  ^ 1,i MKTd  ^ 2,i SMBd

 ^ 3,i HML d  a i ,d (4.3)

where subscript d denotes a particular day, Ri ,d is the return on stock

i; rf d is the risk-free rate (the one-month Treasury bill rate); MKTd is
the market’s excess return, SMBd and HML d are the daily premiums

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 The Lottery Mindset

for Small-minus-Big and High-minus-Low portfolios obtained from

Professor Kenneth French’s website (http://mba.tuck.dartmouth.edu/
pages/faculty/ken.french/data_library), and a i ,d is the regression
residual for stock i. The regression is estimated using a window period
of one month for all stocks that have at least 16 data points within the
month. The estimate for IVOL is the square root of the variance of the
regression residual:

IVOLi ,t  Var a i ,d (4.4)

Idiosyncratic skewness (ISKEW)

Estimation of ISKEW follows Harvey and Siddique (2000). Each month
t, we regress the daily returns of stock i based on the following model

Ri ,d rf d  ] i  ^ i MKTd  c i MKTd2  a i ,d
(4.5)

ISKEW is defined as the skewness of a i ,d . As with IVOL and TSKEW,

the regression window is one month.

Maximum daily returns (MAX)

Following Bali, Cakici and Whitelaw (2011), MAX is defined as the
maximum daily return of a stock in the previous month.

Constructing the Lottery Factors

To form a lottery factor (say, for TSKEW), we regress stock returns
each month against the three risk factors of Fama and French and
a dummy variable for low and high-TSKEW stocks. The regression
specification takes the following form (omitting firm subscripts for
brevity):

Rt  h 0,t 1  h 1,t 1 MEt  h 2,t 1 BMt 1  h 3,t 1 MOMt 1

(4.6)
 h 4,t 1 LTSKEWt 1  h 5,t 1 HTSKEWt 1  a t

The dependent variable Ri ,t refers to stock i’s return in month t. MEi ,t 1 is

the natural log of the firm’s market capitalization in month t – 1, BMi ,t 1
is the firm’s book-to-market ratio in t – 1, and MOMi ,t 1 is the cumulative

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 Growth Stocks 

returns of stock i from month t–12 to month t–2. LTSKEWi ,t 1 is a dummy

variable with value equals to one if stock i is in the lowest TSKEW quintile
in month t–1, and zero otherwise. HTSKEWi ,t 1 is a dummy variable with
value equals to one if stock i is in the highest TSKEW quintile in month
t–1 and zero otherwise. All right-hand side variables are computed using
information prior to month t.
The TSKEW lottery factor (TSKEWFt ) is measured by h 4,t 1 h 5,t 1.
This factor represents the return in month t of a zero-dollar investment
strategy formed one month ago that takes a long position in a pure low-
TSKEW portfolio and a short position in a pure high-TSKEW portfolio.
Lottery factors for the other lottery characteristics are constructed
analogously.

Appendix 4.2: Earnings growth persistence:

is it there?

The persistence of past earnings growth is central to the question of

whether investors overpay for growth stocks. In their seminal study
on the sustainability of high growth rates, Chan et al. (2003) track the
earnings growth of almost 3,000 firms over the period from 1951 to
1998. Each year-end, they calculate the number of firms that achieve
“runs” over horizons of 1 to 10 years. A firm with an N-year run shows
superior growth rates in each of the following N years. Chan et al. used
three measures of operating performance to calculate growth rates: net
sales, operating income before depreciation, and income before extraor-
dinary items. For brevity, I shall focus on their results using the second
measure.
On average, the sample in Chan et al.’s study includes about 3000
firms each year-end. The average number of firms that survived after 1,
5, and 10 years is 2730, 1833, and 1223 respectively. Of these, the number
of runs (firms with above-median growth rates) over these horizons is
1365, 67, and 4, which implies a run rate of 50% after 1 year, 3.6% after
5 years and 0.3% after 10 years. The steep drop in the run rate after
one year already indicates a lack of persistence in firms’ short-term
earnings growth rates. In fact, their results show that by the end of the
second year, over 70% of valid firms failed to exhibit even a two-year
run.

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 The Lottery Mindset

Figure 4.4 shows the average run rate (on the vertical axis) for different
categories of firms analyzed by Chan et al. The shaded bars denote the
actual run rates, while the white bars show run rates that are expected
by chance. Five groups of firms are depicted in the figure: (a) large firms,
(b) small firms, (c) technology firms, (d) glamour firms, and (e) value
firms. Large firms are those in the top two deciles by equity market value.
Small firms are those in the bottom three deciles by equity market value.
Glamour (growth) firms are those ranked at the bottom three deciles by
the BM ratio, and value firms are those ranked in the top three deciles by
the BM ratio.

52
1 Year

51

50

49

48
All Large Small Tech Glamour Value

20
3 Years

15

10

0
All Large Small Tech Glamour Value

figure 4.4 Conitnued

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 Growth Stocks 

6
5 Years

0
All Large Small Tech Glamour Value

0.8
10 Years

0.6

0.4

0.2

0
All Large Small Tech Glamour Value

figure 4.4 Average run rates for operating income: various categories of firms
and time horizon
Source: Chan, Karceski, and Lakonishok (2003), Tables 3 and 4.

In general, there is a sharp drop in run rates over time. Also, for most
cases, run rates are not very different from that implied by chance. Across
all surviving firms over a five-year horizon, only 67 firms enjoyed a five-
year run, implying a run rate of 3.6%. The run rate implied by chance
is 3.1% or 58 firms, meaning that only nine firms (out of an average of
1883 valid firms) exhibit a statistically significant five-year run. The same

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 The Lottery Mindset

pattern holds for the ten-year horizon where only 4 firms out of 1223
valid firms had consistently above-median earnings growth rates.
One category of firms (technology) does exhibit stronger earnings
growth persistence in the long run. For the five-year horizon, the run
rate for technology firms is 5.3%, two percentage points higher than
that implied by chance (3.1%). However, since there were 331 surviving
technology firms over this horizon, the 2% difference translates to only
6.6 firms.
Overall, Chan et al. concludes that there is no persistence in long-
term earnings growth beyond chance. This finding implies that valua-
tion metrics such as the book-to-market ratio are of little use for sorting
future winners from future losers.

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 5
The Beta Anomaly
Abstract: The notion that high-beta stocks should earn higher
average returns than low-beta is the cornerstone of modern
finance. Empirical evidence not only does not support this
prediction, high-beta stocks underperform low-beta stocks on
a risk-adjusted basis. The beta anomaly is large, persistent,
and exists in a variety of asset classes. This chapter argues
and provides empirical evidence that lottery stock preferences
combined with institutional constraints that limit arbitrage
are important drivers of the beta anomaly. While gambling-
prone investors pay the price for high-beta stocks in terms of
poor returns, over the long run, investors of low-beta stocks
benefit not only from the superior returns of these stocks but
also from the boost in geometric mean returns that comes
with low-risk investing.

Keywords: beta; lottery stock preferences;

overconfidence; realization utility

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. New York: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0010.

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 The Lottery Mindset

5.1 Introduction

The notion that investors are rewarded for bearing risk is one of the
cornerstone of financial economics. Central to this idea is the CAPM or
Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965; Mossin, 1966)
which predicts a positive linear relationship between risk (market beta)
and expected return. Despite its elegance and intuitive prediction, the
CAPM has failed to garner much empirical support (Fama and French,
2004).
Douglas (1969) published the first tests of the CAPM. He showed
that the average returns of individual stocks were not related to beta
but instead, was positively correlated with their residual variance,
the variance of a stock’s returns minus the square of its beta times the
market’s variance. Douglas’s finding anticipated recent research by Ang
et al. (2006, 2009) who show that expected returns are correlated with
idiosyncratic risk contradicting the theory that only market risk is priced
in an efficient market.
Another early test of the CAPM is the well-cited paper by Black,
Jensen, and Scholes (1972), which finds that the security market line is
flatter than that predicted by the CAPM. This result implies that high-
beta stocks have negative alphas (i.e., are overpriced) while low-beta
stocks have positive alphas (are underpriced). Black’s (1972) zero-beta
CAPM, which relaxes the unrealistic assumption of unrestricted risk-
free borrowing and lending, has been more successful empirically than
the standard version of the CAPM. Nonetheless, Fama and French (1992)
dealt a decisive blow to the CAPM by showing that firm size and the
book-to-market (BM) ratio explain the cross-section of average returns
much better than beta. The problem does not seem to lie with the
assumption of a constant beta in the static CAPM. Lewellen and Nagel
(2006) show that the conditional CAPM with time-varying betas fails to
explain the book-to-market or momentum anomaly.
Interest in the beta anomaly has gained momentum in recent years with
the publication of several studies on the beta anomaly across markets and
asset classes. Blitz and van Vliet (2007) find that low-beta stocks outper-
form high-beta stocks in both the United States and international stock
markets. Frazzini and Pedersen (2014) show that the beta anomaly also
exists in other asset classes such as bonds, currencies, and commodities.
Section 5.2 of this chapter reviews and extends the evidence on the
beta anomaly. Compounding returns over long periods greatly amplify

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 The Beta Anomaly 

the differences in investment outcomes for low and high-beta stocks.

Section 5.3 examines the effects of beta on cumulative returns over the
past four decades. In Section 5.4, we investigate whether high-beta stocks
earn lower returns because they are more liquid or are less exposed
to financial distress than low-beta stocks. Section 5.5 relates the beta
anomaly to individual investors’ preference for lottery-type stocks and
arbitrage limits. Section 5.6 concludes the chapter.

5.2 The beta anomaly around the World

5.2.1 US evidence
In a seminal paper, Fama and French (1992) show decisively that beta
does not explain the cross-section of stock expected returns, but size
and book-to-market ratio do. Figure 5.1 summarizes Fama and French’s
(1992) key results by plotting monthly average returns of stocks sorted
into beta deciles. B1 consists of stocks in the lowest beta decile, while
B10 consists of stocks in the highest beta decile. All portfolios are equal-
weighted. The sample period is from July 1963 to December 1990.
The bold line in Figure 5.1 shows the return-beta relationship for all
stocks in their sample. The dash line depicts the relationship for the two
smallest size deciles, while the dotted line depicts the relationship for the
two largest size deciles. Stocks with high betas tend to have lower average
returns than those with higher betas, contradicting CAPM’s prediction.
Figure 5.1 also shows a prominent size effect. That is, small firms
outperform big firms, which is consistent with small firms being riskier.
However, the beta anomaly is not due to the size effect. Among big firms
(those in size deciles 9 and 10), the return difference between high- and
low-beta stocks is 0.42% per month or 5.04% per annum. This return
difference is larger than that for small firms.
Market anomalies that can be easily arbitraged away should disap-
pear fairly quickly. To see whether the beta anomaly has persisted, I
examine the beta effect using data after 1972, the year that Black et al.
(1972) reported that the security market line is too flat. Specifically, I
sort common stocks on NYSE and AMEX at the start of each month
from July 1972 to November 2012 based on their prior-month betas. I
then assign them into five portfolios, where B1 is the lowest beta quin-
tile and B5, the highest beta quintile. All portfolios are equal-weighted.

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 The Lottery Mindset

1.8

1.6

1.4

1.2
Monthly Returns (%)

0.8

0.6
All Firms
0.4
Large Firms
0.2 Small Firms

0
B1 B2 B3 B4 B5 B6 B7 B8 B9 B10
Beta Deciles

figure 5.1 Average returns of portfolios sorted by firm size and beta
Source: Fama and French (1992), Table 1, Panel A.

Stocks with prices below $5 are excluded from the sample to mitigate
the bid–ask bounce effect and to ensure that the sample contains
relatively liquid stocks. Betas are computed using daily returns with
five-year rolling regressions similar to the method used by Frazzini and
Pedersen (2014). These betas are referred to as ex-ante or pre-ranking
betas.
The first line of Panel A in Table 5.1 reports ex-ante betas for each
quintile. The betas have a wide dispersion, ranging from 0.69 for B1
to 1.44 for B5. The next line reports ex-post or post-ranking betas.
These betas are the realized loading on the market portfolio estimated
via a CAPM regression over the entire sample period. Table 5.1 shows
that the post-ranking betas closely mirror the ordering of the ex-ante
betas. This is important for the empirical tests as it indicates that the
ex-ante betas reliably capture the ordering of the post-ranking betas.
We will focus on Panel B which reports excess returns and alphas
(monthly percentages) for the beta portfolios. Alphas are computed
using monthly returns based on three asset pricing benchmarks: the

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 The Beta Anomaly 

table 5.1 Returns and alphas of beta quintiles: 1972–2012

B B B B B B–B
Panel A (Low-beta) (High-beta)
Ex-ante beta 0.69 0.88 1.01 1.16 1.44
Ex-post beta 0.60 0.86 1.03 1.19 1.48

Panel B Excess returns and alphas ()

Excess returns 0.74 0.84 0.79 0.80 0.60 0.14
t-stat (4.71) (4.16) (3.37) (2.96) (1.79) (0.59)
CAPM alpha . . . . –0.17 .
t-stat (4.45) (4.18) (2.68) (1.67) (1.34) (4.01)
FF3 alpha . . 0.01 –0.09 –. .
t-stat (2.32) (2.00) (0.12) (–1.08) (–3.73) (4.04)
FF4 alpha . . 0.05 –0.01 –. .
t-stat (1.95) (1.91) (–0.60) (–0.10) (–2.03) (2.60)
Source: Author’s research.

CAPM, the Fama-French three-factor model (FF3) and a four-factor

model (FF4), which adds a momentum factor measuring the winner
minus loser effect (see Cahart, 1997).
Two results are worth noting. First, average excess returns do not vary
much across the beta quintiles, consistent with a flat security market
line. Second, the beta anomaly shows up in all the alphas, most of which
are statistically significant at 10% or better. For example, the FF4 alpha is
0.16% for B1 and –0.2% for B5, which implies an alpha spread of 0.36%
per month or 4.32% per annum. CAPM and FF3 alphas are even larger.
Note that the middle beta quintile (B3) is efficiently priced in relation to
both the FF3 and FF4 benchmarks.

5.2.2 International evidence

The beta anomaly is not confined to the United States. Frazzini and
Pedersen (2014) show that the beta anomaly exists in 19 other developed
stock markets in the period from 1989 to 2012. Using beta deciles, they
find that the FF3 alpha of an equal-weighted portfolio of stocks in the
highest beta portfolio (B10) is –6% per annum compared to 3.36%
per annum for B1, implying an enormous alpha spread of over 9% per
annum. Figure 5.2 plots the FF3 alphas (in percent per year) for each of
their beta deciles.

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 The Lottery Mindset

2
FF3 Alpha (% Per Annum)

–2

–4

–6

Beta Deciles
–8
B1 B2 B3 B4 B5 B6 B7 B8 B9 B10

figure 5.2 The beta anomaly in international markets: 1989–2012

Source: Frazzini and Pedersen (2014), Table 3.

The size and persistence of the beta anomaly point to deep-seated

causes behind this anomaly. One reason for the anomaly is that some
investors are willing to pay a large price premium for stocks that have
lottery-like payoffs. Several behavioral biases may underlie this prefer-
ence. Barberis and Xiong (2012) develop a realization utility model to
explain both lottery stock preferences and the disposition effect (Shefrin
and Statman, 1985). They postulate that volatile stocks attract investors
because of “narrow framing”. That is, investors view their investment
history as a series of gains and loss episodes rather than in terms of
their overall portfolio returns. Each time an investor profits from selling
a stock, he enjoys positive realization utility. On the other hand, he will
postpone selling a losing stock to mitigate the pain of realizing a loss.
Barberis and Xiong argue that this asymmetry in behavior causes the
investor to seek stocks that have a greater chance of realizing extremely
positive (“jackpot”) returns. Their model also predicts that realization
utility should matter more to individual investors than institutions

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 The Beta Anomaly 

because many institutions are bound by the “prudent man rule” to invest
in a diversified manner (Del Guericio, 1996; Badrinath, Gay, and Kale,
1989; Gompers and Metrick, 2001; Lewellen, 2011). Consistent with this
view, Kumar (2009) finds that individual investors overweight highly
volatile, lottery-type stocks while institutions underweight these stocks
(see also Lewellen, 2011).
Cornell (2009) argues that overconfidence promotes risk-seeking
behavior because when predicting investment outcomes, these investors
form confidence intervals that are too narrow. Bailey, Kumar, and Ng
(2011) find that investors who are overconfident are more likely to invest
in lottery-type stocks.
Strong demand for high-beta stocks coupled with short-sale constraints
for these stocks suggest that the beta anomaly is mainly driven by over-
priced high-beta stocks. Table 5.2 provides evidence consistent with this
view. The table reports monthly FF3 alphas of extreme and medium
beta portfolios. The first and third sets of results are from Frazzini
and Pedersen (2014, Tables 3 and 5) for US- and international stocks
respectively. The beta portfolios in their study are deciles. The second
set of results is based on my analysis of beta quintiles using US data for
1972–2012 as described previously.
The last column that shows the ratio of the difference in FF3 alphas
between high- and medium-beta portfolios to the difference in alphas
between high- and low-beta portfolios. This ratio captures the extent to
which the beta anomaly is due to the overpricing of high-beta stocks.
Consistent with theory, overpricing of high-beta stocks accounts for the
bulk of the beta anomaly.

table 5.2 Contribution of high-beta stocks mispricing to the beta anomaly

Difference in High-
Beta alpha medium/
Sample Low- High- Low-
Market Period Low Medium High high medium high
US 1926–2012 0.40 0.13 –0.49 0.89 –0.62 –0.70
US 1972–2012 0.18 0.01 –0.39 0.57 –0.40 –0.70
International 1989–2012 0.28 0.22 –0.50 0.78 –0.72 –0.92
Notes: Results for US (1926–2012) and International (1989–2012) are from Frazzini and
Pedersen (2014), Table 3
Results for US (1972–2012) are based on the author’s research.

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 The Lottery Mindset

5.3 The beta anomaly: long-run consequences

Investors who concentrate on high-beta stocks pay a high price for

their bets. The short-term cost (measured by monthly FF3 alphas) is
roughly 0.6% per month for the period from July 1972 to December
2012. This cost is greatly amplified over the long-term due to the effects
of compounding.
Figure 5.3 plots cumulative returns of beta portfolios from 1972 to 2012,
assuming that $1 was invested in portfolios B1, B3, and B5 in end-June 1972
and held until December 2012. Over this period, a dollar grew to about
$178, $144, and $27 respectively. Since inflation reduced the real value of $1
to about 18 cents over this period, in real terms, these investments would
have yielded $32.04, $25.92, and $4.86 respectively. Viewed differently,
over this 41-year period, B5 provided an annual real return of only 3.93%
compared to over 8% per annum for the other two portfolios. Figure 5.3
also shows that the disparity in cumulative returns between B5 and B3 is
much larger than the disparity between B1 and B3, which underscores the
return impact of overpriced volatile stocks. Note that these results are not
unique to beta-sorted portfolios. Because ranking stocks based on past

200
B1
180
B3
160 B5

140
Cumulative Returns

120

100

80

60

40

20

0
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20

figure 5.3 Cumulative returns of beta-sorted portfolios: 1972–2012

Source: Author’s research

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 The Beta Anomaly 

volatility yield similar portfolios as ranking stocks based on betas, qualita-

tively similar conclusions hold for volatility-sorted portfolios.
Investor sentiment may play an important role in explaining varia-
tions in the beta anomaly over time. If we view investor sentiment as the
propensity for investors to speculate, then almost by definition, inves-
tors with a lottery mindset are more likely to bet on riskier stocks when
market-wide sentiment is positive.
Stambaugh, Yu, and Yuan (2012) find that investor sentiment explains
a broad set of stock-market anomalies (though they did not study the
beta anomaly specifically). Baker and Wurgler (2006) show that major
speculative episodes in the US stock market coincide with periods of
high sentiment. Other studies show that sophisticated investors also bet
in the direction of sentiment during the internet stock bubble of the late
1990s. For example, Brunnermeier and Nagel (2004) and Griffin et al.
(2011) report that hedge funds, among the most sophisticated of insti-
tutional investors, were aggressive buyers of tech stocks when investor
sentiment for these stocks was most positive.
Figure 5.4 plots cumulative excess returns (over the one-month
Treasury bill rate) of beta quintiles from 1995 to 2012. Consistent with

12

10

8
Cumulative Returns

Highest Beta
4

2 Lowest
Beta

0
1995 1997 1999 2001 2003 2005 2007 2009 2011

figure 5.4 Cumulative returns of beta-sorted portfolios: 1995–2012

Source: Author’s research.

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 The Lottery Mindset

the sentiment story, high-beta stocks outperformed low-beta stocks

from 1995 to the early 2000s as investors rode on bullish sentiments for
tech stocks during this period.
Figure 5.4 is a reminder that the beta anomaly does not hold at all
times, which explains why it can be risky for arbitrageurs to bet against
beta (Frazzini and Pedersen, 2014). Nonetheless, the plot shows that
patient investors who stayed the course with low-beta stocks for the full
sample period were still ahead in performance. A dollar invested in B1
at the start of 1995 increased to $10.80 by the end of 2012, compared to
$7.54 for B5. Fong (2014) uses bootstrap simulations to study the benefits
of low-risk investing under uncertainty.

5.4 Omitted risks

The results so far are based on the FF3 or FF4 models for risk-adjust-
ment. Skeptics of the beta anomaly might argue that these models omit
other important types of risk such as firms’ financial risk. Firms that are
financially distressed should compensate investors with higher returns.
It may be that low-beta firms are distressed firms while high-beta stocks
are healthy firms. Another source of risk is liquidity risk. It may be that
low-beta stocks are more thinly traded and incur higher trading costs
than high-beta stocks. The section investigates whether these omitted
risks can explain the beta anomaly.

5.4.1 Financial distress

Do the relatively high returns of low-beta stocks reflect higher firm
distress risk, and if so, can distress risk fully explain the beta anomaly?
An affirmative answer to both questions implies that the beta anomaly is
not a true market anomaly.
It is worthwhile remembering that the SMB and HML factors in
the FF3 model are supposed to capture firm distress risk. So if these
are the only distress risk factors priced by the market, the evidence
already suggests that distress risk cannot account for the beta
anomaly. Nevertheless, since the intuition that distressed stocks ought
to have higher expected returns is a strong one, I control for distress
risk using direct measures of financial distress similar to those used

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 The Beta Anomaly 

by Campbell, Hilscher, and Szilagyi (2006) and Conrad, Kapadia, and

Xing (2014).
I focus on five measures of distress risk: (1) a market-valued version
of the leverage ratio (MLEV), (2) the ratio of a firm’s cash and short-
term assets to the market value of its assets (CASH), (3) the log ratio of
a firm’s market capitalization to that of the S&P 500 index as a measure
of relative size (RSIZE), (4) the daily standard deviation of a firm’s stock
returns over the prior three months (SIGMA), and (5) the firm’s return
on assets (ROMA), computed by dividing the last fiscal year net income
by the market value of the firm’s assets. Further details of these distress
variables are given in the appendix.
Each month, I sort stocks into quintiles by each distress variable.
Within each quintile, I sort stocks into beta quintiles, forming a total
of 25 portfolios (all equal-weighted) on these two dimensions. I then
average returns across distress variable quintiles for a given beta
quintile, thus obtaining portfolios that show dispersions in betas but
with similar levels of distress. The results are shown in Table 5.3. The
numbers under each column are average excess returns in percent per
month. I will focus on the last row which shows the mean difference
in alphas between B1 and B5. If distress risk explains the beta anomaly,

table 5.3 Returns on beta-sorted portfolios controlling for firm distress

Firm distress proxies
Beta Quintiles MLEV CASH RSIZE SIGMA ROMA

B1 (Low-beta) 1.18 1.20 1.15 1.21 1.15

(–7.15) (–7.37) (–7.38) (–5.11) (–7.10)
B2 1.25 1.25 1.27 1.19 1.23
(–6.18) (–6.17) (–6.27) (–4.27) (–6.05)
B3 1.23 1.22 1.23 1.20 1.22
(–5.22) (–5.20) (–5.19) (–3.99) (–5.18)
B4 1.21 1.22 1.23 1.15 1.22
(–4.46) (–4.52) (–4.51) (–3.52) (–4.52)
B5 (High-beta) 1.03 0.98 0.99 0.87 1.09
(–3.12) (–2.94) (–2.95) (–2.49) (–3.30)
Return difference 0.15 0.22 0.16 0.34 0.06
(–0.68) (–1.01) (–0.69) (–1.64) (–0.27)
FF4 alpha difference . . . . .
(2.49) (3.24) (2.71) (2.41) (1.87)
Source: Author’s research.

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 The Lottery Mindset

these alphas should be zero. The results do not support the distress
risk hypothesis. In fact, all alphas are positive and four are significant
at 5%.
A limitation of the bivariate analysis is that it does not allow us to
examine the joint effects of all distress variables or to treat each distress
measure as a continuous variable. To address these limitations, I estimate
Fama-MacBeth (FM) cross-sectional regressions using as dependent
variable, the excess returns of individual firms. The explanatory variables
are lagged values of each distress variable, book-to-market ratio, and
beta (computed using past five years of data). The goal of the regressions
is to test whether distress risk is priced in stock returns.
Instead of presenting the detailed numerical results, I summarize the
key findings graphically. Figure 5.5 shows the time series average of FM
regression coefficient estimates for each distress variable. Coefficient
estimates that are statistically significant are shown by black bars. While
the coefficient estimates for ROMA, CASH, SIGMA, and RSIZE are
significant, all but one have the “wrong” sign. Because firms with high
ROMA, high CASH, low SIGMA, and high RSIZE have low distress risk,
they should have lower average returns than firms with high distress

0.25

0.20

0.15
Variable Coefficient Estimates

0.10

0.05

0.00

–0.05

–0.10

–0.15

–0.20
ROMA MLEV CASH PRC15 SIGMA RELSIZE

figure 5.5 Fama-MacBeth regression estimates: coefficients on distress variables

Source: Author’s research.

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 The Beta Anomaly 

risk. The results generally contradict this view (see also Campbell et al.
2008).

5.4.2 Liquidity risk

Do high-beta stocks deserve a price premium because they are more
liquid and less costly to trade? I use the bivariate analysis discussed
earlier to test the liquidity hypothesis. First, we need to identify reason-
able proxies for illiquidity. I use the following four measures: (1) market
value of a firm’s equity (ME), (2) the Amihud (2002) illiquidity measure,
which I denote by ILLIQ, (3) institutional ownership ratio (IOR), defined
as the percentage of a firm’s equity owned by large institutions based on
13F ownership filings with the Securities Exchange Commission, and
(4) Analyst coverage (ANC), the number of securities analysts that have
made earnings forecasts for a firm in a particular fiscal year. Stocks with
low ME, high Amihud measure, low IOR, and low ANC are considered
as less liquid than firms with opposite characteristics. Further details of
the four illiquidity measures are given in the appendix.
Table 5.4 shows average returns and alphas of the beta portfolios,
controlling for illiquidity. All returns and alphas are monthly percent-
ages. The last two rows of the table reports the alphas of the long/short

table 5.4 Returns on beta-sorted portfolios controlling for illiquidity

Illiquidity measure
ME ILLIQ IOR ANC
B1 (Low-beta) 1.15 1.15 1.24 1.21
(7.38) (7.39) (7.24) (7.46)
B2 1.27 1.27 1.29 1.31
(6.27) (6.32) (6.01) (6.24)
B3 1.23 1.22 1.24 1.23
(5.19) (5.18) (4.89) (4.92)
B4 1.23 1.21 1.21 1.28
(4.51) (4.46) (4.14) (4.40)
B5 (High-beta) 0.99 0.98 1.00 1.01
(2.95) (2.93) (2.76) (2.81)
B1–B5 0.16 0.17 0.24 0.20
(0.69) (0.69) (0.96) (0.70)
FF4 Alpha Difference . . . .
(2.71) (2.95) (3.54) (3.40)
Source: Author’s research.

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 The Lottery Mindset

portfolio (B1–B5). All the alphas are positive, large, and statistically
significant. Thus, high-beta stocks still underperform low-beta stocks
after controlling for liquidity and the standard risk factors.
We can also sort stocks into liquidity quintiles using the above meas-
ures and test whether B1–B5 alphas are statistically different across the
lowest and highest liquidity quintiles. If the beta anomaly is driven by
liquidity risk, B1–B5 alphas should be higher in the low-liquidity quin-
tile than in the high-liquidity quintile. To perform this test, I sort stocks
independently each month into quintiles based on betas and liquidity,
forming 25 (equal-weighted) portfolios at the intersection of these
characteristics. I then compute B1–B5 alphas for the lowest and highest
liquidity quintiles. The results of this test (not reported) show that (a)
B1–B5 alphas are positive and significant in both high and low-liquidity
quintiles, and (b) there is no significant difference in the alphas across
the two liquidity groups. These results hold for all five liquidity meas-
ures. Once again, the beta anomaly cannot be explained by liquidity
risks.

5.5 Explaining the beta anomaly

If the beta anomaly gives rise to positive risk-adjusted returns, why

don’t institutional investors arbitrage this effect away? The literature has
proposed several explanations to explain the puzzling persistence of the
beta anomaly.
Baker, Bradley, and Wurgler (2011) explain the phenomenon from a
behavioral perspective, arguing that an irrational preference for lottery-
type stocks combined with behavioral biases such as overconfidence
and the representativeness heuristic lead investors to overpay for high-
volatility stocks. Griffin and Tversky (1992) report that people are prone
to be overconfident when uncertainty is high and predictability is low.
This is precisely the kind of situations investors face when dealing with
high-beta stocks.
Barberis and Xiong (2012) invoke mental accounting (a form of narrow
framing) to explain why individual investors desire high-volatility stocks.
Kumar (2009) presents compelling evidence of lottery-stock preferences
among individual investors.
Recent research using brain scans confirms that risk taking is strongly
linked to specific brain regions associated with positive emotions such

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 The Beta Anomaly 

as reward anticipation (Knutson et al. 2008; Kuhnen and Knutson,

2011). This may explain why individual investors send more money into
mutual funds (particularly aggressive growth funds) in bullish markets
and withdraw capital from these funds in bearish markets (Karceski,
2002). As agents for individual investors, fund managers also have strong
incentives to take more risk in up markets.
Institutions not subject to the same biases as individuals (or at least
to a lesser extent) may lack incentives to exploit the beta anomaly.
First, as Brennan (1993) and Baker et al. (2011) argue, institutions typi-
cally have a mandate to maximize the information ratio (IR) relative
to specific capitalization-weighted benchmarks. Although investing in
low-beta stocks or short selling high-beta ones may generate alphas, this
is usually not sufficient to compensate for the increased tracking error
(the denominator of the IR) that results from deviating from the bench-
mark. For example, if a fund manager expects the overall stock market
to return 10% with a standard deviation of 20%, she will not find a stock
with a beta of 0.70 attractive to invest unless the alpha is at least 3% per
annum. The same argument works in reverse for a high-beta stock; the
manager will not short sell the stock even if it is overpriced unless the
absolute alpha is larger than 3%. Furthermore, in reality, most institu-
tions do not have the mandate to short or a culture that encourages short
selling. Even institutions that can short-sell face important hurdles when
they try to do so. First, there are serious short-sale constraints for stocks
that are small, illiquid, or have low institutional ownership (Nagel, 2005).
Second, short-sellers face the risk that an overpriced stock may become
more overpriced in the short run. As argued by Shleifer and Vishny
(1997), the higher is a stock’s idiosyncratic risk, the higher is the arbitrage
risk. Consistent with their predictions, Ali et al. (2003) find evidence of a
higher value premium among stocks with high idiosyncratic risk. More
generally, Lewellen (2011) show that institutions as a whole do not do
much more than hold the market portfolio, consistent with these inves-
tors’ reluctance to exploit security mispricings.
Stocks that are costly to short sell are prone to overvaluation because
their prices only reflect the opinions of the most optimistic investors
(Miller, 1977). Consistent with Miller’s hypothesis, Stambaugh et al.
(2011) show that overpricing drives the profitability of long/short strate-
gies that are related to a broad range of market anomalies.
To see whether the above arguments resonate with the beta anomaly,
Table 5.5 reports firm characteristics for beta-sorted portfolios. The

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 The Lottery Mindset

Table 5.5 Firm characteristics of beta-sorted portfolios

B B B B B
Characteristics (Low-beta) (High-beta)

Ex-ante beta 0.69 0.88 1.01 1.16 1.44

Ex-post beta 0.60 0.86 1.03 1.19 1.48
Skewness 0.1 0.133 0.148 0.169 0.2
Idiosyncratic
volatility 0.206 0.249 0.276 0.31 0.391
Price 166.3 98 52.4 35.3 27.8
Firm size
($ millions) 5,614 4,956 4,732 4,647 4,894
Book-to-market
ratio 0.69 0.66 0.65 0.64 0.67
Illiquidity 0.2 0.141 0.11 0.096 0.089
Source: Author’s research.

sample period is the same as before (1972–2012). The first two rows
reproduce the estimated betas shown in Table 5.1. The other rows report
monthly averages of the cross-section mean values of six firm character-
istic: total skewness, annualized idiosyncratic volatility, stock price, firm
size, book-to-market ratio, and illiquidity.
Skewness is defined as the third moment of a stock’s daily returns in
the past month. A stock’s idiosyncratic volatility is computed using the
following regression:
Ri ,t  ] i ,t  ^ i ,MKT MKTt  ^ i ,SMB SMBt  ^ i ,HML HMLt  a i ,t (5.1)

where Ri ,t is the excess return of stock i on day t; MKTt is the excess

return on the market index SMBt is the return of a portfolio of small
stocks minus the return on a portfolio of large stocks, and HMLt is the
return of a portfolio of stocks with high book-to-market (BM) ratios
minus the return of a portfolio of stocks with low BM ratios. We define
the idiosyncratic volatility of stock i as IVO Li ,t  var(a i ,t ) .
The book-to-market ratio for a firm is calculated in the same way
as Fama and French (1992, 1993) except that we use market values
of the previous month rather than the end of the previous calendar
year, following Asness, Frazzini, and Pedersen (2013). Book values
are lagged six months to ensure that the data is available to inves-
tors at the time. Finally, the illiquidity measure is that of Amihud
(2002).

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 The Beta Anomaly 

Table 5.5 shows that low- and high-beta stocks differ significantly in
all the above characteristics. In particular, high-beta stocks have higher
skewness, higher idiosyncratic volatility, lower price, smaller market
value, and lower illiquidity than low-beta stocks. Except for the last
characteristic, high-beta stocks fit the description of stocks that are
difficult and risky to arbitrage. Institutions generally avoid small firms,
preferring those that are large, liquid, and have high institutional owner-
ship (Falkenstein, 1996; Gompers and Metrick, 2001; Lewellen, 2011).
The characteristics of high-beta stocks also support Shleifer and Vishny
(1997)’s argument that these stocks are likely to be overpriced due to
high arbitrage risks.
Finally, high-beta stocks have very similar characteristics as lottery-
type stocks. Kumar (2009) and Goetzmann and Kumar (2008) find that
in contrast to institutions, individual investors have a strong preference
for low-priced stocks with high volatility and skewness. I find consist-
ent evidence by sorting stocks according to institutional ownership: the
beta anomaly is most pronounced among stocks in the bottom quintile
of institutional ownership and is completely absent among stocks with
high levels of institutional ownership (see Appendix 5.2 for details).
Collectively, these factors provide a coherent and framework for explain-
ing the beta anomaly.

5.6 Conclusion
A basic tenet of the CAPM is that securities with higher systematic risk
should have higher average returns. However, as Friedman and Savage
(1948) noted long ago, investors are not wholly risk-averse as evidenced
by people buying both insurance and lotteries. The desire for lottery
payoffs provides a more consistent explanation for the flatness of the
security market line.
This chapter has reviewed the empirical evidence of the beta anomaly
in the United States as well as international markets. Consistent with
previous studies, there is clear evidence that high-beta stocks under-
perform low-beta stocks on a risk-adjusted basis. The beta anomaly
exists globally, is large in magnitude, and has persisted over time
despite the rise of equity ownership by institutional investors, who are
often viewed as sophisticated arbitrageurs as opposed to individual
investors.

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 The Lottery Mindset

High-beta stocks bear striking resemblance to stocks with lottery-type

characteristics (Kumar, 2009), which implies that they appeal mainly
to individual investors rather than institutions. A variety of behavioral
biases such as representativeness, overconfidence, narrow framing, and
the tendency for people to overweight low-probability events induce
these investors’ risk-seeking propensities. The bulk of the beta anomaly
is driven by overpriced high-beta stocks rather than underpriced low-
beta stocks, consistent with lottery stock preferences and the absence of
significant arbitrage actions by institutional investors. As long as these
forces are in place, the beta anomaly looks likely to stay.

Appendix 5.1 Distress and liquidity measures

Measures of financial distress

Following Campbell et al. (2008) and Conrad et al. (2014), I choose five
measures of distress to analyze the beta anomaly. The five measures are:
market leverage (MLEV), the ratio of cash and short-term investments to
the firm’s market value of assets (CASH), firm size relative to the S&P500
(RSIZE), annualized three-month rolling standard deviations of stock
returns (SIGMA), and net income as a fraction of the firm’s market value
of assets (ROMA). These distress variables are calculated by using daily
and monthly equity market data from CRSP and quarterly accounting
data from COMPUSTAT.
The distress variables for firm i in month t are computed as follows:
Total Liabilities
MLEVi ,t 
Firm Market Equity i ,t  Total Liabilitiesi ,t
Cash and Short Term Investmentsi ,t
CASHi ,t 
Firm Market Equity i ,t  Total Liabilitiesi ,t
¥ Firm Market Equity i ,t ´
RSIZEi ,t  ln ¦ µ
§ Total S&P500 Market Valuei ,t ¶
1
t
¥ 1 ´2
SIGMAi ,t  ¦ 252 s s ¤ ri2, k µ
§ N 1 k t 2 ¶
Net Incomei ,t
ROMAi ,t 
Firm Market Equity i ,t  Total Liabilitiesi ,t

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 The Beta Anomaly 

As in Campbell et al. (2008), each company’s fiscal year is aligned to the

relevant calendar year, and the accounting variables are lagged by two
months to avoid look-ahead bias.

Measures of illiquidity
Amihud’s measure
Following Amihud (2002), I define a stock’s illiquidity (ILLIQ) as the
absolute change in price per unit dollar trading volume. The expression
for ILLIQ is:

D i ,t
1 Ri ,t
ILLIQi ,t 
D i ,t
¤ VOLD
t 1 i ,t

where D i ,t corresponds to the number of days of daily trading data avail-

able in month t; Ri ,t refers to the daily return of the stock; and VOLDi ,t
is the daily trading volume in dollars.

Institutional ownership
Stocks that have lower institutional ownership are generally less liquid
than those with high institutional ownership. Quarterly data on the
equity holdings of large institutions are obtained from Thomson Reuters’
13F holdings database. For a given stock in each month, I use the latest
quarterly 13F report to compute the stock’s IOR. IOR for a stock is the
sum of institutional holdings for the stock divided by the total shares
outstanding.

Analyst coverage and residual analyst coverage

Stocks that are not widely followed by securities analysts tend to be
smaller, less liquid firms. The methodology for calculating analyst cover-
age (ANC) follows Campbell et al. (2008) and Conrad et al. (2014). For
each stock, I identify the number of distinct analysts in the I/B/E/S data-
base that have made earnings projections in fiscal year t, which I denote

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 The Lottery Mindset

by N i ,t. The ANC for firm i in fiscal year t is computed as the natural
logarithm of 1 plus N i ,t :

ANC i ,t  ln 1  N i ,t

Price and firm size

Price refers to a firm’s stock price for a given month. Firm size is the
market capitalization of the firm’s equity in a given month.

Appendix 5.2 Institutional ownership and the beta

anomaly

I use quarterly institutional equity holdings data (13F filings to the

Securities Exchange Commission) from Thomson Reuters to sort
stocks by IOR. The sample period for the analysis is from May 1980 to
December 2012.
At the start of each month, all common stocks on the CRSP database
are sorted into five IOR quintiles based on data in the quarter preceding
that month. The IOR is the fraction of a company’s stock that is owned by
institutions and is computed by summing the holdings of all 13F report-
ing institutions and dividing this sum by the total shares outstanding for
that company. Quintile Q1 (Q5) denotes the portfolio with the lowest
(highest) IOR. Within each IOR quintile, stocks are sorted into five beta
quintiles (B1–B5) based on their five-year trailing betas estimated at the
end of the previous month.
Table 5.6 reports risk-adjusted returns (in monthly percentages) for
the 25 portfolios using the FF3 model (Panel A) and the FF4 model
(Panel B). All portfolios are equal-weighted. Numbers in parentheses are
t-statistics. Numbers highlighted in bold are significant at 10% or below.

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 The Beta Anomaly 

Table 5.6 Alphas of portfolios sorted by Institutional Ownership and Betas

Beta quintiles
IOR
quintiles B B B B B B–B
Panel A: FF alphas
Low 0.11 0.02 0.07 –0.29 –0.8 .
(0.81) (0.14) (0.37) (–1.22) (–3.04) (3.90)
2 0.21 0.24 0.39 0.15 –0.16 .
(2.15) (2.17) (2.79) (0.90) (–0.76) (1.82)
3 0.27 0.23 0.19 0.03 –0.08 .
(3.40) (2.88) (1.98) (0.25) (–0.53) (2.19)
4 0.24 0.17 0.15 –0.01 0.07 0.17
(3.17) (2.15) (1.70) (–0.16) (0.60) (1.15)
High 0.18 0.08 0.06 –0.05 –0.01 0.19
(1.99) (0.97) (0.68) (–0.53) (–0.10) (1.31)
IOR Panel B: FF alphas
Low 0.17 0.08 0.25 –0.07 –0.53 .
(1.24) (0.52) (1.26) (–0.29) (–2.04) (3.02)
2 0.25 0.30 0.52 0.36 0.10 0.15
(2.51) (2.64) (3.76) (2.19) (0.49) (0.75)
3 0.28 0.29 0.31 0.25 0.17 0.11
(3.52) (3.61) (3.35) (2.49) (1.32) (0.76)
4 0.23 0.2 0.24 0.12 0.33 –0.10
(3.08) (2.54) (2.78) (1.36) (3.38) (–0.74)
High 0.15 0.12 0.15 0.11 0.14 0.010
(1.64) (1.39) (1.63) (1.17) (1.27) (0.10)

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 6
The IVOL Puzzle
Abstract: Stocks with high-idiosyncratic volatility (IVOL)
have lower average returns than low-IVOL stocks. The IVOL
effect has been documented in many stock markets and is
closely related to the beta anomaly discussed in the previous
chapter. This chapter presents updated evidence on the IVOL
effect, with a focus on the US stock market. The characteristics
and investor profile of high-IVOL stocks are analyzed. New
evidence on the relationship between the IVOL effect and
other lottery stock anomalies are presented. The long-term
implications of investing in high-IVOL stocks are discussed.

Keywords: idiosyncratic skewness; idiosyncratic volatility

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. New York: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0011.

 DOI: 10.1057/9781137381736.0011

 The IVOL Puzzle 

6.1 Introduction

High-beta stocks are not the only type of volatile stocks with low aver-
age returns. Investors also gamble on stocks with high residual volatil-
ity. Roughly speaking, a stock’s residual volatility is the volatility that
remains after controlling for its exposure to systematic risk factors such
as the overall stock market’s returns. Residual volatility is also known as
idiosyncratic volatility or IVOL for short.
There is an IVOL anomaly analogous to the beta anomaly discussed
in the previous chapter. In a well cited paper, Ang et al. (2006) find that
high-IVOL stocks earn inferior average returns compared to low-IVOL
stocks (their research methodology is detailed below). Specifically,
buying stocks in the highest IVOL quintile and shorting stocks in the
lowest IVOL quintile yields an average return of around –1% a month, or
a staggering loss of 12% a year. In a follow-up research, Ang et al. (2006)
report that the IVOL effect not only exist in the United States but is also
present in many other developed country stock markets. Therefore,
high-IVOL stocks appear to be overpriced everywhere. Substantiating
the overpricing hypothesis is evidence that the IVOL effect is almost
exclusively driven by the short-leg of the strategy.
Who are the primary investors of high-IVOL stocks, and what factors
motivate them to accept the low average returns of such stocks? The
many similarities between the IVOL and beta anomaly suggest that
investors’ preference for high IVOL stocks is strongly correlated with
their desire for lottery-type payoffs (Kumar, 2009; Bailey, Kumar, and
Ng, 2011).
In this chapter, we update Ang et al.’s (2006) evidence on the IVOL
effect using a longer sample and study the investor profile of high-IVOL
stocks using data on institutional ownership and firm characteristics of
IVOL-sorted portfolios. The relationship between the IVOL effect and
other lottery stock phenomena will also be examined.

6.2 The IVOL anomaly revisited

If investors are fully diversified, idiosyncratic risk should not be priced

(Merton, 1987; Malkiel and Xu, 2006). But idiosyncratic risk is priced,
but in the “wrong way.” Ang et al. (2006) is the seminal study on the

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 The Lottery Mindset

IVOL anomaly. Their sample consists of stocks traded on NYSE, AMEX,

and NASDAQ over the period from July 1963 to December 2000. Each
month, they form quintile portfolios by sorting stocks based on their
previous month IVOL. Let us denote the lowest and highest IVOL quin-
tile by Q1 and Q5 respectively. Ang et al. find that the average return
of Q5–Q1 is –0.97% a month or about –12% a year. Adjusting for risk
using the Fama-French three-factor (FF3) model actually worsens the
underperformance of high-IVOL stocks to –1.31% a month. The return
differentials documented by Ang et al. (2006) are both statistically
significant, and economically large.
Ang et al. (2006) show that the IVOL effect also exists for a 12-month
holding period, and that it remains significant after controlling for a large
number of firm specific variables, including firm size, book-to-market
ratio, firm leverage, liquidity risk, trading volume, bid-ask spreads, and
dispersion of analysts’ earnings forecasts.
Stocks with more positive co-skewness with the market also earn
lower returns (Harvey and Siddique 2000). However, Ang et al. (2006)
show that the IVOL anomaly is robust to the co-skewness effect. Using
option price data, Conrad, Dittmar, and Ghysels (2013) confirm the
existence of a negative risk-return relationship for individual stocks.
They too find that this inverse relationship is mainly caused by the
idiosyncratic components of returns rather than their co-moments
with the market. Similarly, Conrad, Kapadia, and Xing (2014) find that
volatility is a much stronger predictor of “jackpot” or extreme positive
returns than skewness.
Fong and Lim (2011) revisit the IVOL anomaly using data from July
1963 to December 2010, thus adding a full decade to the sample period
studied by Ang et al. (2006). Our sample includes all common stocks
traded on NYSE and AMEX with share codes 10 or 11 in the Centre
for Research on Security Prices (CRSP) database. In common with
the literature, we excluded the following categories of firms: closed-
end funds, primes and scores, real estate investment trusts (REITS),
American Depository Receipts (ADRs), shares of beneficiary
interests (SBIs), and foreign firms. To mitigate concerns associated
with small and illiquid stocks, we exclude stocks with share prices
below $1.
As in Ang et al. (2006), we form value-weighted quintiles based on
each eligible firm’s idiosyncratic volatility. We estimate a firm’s IVOL

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 The IVOL Puzzle 

each month by regressing its daily excess returns against the FF3 risk
factors for that month. The regression model is:
Ri ,t ] i ,t  ^ i ,MKT MKTt  ^ i , SMB SMBt  ^ i , HML HMLt a i ,t (6.1)

where Ri ,t is the excess return of stock i on day t, MKTt is the excess return
on the market index (the CRSP value-weighted stock index), SMBt is the
return of a portfolio of small stocks minus the return on a portfolio of
large stocks, and HMLt is the return of a portfolio of stocks with high
book-to-market (BM) ratios minus the return of a portfolio of stocks
with low BM ratios. The idiosyncratic volatility of stock i is defined as
IVOLi ,t  var(a i ,t ) .
Table 6.1 reports average returns, CAPM alphas and FF3 alphas
(monthly percentages) for each IVOL quintile, where Q1 (Q5) is the
portfolio with the lowest (highest) IVOL. The mean monthly return of
the High-IVOL portfolio is 0.53% and the mean return of the low-IVOL
portfolio is 0.91%. Therefore, the IVOL effect (the difference in mean
return between Q5 and Q1) is –0.38%. Although this return difference
between Q5 and Q1 is not statistically significant, both the CAPM and
FF3 alphas for Q5–Q1 are highly significant and large. For example, the
CAPM alpha is –0.74% a month or about –9% a year. Adjusting for risk
using the FF3 model increases the alpha to –0.98% or almost –12% a
year.

table 6.1 Returns and alphas of IVOL-sorted portfolios

IVOL quintile Mean return  CAPM alpha  FF alpha 
Low 0.91 0.11 0.10
(1.85) (2.06)
2 0.95 0.03 –0.02
(0.50) (–0.36)
3 1.07 0.050 0.00
(0.65) (0.09)
4 0.96 –0.15 –0.26
(–0.93) (–1.98)
High 0.53 –0.64 –0.89
(–2.44) (–3.85)
5–1 –0.38 –. –.
(–1.14) (–2.62) (–3.94)

Source: Fong and Lim (2011).

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 The Lottery Mindset

To study the IVOL effect further, we compute average returns and

alphas for Q5–Q1 over longer holding periods of 3, 6, and 12 months.
The returns for each holding period are computed one month after the
portfolio formation date to avoid biases due to bid-ask bounce. In Table
6.2, we report these returns for the two extreme IVOL portfolios and the
intermediate IVOL portfolio (Q3). These portfolios comprise stocks with
IVOL in the bottom 20%, middle 60%, and upper 20%.
Table 6.2 shows that Q5 underperforms Q1 for all the holding peri-
ods. The FF3 alpha for Q5–Q1 is –1.95% for the three-month horizon,
–3.47% for the six-month horizon, and –4.96% for the 12-month

table 6.2 Returns and alphas of IVOL-sorted portfolios: longer holding periods
Holding period Quarter Semi-annual Annual
LOW IVOL (Q)
Mean return (%) 2.70 5.43 11.09
(5.40) (5.48) (5.52)
CAPM alpha (%) 0.27 0.52 1.00
(1.66) (1.71) (1.58)
FF3 alpha (%) 0.26 0.50 0.92
(2.25) (2.01) (1.82)
Intermediate IVOL (Q)
Mean return 2.93 5.87 11.86
(4.34) (4.32) (4.32)
CAPM alpha 0.04 0.05 0.16
(0.27) (0.15) (0.26)
FF3 alpha –0.15 –0.34 –0.58
(–1.08) (–1.21) (–1.04)
High IVOL (Q) High IVOL (Q)
Mean return 2.48 5.53 12.65
(2.26) (2.29) (2.83)
CAPM alpha –0.95 –1.34 –0.85
(–1.59) (–1.10) (–0.38)
FF3 alpha –1.69 –2.96 –4.04
(–3.44) (–3.17) (–2.59)
Q–Q
Mean return –0.22 0.11 1.56
(–0.26) –0.06 –0.46
CAPM alpha –. –1.87 –1.85
(–1.98) (–1.37) (–0.72)
FF3 alpha –. –. –.
(–3.73) (–3.43) (–2.84)

Source: Fong and Lim (2011).

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 The IVOL Puzzle 

horizon. A closer examination of the results shows that Q5 accounts

for the bulk of the anomalously low returns of the long/short strategy.
We can see this from the ratio of the difference in alphas between Q5
and Q3 to the difference in alphas between Q5 and Q1. This ratio is
plotted in Figure 6.1. Similar to the beta anomaly, the IVOL effect is
mainly the result of overpriced high-IVOL stocks than underpriced
low-IVOL stocks.
In summary, we find that the IVOL effect has persisted over time.
The effect is statistically significant, robust across a range of investment
horizons, and large in magnitude. Given theoretical arguments that
high-IVOL stocks should not command a price premium, the persist-
ence of the IVOL effect supports Ang et al.’s conclusion that it is indeed a
“substantive puzzle” (Ang et al., 2006, p. 262).
How much do high-IVOL investors lose out in the long run? To get
a feel of the long-run impact of investing in high-IVOL stocks versus
less risky stocks, consider a hypothetical example of a young person
investing to build a retirement fund. Suppose our investor decides to

80%

78%

76%
Degree of Overpricing in Q5

74%

72%

70%

68%

66%

64%
3 12 6
Holding Period (Months)

figure 6.1 Fraction of IVOL effect due to overpricing of high-IVOL stocks

Source: Fong and Lim (2011).

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 The Lottery Mindset

invest $20,000 each year in high-IVOL stocks to build his retirement

fund, and that the investment horizon is 25 years. Based on an average
annual return of 6.36% (0.53% × 12) for high-IVOL stocks, his portfolio
can be expected to grow to about $1.15 million in 25 years. If he can
earn the same rate of return during retirement, this sum of money will
provide him an income of $73,140 a year ($1.15 million × 6.36%).
Compare this scenario with an alternative strategy where $20,000 is
invested each year in the market portfolio. Over the period from 1963 to
2010, the average return on the market portfolio was 0.89% a month or
10.68% per annum. Based on these assumptions, the expected portfolio
value in 25 years is $2.41 million. If the investor can continue to earn
this rate of return in retirement, he would be able to enjoy an income of
$257,388 a year ($2.41 million × 10.68%), substantially more than in the
first case. This superior outcome is actually better than it appears because
the market portfolio is less volatile and thus has a higher geometric mean
return than high-IVOL stocks, a point that is often missed in discussions
of long-term investing.
Future returns will of course differ from past returns, but as we point
out in the previous chapter, the benefits of low-risk investing are likely
to persist as long as individual investors clamor for lottery-type stocks
while agency constraints discourage the smart money from arbitraging
away the IVOL effect. Fong and Koh (2014) present further evidence
on the long-term benefits of low-risk investing using bootstrap
simulations.

6.3 Who invest in high-IVOL stocks?

Who are the investors of high-IVOL stocks and why are they willing
to put up with the low average returns of these stocks? The character-
istics of high and low-IVOL stocks provide useful clues to these ques-
tions. In this section, we show that highly volatile stocks display firm
characteristics that appeal to investors with lottery stock preferences.
We focus on six characteristics: (1) Std Dev (the standard deviation
of a stock’s daily returns in the previous month), (2) Beta (the market
beta of a stock estimated using daily data over the previous month),
(3) % MKT Share (the ratio of a portfolio’s market capitalization to the
total market capitalization of all portfolios, (4) Price (price per share),
(5) Size (market capitalization), (6) Forecast dispersion (standard

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 The IVOL Puzzle 

deviation of earnings per share or EPS forecast scaled by the mean EPS
forecast, and (7) Illiquidity (the Amihud illiquidity measure).
The first five characteristics are self-explanatory. We use stock
analysts’ forecast dispersion as a measure of the heterogeneity of beliefs
(Anderson, Ghysels, and Juergens, 2005; Verardo, 2009). Following
Diether, Malloy, and Scherbina (2002), we use data from Institutional
Brokers’ Estimate System (I/B/E/S) to compute forecast dispersion. This
data starts in January 1976. We use the Amihud (2002) illiquidity meas-
ure to capture a stock’s liquidity, where a larger number indicates greater
illiquidity. We compute the Amihud measure by dividing the absolute
value of the stock’s weekly log returns by its average weekly dollar trad-
ing volume over the past year. We compute this statistic for every stock
that has at least 26 weeks of data.
Table 6.3 shows the time series average of the cross-section mean for
each characteristics. The table confirms that IVOL is strongly correlated
with characteristics. In particular, the typical high-IVOL stock (Q5) has a
low price, low market capitalization, high beta, high total volatility, high
forecast dispersion, and low liquidity. Kumar (2009) shows that indi-
vidual investors overweight lottery-type stocks relative to their weights
in the market portfolio. He defines a lottery-type stock as one with a
low price, high-idiosyncratic volatility and high-idiosyncratic skewness.
Table 6.3 shows that high-IVOL stocks are clearly lottery-type stocks.
To probe further into the role of individual investors in driving the
IVOL anomaly, we examine the size of the IVOL effect by institutional
ownership. The Securities Exchange Commission (SEC) in the United
States requires ‘large’ institutional investors (those with more than $100
million of securities under discretionary management) to report their
holdings to the SEC at the end of every quarter (starting from the first

table 6.3 Characteristics of IVOL-sorted portfolios

IVOL Std.  MKT. Size Forecast
quintile Dev. Beta share Price () ( millions) dispersion Illiquidity
Low 3.90% 0.82 63.60% 49.0 2573 3.00% 0.025
2 5.00% 1.01 23.49% 37.1 2103 4.60% 0.043
3 6.03% 1.16 8.70% 29.2 1664 5.70% 0.090
4 7.34% 1.23 3.25% 20.3 883 7.80% 0.160
High 8.76% 1.38 0.95% 14.3 274 13.60% 0.280
5–1 0.05 0.56 –62.7% –34.8 –2299 10.60% 0.26

Source: Fong and Lim (2011).

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 The Lottery Mindset

quarter of 1980). These filings (form 13F) include all common stock posi-
tions greater than 10,000 shares or $200,000. We use 13F institutional
holdings data from Thomson Reuters to sort stocks into three equal-size
groups representing low, medium, and high institutional ownership.
Our sample period runs from May 1980 to December 2010 and includes
all common stocks listed on NYSE/AMEX/NASDAQ with share codes
10 and 11 on the CRSP database.
Each month, we sort stocks by their prior-quarter institutional owner-
ship ratio (IOR) into IO tertiles, where IO1 (IO3) consists of stocks with
the lowest 33rd percentile of institutional ownership and IO3 consists of
stocks with highest 33rd percentile of institutional ownership. The IOR
for a stock is calculated by dividing the sum of all institutional holdings
for that stock by the total shares outstanding for the stock. If CRSP indi-
cates that a stock is not held by any institution, we set the IOR to zero.
Within each IOR quintile, we sort stocks into IVOL tertiles, thus forming
a total of fifteen portfolios for which we calculate value-weighted aver-
age returns, CAPM alphas and FF3 alphas. Table 6.4 displays the return

table 6.4 IVOL effect by institutional ownership

IVOL Panel A. Low institutional ownership
Tertile Mean return () CAPM alpha () FF alpha ()
1 (Low) 0.54 –0.34 –0.49
(–1.10) (–2.40)
2 0.21 –0.71 –0.78
(–1.87) (–2.94)
3 (High) –0.16 –1.04 –1.10
(–2.45) (–3.61)

3–1 –. –. –.

(–2.69) (–2.68) (–2.45)
Panel B. High institutional ownership
1.45 0.49 0.21
1 (Low) (1.59) (0.78)
0.21 –0.19
2 1.17 (0.54) (–0.59)
0.55 0.1
3 (High) 1.15 (1.19) (0.27)

3–1 –0.30 0.06 –0.11

(–0.83) (0.14) (–0.24)

Source: Fong and Lim (2011).

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 The IVOL Puzzle 

summary statistics for IO1 and IO3. It is clear that the IVOL effect is
concentrated among stocks with low IO.
Over the sample period, IO1 (IO3) accounts for less than 10% (more
than 70%) of the overall market’s capitalization. Moreover, the average
stock in IO3 has a market capitalization that is 40 times larger than the
average stock in IO1. These stock profiles indicate that the IVOL effect
is largely concentrated in stocks that are mainly owned by individual
investors.

6.4 Does idiosyncratic skewness drive the IVOL

effect?

High-IVOL stocks tend to have above-average idiosyncratic skewness

(ISKEW). A number of theoretical models argue that investors subject
to behavioral biases prefer stocks that have positively skewed returns.
These theories assume that investors have some form of optimistic
beliefs in the likelihood of the occurrence of extremely positive returns.
For example, Barberis and Huang (2008) develop a theory in which
investors have cumulative prospect theory preferences and overweight
the probabilities of extreme outcomes. As a result, they choose to
gamble by holding undiversified portfolios. Mitton and Vorkink (2007)
envisage a market in which some investors are mean-variance utility
maximizers while others display a preference for positive skewness.
Brunnermeir, Gollier and Parker (2007) emphasize that investors derive
higher current utility by optimally overestimating the future probabili-
ties of good outcomes. Kumar (2009) argue that while positive skewness
increases the appeal of lottery-type stocks, extreme volatility is more
salient because a stock that moves a lot in the past may be expected to
remain volatile in the future. Investors are also likely to find volatility
easier to compute than skewness which involves the third moments of
an asset’s return distribution. Preference for highly volatile securities
is the central prediction of the realization utility model developed by
Barberis and Xiong (2012).
Fong and Chong (2011) perform conditional sorts on IVOL to control
for the effects of idiosyncratic skewness. Similar to Kumar (2009),
they focus on low price stocks (those in the lowest price tertile). Each
year from June 1980 to June 2009, they sort all eligible stocks, first into
ISKEW tertiles, then into IVOL tertiles within each ISKEW tertile.

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 The Lottery Mindset

Sorts are based on tertiles instead of quintiles to ensure that there are
sufficient number of firms within each group. After forming the nine
portfolios, they value weight the returns of IVOL portfolios across the
ISKEW tertiles, thereby controlling for the effects of ISKEW. IVOL is
computed using Equation (6.1). Following Harvey and Siddique (2000)
and Kumar (2009), they define ISKEW in month t as the third moment
of the residuals obtained by regressing daily stock returns in month t – 1
on the returns and squared returns of the market index in month t – 1.
Table 6.5 (Panel A) shows the performance of IVOL portfolios after
controlling for ISKEW. All returns are in percent per month. The second
column shows the time series average of the cross-sectional mean ISKEW
of each IVOL tertile. The averages are quite similar, indicating that the
conditional sort achieved its effect of controlling for ISKEW. The third
column shows the average annualized IVOL of each IVOL tertile which
ranges from 48% to 101% per annum. The next three columns report
average returns and alphas. The raw IVOL effect is –10.33% per annum
(–0.86% × 12). The CAPM and FF3 alphas are of similar magnitudes,

table 6.5 IVOL Effect controlling for idiosyncratic skewness

Panel A. Returns of conditionally IVOL-sorted portfolios ()
IVOL Firm ISKEW Firm IVOL Mean return CAPM alpha FF alpha
1 (Low) 0.44 48.1 1.05 0.12 –0.16
(0.48) (–0.92)
2 0.38 70.1 0.61 –0.35 –0.58
(–1.04) (–2.73)
3(High) 0.40 101.1 0.19 –0.79 –1.06
(–2.00) (–3.73)
3–1 –. –. –.
(–3.28) (–3.56) (–3.82)

Panel b. Returns of conditionally ISKEW-sorted portfolios ()

ISKEW Firm ISKEW Firm IVOL Mean return CAPM alpha FF alpha
1 (Low) –0.50 32.15 0.75 –0.20 –0.50
(–0.65) (–2.32)
2 0.58 32.20 0.82 –0.13 –0.38
(–0.44) (–2.03)
3(High) 1.68 34.30 0.58 –0.33 –0.56
(–1.11) (–3.07)
3–1 –0.17 –0.13 –0.06
(–0.93) (0.72) (0.32)

Source: Fong and Chong (2011).

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 The IVOL Puzzle 

and both are significant. Therefore, controlling for past ISKEW does not
explain the IVOL anomaly.
Panel B of Table 6.5 analyzes the ISKEW effect, controlling for IVOL.
Here, the order of the sorts is reversed. That is, stocks are first sorted
into IVOL tertiles, then into ISKEW tertiles within each IVOL tertile.
There is no evidence of an ISKEW effect after conditioning on IVOL.
Together, these results imply that the IVOL effect is not driven by inves-
tors’ preference for positive skewness, but by their preference for highly
volatile stocks.
There are at least two main reasons why investors like high-IVOL
stocks. First, highly volatile stocks are more likely to be “attention grab-
bing” than stable stocks. Barber and Odean (2008) show that individual
investors are net buyers of attention-grabbing stocks. They argue that
this preference is a heuristic solution to the search problem that inves-
tors face when trying to choose among thousands of stocks. Fang and
Peress (2009) find that investors overpay for stocks that appear often
in the media. Overpricing of media stocks is more pronounced among
small stocks, stocks with low institutional ownership, and high-IVOL
stocks.
Second, investors may also be attracted to high-IVOL stocks to
profit from occasional “jackpot” returns, as predicted by the Barberis
and Xiong’s (2012) realization utility model. Recent tests of the realiza-
tion utility model using brain scans provide confirming evidence that
subjects’ neural response to capital gains increases with the magnitude
of the proportion of gains realized (Frydman et al., 2014). Using market
data, Conrad et al. (2014) find that firm age, size, and recent volatility
have the largest predictive impact on the probability of jackpot returns.
A one standard deviation increase in past three-month stock returns
volatility increases the odds ratio for jackpot returns by about 33%,
compared to 7.4% for past skewness. They also find that high prob-
ability of jackpot returns partially explains the low average returns of
stocks that have high financial distress risk. Investors bid up the prices
of distressed stocks as if these stocks as offer lottery-type payoffs.

6.5 IVOL and beta

The IVOL anomaly is related to the beta anomaly. Using data from 1972
to 2012, Fong and Chong (2014) find a correlation coefficient of 0.78

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 The Lottery Mindset

between the IVOL effect and the beta effect. This high correlation is
intriguing since IVOL is supposed to be orthogonal to beta. It is possible
that speculators view the two risk measures as close proxies for lottery-
type returns. If this hypothesis is true, the IVOL effect may potentially
account for the beta anomaly.
Fong and Chong (2014) test this hypothesis by asking whether beta
anomaly is fully explained in the cross-section of stock returns. They
compute alphas based on a standard asset pricing model augmented by
two lottery factors, one capturing the IVOL effect (the IVOL factor) and
the other capturing an ISKEW effect (the ISKEW factor). We will denote
these factors as IVOLF and ISKEWF respectively. The risk factors in the
asset pricing model are firm size, book-to-market ratio, and momentum.
The IVOL and ISKEW factors are meant to capture a systematic lottery
effect on stock prices due to investors’ preference for high-IVOL and
high-ISKEW stocks respectively.
Fong and Chong (2014) construct the two lottery factors along the
lines of George and Hwang (2010) and Palazzo (2012). To form the IVOL
factor, they regress stock returns each month against the three risk factors
and a dummy variable each for low and high-IVOL stocks. The regres-
sion specification takes the following form (we omit firm subscripts for
brevity):
Rt  h 0,t 1  h 1,t 1 MEt  h 2,t 1 BMt 1  h 3,t 1 MOMt 1
 h 4,t 1 LIVOLt 1  h 5,t 1 HIVOLt 1  a t (6.2)

The dependent variable Ri ,t refers to stock i’s return in month t. MEi ,t 1 is

the natural log of the firm’s market capitalization in month t – 1, BM i ,t 1
is the firm’s book-to-market ratio in t – 1, and MOMi ,t 1 is the cumulative
returns of stock i from month t – 12 to month t – 2. LIVOLi ,t 1 is a dummy
variable with value equals to one if stock i is in the lowest IVOL quintile
in month t – 1, and zero otherwise. HIVOLi ,t 1 is a dummy variable with
value equals to one if stock i is in the highest IVOL quintile in month
t – 1 and zero otherwise. IVOL quintiles are constructed in the manner
described previously. All right-hand side variables are computed using
information prior to month t.
The IVOL factor ( IVOLFt ) is measured by h 4,t 1 h 5,t 1. This factor
represents the return in month t of a zero-dollar investment strategy
formed one month ago that takes a long position in a pure low-IVOL
portfolio and a short position in a pure high-IVOL portfolio. The ISKEW

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 The IVOL Puzzle 

table 6.6 Cross-sectional regressions with IVOL and ISKEW factors

Beta quintiles
Lottery
variable Alpha () B B B B B B–B
CAPM 0.43 0.39 0.26 0.18 –0.17 .
None (4.45) (4.18) (2.68) (1.67) (–1.34) (4.01)
FF3 0.18 0.15 0.01 –0.09 –0.39 .
(2.32) (2.00) (0.12) (–1.08) (–3.73) (4.04)
IVOL CAPM + IVOLF 0.31 0.37 0.31 0.3 0.19 0.12
(3.24) (3.84) (3.22) (2.73) (1.70) (0.98)
FF3 + IVOLF –0.1 –0.04 –0.06 –0.1 –0.13 0.04
(–1.38) (–0.52) (–0.77) (–1.10) (–1.28) (0.28)
ISKEW CAPM + ISKEWF 0.31 0.28 0.13 0.03 –0.28 .
(3.04) (2.77) (1.28) (0.29) (–2.02) (3.66)
FF3 + ISKEWF 0.11 0.07 –0.08 –0.2 –0.5 .
(1.34) (0.87) (–1.03) (–2.24) (–4.49) (4.04)

Source: Fong and Chong (2014).

factor is constructed analogously using ISKEW as the lottery measure.

Fong and Chong (2014) find that consistent with the IVOL effect, the
loading on LIVOL and HIVOL are significantly positive and nega-
tive respectively, and that similar results hold for the ISKEW dummy
variables.
Table 6.6 presents the key results showing the impact of the IVOL
anomaly on the beta anomaly. The table is divided into three panels.
The first panel reports alphas for each beta quintile and the difference
in alphas (with t-statistics) for B1–B5 where B1 is the low-beta quintile
and B5 is the high-beta quintile. This panel is similar to that discussed
in the previous chapter, and it shows a pronounced beta anomaly. The
next panel presents returns after adjusting for fundamental risks and
the IVOL factor. Alphas for B1–B5 are now insignificant. The last panel
presents returns after adjusting for fundamental risks and the ISKEW
factor. Consistent with previous results, controlling for ISKEW does
not account for the beta anomaly. Overall, stocks with high volatility
(either IVOL or betas) appear to attract more intense speculative inter-
est among investors than do stocks with high ISKEW. The evidence is
consistent with behavioral models emphasizing volatility as a salient
lottery measure.
Fong and Chong (2014) also examine how mispricing of extreme IVOL
stocks influences the beta effect over time. They do so by estimating factor

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 The Lottery Mindset

models in which the dependent variable is the difference in monthly

returns between low and high-beta stocks (B1–B5). They report results
based on two regression specifications. In the first specification, the
explanatory variables are contemporaneous values of five risk factors:
market excess return (MKT), the size risk factor (SMB), the value risk
factor, (HML), the UMD (up-minus-down) risk factor (Cahart, 1997),
and the Pastor-Stambaugh liquidity risk factor (Pastor and Stambaugh,
2003). The results of this specification are shown in the second and third
columns of Table 6.7. In factor models such as these, the intercept is a
measure of pricing error which means that if the five risk factors suffice
in explaining the beta effect, the intercept should be zero. The results do
not support this view. The intercept is a statistically significant 0.31% per
month or 3.72% a year.
The second regression specification adds IVOLF to the five risk
factors. This specification tests whether fundamental risks combined
with time variation in the demand for extreme IVOL stocks can
explain the beta anomaly. The results (last two columns of Table 6.7)
give an affirmative answer. The intercept is no longer significant even
at the 10% level, and the coefficient for IVOF is positive and highly
significant, implying that when extreme IVOL stocks are mispriced, so
are extreme beta stocks. Note that the SMB factor is no longer signifi-
cant in this specification. This is because IVOLF is inversely related to
firm size. Accounting for the IVOL factor negates the significance of
the SMB factor.

table 6.7 Time series regressions: returns of high-minus-low beta portfolio on

IVOL factor
Without IVOLF With IVOLF
Variable Coefficient t-statistics Coefficient t- statistics
C 0.312 1.91 –0.078 –0.57
MKT –0.746 –14.13 –0.50 –10.13
SMB –0.358 –5.03 –0.07 –0.95
HML 0.192 2.59 0.22 3.34
UMD 0.233 4.10 0.14 2.52
PSLIQ 0.038 0.74 0.04 0.88
IVOLF 0.53 9.08
Adjusted R-square 0.696 0.772

Source: Fong and Chong (2014).

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 The IVOL Puzzle 

6.6 Conclusion

Investors’ penchant for undiversified bets on highly volatile stocks helps

explain the IVOL puzzle. Over the period 1963 to 2010, high IVOLs
underperform low IVOLs by about 0.7% a month after adjusting for
market risk. The evidence shows that individual investors are the main
clientele of high-IVOL stocks. Institutional investors do not arbitrage
the anomaly away due to mandates against short-selling and agency
costs. Shleifer and Vishny (1997) argue that investment managers who
care about performance over short periods may not wish to exploit
anomalies due to arbitrage risks. Brennan (1993) and Baker, Bradley,
and Wurgler (2011) add that when an active manager’s performance is
benchmark against market returns, fear of large tracking errors blunt the
incentives to exploit anomalies. In addition, many institutions, such as
mutual funds, are not permitted to short-sell. All in all, preference for
lottery-type payoffs combined with market frictions indicate the IVOL
effect, like the beta anomaly, will not go away anytime soon. Individual
investors need to ask whether high-risk stocks should be a big part of
their portfolios.

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 7
The MAX Effect
Abstract: With thousands of stocks to choose from, gambling-
prone investors focus on stocks with salient lottery-type
characteristics such as those that occasionally produce
extremely large (“jackpot”) returns. This chapter examines
the MAX strategy where this form of salience looms large. The
MAX strategy buys stocks with high maximum daily returns
in the previous month and sells those that have low maximum
returns over the same period. Bali, Cakici, and Whitelaw
(2011) show that the MAX strategy earns significantly negative
risk-adjusted returns, mainly due to the anomalously low
returns of high-MAX stocks. I present similar evidence on
the MAX anomaly and show that high-MAX stocks have
low-institutional ownership, suggesting that they attract
mainly individual investors. I also present evidence that
investor sentiment plays an important role in explaining
investors’ optimism about high-MAX stocks.

Keywords: investor sentiment; maximum daily returns;

salience

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. Basingstoke: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0012.

 DOI: 10.1057/9781137381736.0012

 The MAX Effect 

7.1 Introduction

Choosing what stocks to buy involves a huge search problem given that
there are thousands of stocks to choose from. Investors often “solve” this
problem by applying heuristics or simple rules of thumb. This chapter
examines an investment strategy based on the following heuristic: buy
stocks which have the highest maximum daily returns over the past
month (high-MAX stocks) and sell stocks which have the lowest maxi-
mum daily returns over the same period (low-MAX stocks). Bali, Cakici,
and Whitelaw (2011) were the first to study this MAX strategy. They found
that the strategy yields anomalously low returns typical of lottery-type
strategies like those based on high-beta and high-idiosyncratic volatility
(high-IVOL).
The MAX strategy is interesting for several reasons. First, its simplic-
ity suggests that high-MAX stocks attract mainly individual investors.
In particular, the MAX strategy uses only recent price signals, a piece
of information that is easily available to the general public. Second, due
to its large maximum daily returns, high-MAX stocks are attention-
grabbing, much like stocks with high abnormal trading volume (Barber
and Odean, 2008). In the language of psychology, the “jackpot” returns of
high-MAX stocks are akin to a highly accessible anchor that could have
significant priming effects on gambling-prone investors (Mussweiler,
2000; Mussweiler and Strack, 2004; Kahneman, 2011). Third, the MAX
effect may also reflect investors’ optimistic beliefs that high-MAX stocks
will continue to generate huge positive returns. This suggests that investor
sentiment should have a role to play in explaining the MAX anomaly.
This chapter summarizes evidence on the MAX effect, drawing on
my research and that of Bali et al. (2011). As in previous chapters, I
show that the MAX effect is concentrated in stocks with low-institu-
tional ownership, and is primarily driven by the overpricing of high-
MAX stocks (i.e., the short-leg of the long-short MAX strategy). I then
present new evidence showing that the MAX effect only exist when
investor sentiment is high. Finally, I show that sentiment negatively
predicts high-MAX returns after controlling for the effects of economic
fundamentals. The implications of these findings for individual inves-
tors are also discussed.

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 The Lottery Mindset

7.2 Sizing up the MAX anomaly

Bali et al. (2011) document a “MAX effect” in the US stock market:

stocks with high maximum daily returns in the previous month
(high-MAX stocks) underperform those with low maximum daily
returns (low-MAX stocks) over the same period. A MAX strategy
of buying high-MAX stocks and shorting low-MAX stocks) earns
significantly negative abnormal returns. For value-weighted decile
portfolios where D10 is the highest MAX decile and D1 the lowest
MAX decile, the difference in alphas between D10 and D1 is –1.18%
per month (t-statistic: –4.71). The corresponding alpha spread for
equal-weighted decile portfolios is –0.66% per month (t-statistic:
–2.31). Bali et al. (2011) find that the MAX effect also exists, and is
in fact stronger, when MAX is defined as the average of N highest
daily returns in the past month, where N ranges from 2 to 5 days.
Finally, they show that the anomaly is robust to controls for firm size,
illiquidity, intermediate momentum, and short-term return reversals
(Jegadeesh, 1990; Lehmann, 1990).
Similar to the IVOL effect discussed in the previous chapter, MAX is
correlated with firm characteristics that suggest individual investors as
the main clientele of high-MAX stocks. For example, Bali et al. (2011)
show that high-MAX stocks are small, less liquid, have higher market
betas, higher IVOL, and slightly higher book-to-market ratios than low-
MAX stocks. To see this more clearly, Figure 7.1 highlights four charac-
teristics: size, BM, beta, and illiquidity, across MAX deciles reported in
Bali et al. (2011), table 5.
Size is defined as the market value of equity (in millions of dollars).
The BM ratio is computed following Fama and French (1992) based on
the market value of equity at end-December of the previous calendar
year and the book value of common equity plus balance sheet deferred
taxes for the latest fiscal year ending in the previous calendar year.
Beta is the slope of a regression of a firm’s monthly excess returns on
the current, lead, and lag of the excess returns on the market portfolio.
Illiquidity is computed using the Amihud (2004) method and multi-
plied by 105. Not shown in the figure is another interesting feature
of extreme MAX portfolios: anti-momentum. Specifically, the high-
MAX decile has large negative cumulative monthly returns, while the
low-MAX decile has large positive cumulative monthly returns in the

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 The MAX Effect 

past year. This implies the MAX effect is distinct from the well-known
momentum effect documented by Jegadeesh and Titman (1993).
The bars in Figure 7.1 denote the average (across months) of the
median value of the four characteristic within each month for the
sample period from July 1962 to December 2005. The lottery-type
characteristic of D10 is clearly evident from these plots. Because small
firms and high-beta firms are riskier than firms with opposite char-
acteristics, adjusting the MAX effect for risk using standard factor

Size
350

300

250
Size ($ millions)

200

150

100

50

0
1 2 3 4 5 6 7 8 9 10
MAX Deciles

Book-to-market
1
0.9
0.8
0.7
0.6
BM Ratio

0.5
0.4
0.3
0.2
0.1
0
1 2 3 4 5 6 7 8 9 10
MAX Deciles
figure 7.1 Continued

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 The Lottery Mindset

Market Beta
1.4

1.2

1
Market Beta

0.8

0.6

0.4

0.2

0
1 2 3 4 5 6 7 8 9 10
MAX Deciles

Illiquidity
4.5
4
3.5
Illiquidity Measure

3
2.5
2
1.5
1
0.5
0
1 2 3 4 5 6 7 8 9 10
MAX Deciles

figure 7.1 Firm characteristics of MAX portfolios. A. Size. B. Book-to-market. C.

Market beta. D. Illiquidity.
Source: Bali et al. (2011), table 5.

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 The MAX Effect 

2
FF4 Alphas Average Returns
1.5

1
% per month

0.5

–0.5

–1

–1.5
1 2 3 4 5 6 7 8 9 10
MAX Deciles

figure 7.2 Average returns and alphas of MAX portfolios

Source: Bali et al. (2011), table 1.

models not only does not explain the anomaly, it actually amplifies
it. This is confirmed by Figure 7.2 which shows post-formation alphas
of the MAX deciles computed using the four-factor (FF4) model of
Fama and French (1993) and Cahart (1997).

7.3 Investor sentiment and the MAX effect

In this section, we examine whether the MAX effect is driven by inves-
tor sentiment. Baker and Wurgler (2006) find that investor sentiment
explains the cross-section of stock returns, with high sentiment being
a significant predictor of the returns of more speculative stocks such
as those of small firms, young firms, and highly volatile firms. When
sentiment is high, subsequent returns to these stocks are low and vice
versa.
The MAX effect may be driven by investors’ belief that high-MAX
stocks will continue to generate large positive returns. To the extent that

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 The Lottery Mindset

investor optimism underpins this belief, investor sentiment should have

a role to play in explaining the MAX effect.
We begin by measuring the MAX effect in US stocks using a slightly
longer sample period than Bali et al. (2011). Our sample of stocks
comes from the Center for Research in Security Prices (CRSP) database
and covers the period from July 1965 to December 2007. Accounting
data such as book value of equity comes from COMPUTSTAT.
Returns for the Fama and French (1992, 1993) risk factors come
from the online data library of Professor Kenneth French. MKT is
the market’s excess returns, SMB is the return on small firms minus
the returns of big firms, HML is the returns on value stocks minus
those of growth stocks, and UMD is the Up-minus-Down factor,
defined as the returns of past winners minus the returns of past losers
(Cahart, 1997).
We form MAX portfolios (deciles) in the same manner as Bali et al.
(2011). Each month, starting from July 1965, we form MAX decile
portfolios by ranking stocks based on their maximum daily return in
the previous month, where D1 comprises stocks in the lowest MAX
decile and D10 comprises stocks in the highest MAX decile. All port-
folios are value-weighted to minimize the impact of illiquidity. The
MAX effect is defined as the difference between the mean return or
alpha of D10 and D1.
Table 7.1 reports summary statistics of the firm characteristics of the
MAX portfolios. The characteristics are MAX, firm size, share price,
market beta, BM ratio, the Amihud illiquidity measure (Illiq). and
IVOL. We report the average (over months) of the median value of each
characteristic in each month. The results confirm Bali et al’s findings
that the typical high-MAX firm (D10) is small, relatively illiquid, has
lower share price, higher beta, and higher IVOL than the typical low-
MAX firm (D1). These differences are pronounced for every character-
istic except BM. For example, the typical firm in D10 is eleven times
smaller, has a share price that is four times lower, and IVOL that is four
times higher than the typical firm in D1. These characteristics indicate
that D10 resemble lottery-stocks which previous studies have shown
to appeal mainly to individual investors (see Goetzmann and Kumar,
2008; Kumar, 2009).
Figure 7.3 shows the performance of MAX portfolios one month
after the portfolio formation date. The bars indicate alphas estimated
using the FF4 model. Several interesting features can be noted. First,

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 The MAX Effect 

table 7.1 Descriptive statistics of MAX portfolios

MAX Deciles
Stock
characteristics D D D D D D D D D D

MAX (%) 2.49 3.22 3.84 4.44 5.08 5.78 6.55 7.45 8.66 11.42
Size ($106) 226.79 273.02 203.71 156.71 122.12 95.97 74.04 55.74 38.60 20.19
Price (dollars) 17.13 22.74 20.51 18.35 16.14 13.86 11.44 9.19 6.87 4.08
Beta 0.26 0.52 0.63 0.71 0.77 0.82 0.87 0.88 0.86 0.74
BM 0.84 0.79 0.75 0.73 0.71 0.71 0.70 0.70 0.72 0.76
Illiquidity (105) 0.54 0.17 0.16 0.19 0.25 0.33 0.48 0.69 1.31 3.50
IVOL 1.24 1.43 1.70 1.96 2.24 2.54 2.87 3.27 3.83 5.08

Source: Fong and Toh (2014), table 1. Reproduced with permission.

0.4

0.2

–0.2
Alpha (% per month)

–0.4

–0.6

–0.8

–1

–1.2

–1.4
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
MAX Deciles

figure 7.3 Post-formation FF4 alphas of MAX portfolios: 1965–2007.

Source: Fong and Toh (2014), table 2.

the alphas for D1 to D7 are small in absolute magnitude, and none are
statistically significant. Second, alphas for D8 to D10 are all significantly
negative, implying that stocks in the top three MAX deciles are over-
priced. Third, consistent with the findings of Bali et al. (2011), D10 is the
most overpriced among MAX portfolios. The MAX effect, as measured
by the difference in alpha between D10 and D1, is –1.1% per month. This
effect is extremely significant, with a t-statistic of –5.0. Similar to the

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 The Lottery Mindset

IVOL anomaly in the previous chapter, the MAX effect is primarily

driven by overpriced high-MAX stocks rather than underpriced low-
MAX stocks.
The characteristics of high-MAX stocks strongly suggest that they
are purchased by gambling-motivated investors. I now examine
whether investor sentiment play a role in explaining the low average
returns of high-MAX stocks. Most of the material that follows comes
from Fong and Toh (2014). In that paper, we measure investor senti-
ment using the sentiment index developed by Baker and Wurgler
(2006) – henceforth, the BW index. The BW sentiment index is the
first principal component of six underlying sentiment proxies: closed-
end fund discount, the number and the first-day returns of IPOs,
NYSE turnover, the equity share in total new issues, and the dividend
premium. By construction, the BW index is a measure of market-wide
sentiment. We use the version of the BW index in which each of the
six sentiment proxies is orthogonalized to a set of business cycle vari-
ables as detailed in Baker and Wurgler (2006). Following Baker and
Wurgler (2007) and Stambaugh et al. (2012), we define a high (low)
sentiment month as one in which the BW index is above (below) the
sample median value. These sentiment states are denoted by 1 and 0
respectively.
Figure 7.4 plots the standardized BW index which has zero mean
and unit standard deviation for the period from July 1965 to December
2010 (bold line). Also plotted is the standardized average discount on
closed-end mutual funds (CEFD), which is one of the components of
the BW index and a sentiment indicator in its own right. Previous stud-
ies show that the CEFD is low in high-sentiment periods and vice versa
(Lee, Shleifer, and Thaler, 1991). Over the sample period, the correla-
tion between the BW index and CEFD is –0.62. The figure shows that
fluctuations in sentiment correspond closely to anecdotal accounts of
changes in investor sentiment over time. Investor sentiment was high
during the electronics bubble of the late 1960s, fell during the 1973–1974
oil crisis, recovered during the 1980s biotech bubble, and reached new
highs in the Dot.com bubble period of the late 1990s.
Figure 7.5 plots FF4 alphas for each MAX portfolio in the two senti-
ment states. Black bars denote alphas following high-sentiment months,
and white bars show alphas following low-sentiment months. The figure
clearly shows that the MAX effect is driven by high sentiment in the
month where MAX portfolios were formed. The difference in alpha

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 3

–1

Closed–End Funds
–2 Discount
Sentiment Index
–3
196507
196702
196809
197004
197111
197306
197501
197608
197803
197910
198105
198212
198407
198602
198709
198904
199011
199206
199401
199508
199703
199810
200005
200112
200307
200502
200609
200804
200911
figure 7.4 Baker-Wurgler sentiment index and closed-end fund discount: 1965–2010
Source: Data for both series are from the website of Professor Jeff Wurgler (http://people.
stern.nyu.edu/jwurgler/)

0.8

0.3

–0.2
Alpha (% per month)

–0.7

–1.2

–1.7

–2.2
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
MAX Deciles
High Sentiment Low Sentiment

figure 7.5 Alphas of MAX portfolios conditional on investor sentiment states

Source: Fong and Toh (2014), table 3.
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 The Lottery Mindset

between D10 and D1 in high-sentiment states is –2.04%, compared to

only –0.12% in low-sentiment states. Furthermore, the alpha spread is
statistically significant only for the high-sentiment states, suggesting that
investors are over-optimistic about the future returns of high-MAX stocks
during such periods. Our results are consistent with Baker and Wurgler
(2006) who found that riskier stocks are more prone to overpricing in
high-sentiment periods because these stocks become more attractive to
optimists, and at the same time, less attractive to arbitrageurs given their
high-idiosyncratic risks (DeLong et al., 1990; Shleifer and Vishny, 1997).
Stambaugh, Yu, and Yuan (2013) show that the IVOL effect is concen-
trated among stocks that are overpriced and is more pronounced during
high-sentiment periods. Our results are consistent with theirs because
high-MAX stocks are also high-IVOL stocks. Using nonparametric
stochastic dominance tests, Fong (2013) provides evidence that investors
become more risk seeking when sentiment is high.

7.4 Institutional ownership and the MAX effect

If the MAX effect is driven by individual investors, it should be more
pronounced among stocks with low-institutional ownership (IO).
Sorting stocks by institutional ownership gives a rough guide as to the
type of stocks that are likely to attract retail interest. Using 13F institu-
tional holdings data from 1980 to 2011, we find that the average IO ratio
(IOR) of the highest IO quintile is 70%, followed by 46% for the second
highest IO quintile. IOR then declines sharply from 28% for the third IO
quintile, to 13% for the second lowest IO quintile. The average IOR for
the lowest IO quintile is just 3%. It is reasonable to assume that stocks in
the two lowest IO quintiles are primarily owned by individual investors.
Figure 7.6 shows formation period average returns of high and low-MAX
stocks across five IO quintiles, where Q1 (Q5) is the portfolio with the
lowest (highest) IOR. Returns for high-MAX stocks are indicated by the
black bars, while returns for low-MAX stocks are indicated by the white
bars. Consistent with the view that the demand for high-MAX stocks
comes mainly from individual investors, formation period returns for
the two highest MAX portfolios (D9 and D10) are much higher in the
two lowest IO quintiles than in the other IO quintiles. For example, the
average formation return for D10 is 15% in Q1 versus 6.8% in Q5, imply-
ing a return difference of 8.2% across these extreme IO quintiles. The

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 The MAX Effect 

18

16 High MAX
Low MAX
Average Returns (% per month) 14

12

10

0
Q1 Q2 Q3 Q4 Q5
Institutional Ownership Quintiles

figure 7.6 Formation period average returns of high- and low-MAX deciles by
institutional ownership
Source: Author’s calculations.

corresponding return difference for D9 is 5.8%. Institutional ownership

has a more muted effect on the returns of less speculative, lower MAX
stocks.
High speculative demand predicts low subsequent returns, particu-
larly among stocks with the lowest IO. Table 7.2 shows the evidence.
Panels A (B) presents FF4 alphas (percent per month) and their t-statis-
tics for MAX deciles in each IO quintile. Panel C shows that the MAX
effect is greatest for Q1 and Q5, smaller for Q3 and Q5, and insignificant
for Q5. Thus, while the MAX effect also exists in some institutional
portfolios, it is most conspicuous in stocks that attract low-institutional
ownership. It is also clear that the MAX effect in these cases is mainly
due to overpricing of high-MAX stocks than underpricing of low-MAX
stocks.
Figure 7.7 plots the MAX effect (the difference in FF4 alphas between
D10 and D1) following low-sentiment periods (grey bars) and high-
sentiment periods (black bars). If individual investors are more prone
to over optimism when sentiment is positive, the MAX effect following
such periods should be larger among low-IO stocks than high-IO stocks.
Figure 7.7 confirms that this is indeed the case.

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 The Lottery Mindset

Table 7.2 The MAX effect by institutional ownership quintiles

Panel A. Alphas
IO
Quintiles: Q Q Q Q Q
Low MAX –0.13 0.11 0.27 0.38 0.01
2 0.12 0.24 0.41 0.39 0.05
3 0.13 0.07 0.00 0.54 0.03
4 –0.18 0.01 0.09 0.44 0.00
5 0.20 –0.02 0.00 0.22 0.04
6 –0.80 –0.06 –0.16 0.26 0.09
7 –1.15 –0.92 –0.16 0.17 –0.02
8 –1.18 –0.67 –0.67 –0.26 0.03
9 –0.99 –1.84 –0.72 –0.46 –0.12
High MAX –2.02 –3.00 –0.98 –1.14 0.02
Panel B. t-statistics
Low MAX –0.70 0.54 1.61 2.58 0.10
2 0.81 1.30 2.46 3.50 0.36
3 0.46 0.33 0.02 3.51 0.27
4 –0.91 0.05 0.46 2.29 –0.01
5 0.71 –0.06 0.00 1.30 0.34
6 –. –0.19 –0.57 1.39 0.70
7 –. –. –0.48 0.85 –0.12
8 –. –1.59 –. –1.19 0.21
9 –1.82 –. –. –1.84 –0.62
High MAX –. –. –. –. 0.11
Panel C. Difference in Alphas
10–1 . . . . –0.01
t-statistics [–3.02] [–4.65] [–2.46] [–3.65] [0.03]

Source: Fong and Toh (2014), table 7. Reproduced with permission.

7.5 Sentiment or fundamentals?

The BW index already controls for the effects of macroeconomic funda-

mentals such as industrial output, real growth in durable, nondurable,
and service consumption, growth in employment, and an NBER reces-
sion indicator. Nonetheless, despite best efforts, it is not possible for any
sentiment measure to be totally free of the influence of economic funda-
mentals. To address this shortcoming, we form a two-by-two classifica-
tion of the state of the economy using the BW index and a comprehensive
proxy for economic fundamentals, the Chicago Fed National Activity
Index (CFNAI). Compiled by the Federal Reserve Bank of Chicago, the

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 The MAX Effect 

2.0
High Sentiment State
Low Sentiment State
1.0

Q1 Q2 Q3 Q4 Q5
0.0
Alpha (% per month)

–1.0

–2.0

–3.0

–4.0

–5.0
Institutional Ownership Quintiles

figure 7.7 The MAX effect in institutional ownership quintiles following high-
and low-investor sentiment states.
Source: Fong and Toh (2014), table 3.

CFNAI is a weighted average of 85 indicators of economic activity and

related inflationary pressure. The index is published monthly, normally
toward the end of each calendar month.
Similar to the BW sentiment index, we standardize the CFNAI so
that it has a mean of zero and a standard deviation of one. Hence, a
positive index indicates that the economy is growing above trend and
a negative index indicates that the economy is growing below trend. We
define a month as a high-CFNAI month (CFNAI = 1) if the index for
that month is positive, and as a low-CFNAI month (CFNAI = 0) if the
index is negative. If the demand for high-MAX stocks is driven by inves-
tors’ optimism about the economy and not by sentiment, there should
be a significant MAX effect only following CFNAI = 1 months and not
CFNAI = 0 months, regardless of the sentiment state. Conversely, there
should not be a significant MAX effect following high-sentiment states
unless the CFNAI state is also high.
Table 7.3 shows the results of this two-way classification analysis. For
brevity, we only present alphas for four MAX decile portfolios: D1 and

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 The Lottery Mindset

table 7.3 FF4 alphas of MAX portfolios: sentiment and economic states
Max
Deciles BW =  Alpha t-statistics BW =  Alpha t-statistics
1 –0.363 (–1.64) 0.310 (1.37)
2 –0.121 (–0.97) 0.240 (1.55)
9 CFNAI = 0 –0.331 (–0.94) –0.231 (–4.29)
10 –0.427 (–0.80) –2.110 (–5.00)
10–1 –0.064 (–0.099) –.
(–0.099) (–4.66)
1 –0.145 (–0.83) 0.136 (0.88)
2 –0.049 (–0.47) 0.317 (1.83)
9 CFNAI = 1 –0.215 (–1.10) –1.002 (–1.99)
10 –0.642 (–1.97) –2.060 (–3.50)
10–1 –0.498 (–1.27) –.
(–1.27) (–3.28)

Source: Fong and Toh (2014), table 4. Reproduced with permission.

D2 to represent low-MAX stocks and D9 and D10 to represent high-

MAX stocks. There is no significant MAX effect following low-sentiment
periods even if the economy was “hot” (the prior-month CFNAI state
was high). On the other hand, a significant MAX effect appears following
high-sentiment periods even if the economy was “cold” (the prior-month
CFNAI was low). The alpha of the long-short MAX strategy is nearly the
same following a high-sentiment month, indicating that sentiment plays a
more important role than fundamentals in driving the MAX effect.
We supplement the above analysis using time series predictive
regressions, thus allowing variables to take continuous values rather
than just discrete values. The dependent variable in these regressions
is the difference in monthly returns between D10 and D1. The main
independent variable is the lagged value of the BW index. The control
variables are lagged values of the CFNAI, current and lagged values of
the Fama-French risk factors (MKT, SMB, and HML), and current and
lagged values of the Pastor-Stambaugh illiquidity risk factor (Pastor and
Stambaugh, 2003). Table 7.4 shows the regressions results. In Model 1,
the BW index is lagged by one month, while in Model 2, it is lagged by
12 months as in Baker and Wurgler (2006). All independent variables are
standardized for easier interpretation of the results.
For both specifications, prior positive sentiment predicts low returns
for high-MAX stocks relative to low-MAX stocks. Apart from the
market’s returns, none of the explanatory variables are significant at the
5% level. Overall, these results convey the same message as the discrete

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 The MAX Effect 

table 7.4 Predictive regressions: returns of the long-short MAX portfolio

on lagged sentiment and macroeconomic variables
Model  Model 
Coefficient t-statistics Coefficient t-statistics
Intercept 0.00 0.01 0.00 –0.12
CFNAI(–1) 0.04 1.38 0.05 1.51
BW(–1) –0.10 –2.99 . .
BW(–12) . . –0.07 –3.05
MKT 0.42 4.65 0.43 4.71
SMB 0.28 2.74 0.28 2.71
HML –0.05 –0.49 –0.05 –0.53
ILLQ –0.06 –1.09 –0.07 –1.29
MKT(–1) –0.02 –0.45 –0.02 –0.33
SMB(–1) 0.06 0.78 0.06 0.82
HML(–1) –0.11 –1.72 –0.11 –1.83
ILLQ(–1) –0.01 –0.10 –0.02 –0.25
Adjusted
R-square 0.384 0.376

Source: Author’s calculations.

state analysis: investor sentiment plays an important factor in driving

the demand for high-MAX stocks.

7.6 Explaining the MAX effect: salience and lottery

stock preference
Why do individual investors exhibit such a strong preference for high-
MAX stocks? Investors face a huge search problem when choosing
what stocks to buy (deciding what stocks to sell is a far easier problem).
Recent research in economics and finance has begun to explore the
implications of limited investor attention for portfolio choice and asset
pricing. Barber and Odean (2008) argue that when individual investors
are faced with hundreds of stocks to choose from, they simply focus on
those that grab their attention. Stocks with salient features like those with
abnormal trading volume, extreme one-day returns, and stocks which
are frequently in the news are more likely to grab investors’ attention
than those with low profiles.
Investors do not buy every stock that catches their attention. Ultimately,
they buy what they prefer. Investors’ preferences are not always rational
from the perspective of expected utility theory. Preferences can be

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 The Lottery Mindset

influenced by distorted beliefs and psychological biases. Cumulative

Prospect Theory or CPT (Tversky and Kahneman, 1992) posits that
people tend to overweight the probabilities of extreme outcomes. In
investments, such distorted beliefs induce a preference for stocks that
have small probabilities of extremely large returns (Barberis and Huang,
2008). On the other hand, Bordalo, Gennaioli, and Shleifer (2012) argue
that individuals do not always overweight low-probability payoffs. They
do so only when these payoffs are salient. Their theory predicts that deci-
sion makers become risk-seeking (risk-averse) when a lottery’s upside
(downside) payoff is very large.
Recent brain scan studies support the importance of salience. A
region of the mid-brain known as the ventral striatum (VS) is known
to be highly responsive to reward stimuli. There is evidence that neuron
activation in the VS depends on the size of the expected reward but not
on the probability of obtaining the reward (Knutson, Fong, et al., 2001;
Knutson and Cooper, 2005). Given their large recent returns, high-MAX
stocks are obviously salient. In fact, one could argue that high-MAX
is a more salient signal that other lottery-type characteristics such as
high-IVOL or high-idiosyncratic skewness (ISKEW). Few individual
investors have probably heard of IVOL and ISKEW, let alone know how
to calculate these quantities. In contrast, MAX is easy to calculate; all
one needs is last month’s daily prices. The accessibility and salience of
high-MAX stocks may explain why Bali et al. find that the MAX effect
survives controls for IVOL and ISKEW.
Investors’ choices are also frequently affected by a host of cognitive
biases. One of the most relevant bias in relation to the MAX anomaly is
overconfidence. There is overwhelming evidence that people are over-
confident about their knowledge and abilities (see Chapter 1). Moreover,
overconfidence is greatest when people are faced with diffuse tasks that
entail highly subjective judgments and noisy feedback (Einhorn, 1980).
Predicting the returns of highly volatile stocks is a good example of a
diffuse task. With limited time and resources to carefully assess invest-
ment prospects, the stocks that investors choose are likely to be those
whose value they have overestimated (van den Steen, 2004).
Psychology research also reveals that people tend to overestimate the
probability of good outcomes, including their successes (Weinstein, 1980;
Alpert and Raiffa, 1982; Sharot et al., 2007). Building on this evidence,
Brunnermeier and Parker (2005), and Brunnermeier, Gollier, and Parker
(2008) develop an optimal expectations model in which investors derive

DOI: 10.1057/9781137381736.0012
 The MAX Effect 

higher utility if they optimally overestimate the probability that their

investments will pay off well. They showed that such investors will prefer
stocks that have a small probability of very high returns.
Positive sentiment amplifies the demand for lottery-type stocks while
negative sentiment dampens it. Indeed, if positive sentiment captures
the propensity for investors to be over-optimistic and to speculate,
then almost by definition, high sentiment increases risk-seeking and
the demand for all forms of lottery-type securities. This chapter has
provided both informal and formal evidence that supports this view.
As we saw earlier, fluctuations in the BW sentiment index line up well
with major speculative episodes in the US stock market, suggesting that
investors sometimes behave as “sentiment-driven herds” (see Banerjee,
1992; Bikhchandani, Hirshleifer, and Welch, 1992, 2000; Avery and
Zemsky, 1998; Cipriani and Guarino, 2014). Our analysis of investor
sentiment and the MAX effect confirms that sentiment strongly mediate
the demand and mispricing of high-MAX stocks.

7.7 Conclusion

The weak form version of the efficient market hypothesis implies that
past prices of risky assets should contain no information for predicting
future prices. The MAX effect is a glaring counterexample to this princi-
ple. We confirm the results of Bali et al. (2011) that a strategy that longs
low-MAX stocks and shorts high-MAX stocks generates economically
large alphas. Consistent with the fundamental proposition in behavioral
finance that investor sentiment affect prices, we show that the MAX
effect exists only following high-sentiment states. Consistent with other
lottery-type stocks described in this book, the MAX effect is primarily
driven by overpriced high-MAX stocks rather than underpriced low-
MAX stocks. The size and persistence of the anomaly speak to two forces
behind the MAX effect: a strong preference by individual investors for
stocks that occasionally provide jackpot returns and the inability or
unwillingness of institutional investors to arbitrage away the anomaly.
Our findings imply that prudent investors should consider reducing
their portfolio allocations in high-MAX stocks when most investors are
optimistic since it is precisely during such periods that these stocks are
overpriced.

DOI: 10.1057/9781137381736.0012
 8
Conclusion

Fong, Wai Mun. The Lottery Mindset: Investors, Gambling

and the Stock Market. Basingstoke: Palgrave Macmillan,
2014. doi: 10.1057/9781137381736.0013.

 DOI: 10.1057/9781137381736.0013

 Conclusion 

Classical finance theory assumes that individual investors are utility

maximizers able to balance risk and return in an informed and opti-
mal fashion. Compelling evidence from behavioral finance shows that
real world investors seldom conform to this ideal. Individuals bring
emotions and cognitive biases into their investment decisions as they
do in many other domains. These psychological factors represent an
unconscious and automatic response to the many complex problems
that investors face, such as what stocks to buy, when to buy, and when
to sell.
Choosing what stocks to buy from thousands that are available
presents an information overload for most investors. A quick heuristic
to “solve” this problem is by focusing on attention-grabbing stocks such
as volatile stocks and stocks that are “in the news.” Investors who are
carried away by this heuristic forget that when too many buyers converge
on the same pool of attention-grabbing stocks, the result is overpricing
and poor average returns.
Choosing when to enter the stock market is another tricky problem
since most investors, including professional ones, lack consistent market-
timing skills. Yet, investor overconfidence and the human tendency to
see patterns where none exist keep the habit of return-chasing alive. The
evidence on market timing is clear: whether they are chasing stocks or
mutual funds, the average investor has a remarkable ability to buy after
superior returns and before poor subsequent returns.
Emotions and behavioral biases also influence the decision on when
to sell. Contrary to standard utility theory, people feel more pain from
a dollar lost than pleasure from a dollar gained. Loss-aversion explains
why investors sell winners too early while keeping losers too long. The
pleasure of realizing gains combined with lottery-type preferences for
volatile stocks explains the tendency for many investors to trade exces-
sively and to their detriment.
Investors the world over are enamored of growth stocks due to these
firms’ past strong earnings record. Fascination with growth stocks over
value stocks is another manifestation of pattern-seeking, applied in
an extrapolative fashion to earnings growth. Since growth stocks have
higher market betas than value stocks, growth investors are effectively
betting on beta rather than against it. As we have seen, a strategy of
betting against beta or at least owning a diversified portfolio of low-beta
stocks is likely to significantly outperform a high-beta strategy in the
long term. Investors seeking to reorientate from a growth to value style

DOI: 10.1057/9781137381736.0013
 The Lottery Mindset

would need to deal with a number of important cognitive biases such as

the availability bias, extrapolation bias, overconfidence, and preference
for lottery-type stocks. Indeed, a central theme of this book is that inves-
tors have much to gain by keeping behavioral biases in check.

DOI: 10.1057/9781137381736.0013
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 Index
active trading, 9–10, 25–45
see also overtrading
adaptive expectations, 47
agency costs, 137
aggressive growth funds,
91, 115
alphas, 29, 104–5, 107, 114, 115,
125, 142, 146, 147, 148
American Association of
Individual Investors
(AAII), 52
American Stock Exchange
(Amex), 73
Amihud’s measure, 119
amygdala, 24
analyst coverage, 119–20
anchoring heuristic, 3, 11–12
anti-momentum, 140–1
arbitrage/arbitrage risk, 85–7,
114, 115, 117, 137, 155
Asian stock markets, 27, 28
availability heuristic, 3, 10–11,
44–5, 158
Baker-Wurgler (BW) index,
146, 147, 150
base rate, 13, 14
Bayes, Thomas, 14
Bayes’s rule, 14
behavioral biases, 38, 43, 60–6,
106, 118, 157, 158
behavioral finance, 1–4, 157
behavioral portfolio theory,
3, 38

beliefs, 3, 4, 15–17, 42–3
beta, 102, 128, 140, 142
beta anomaly, 101–21
explanations for, 114–17
high-beta stocks and, 107
institutional ownership and,
120–1
international evidence for,
105–7
IVOL anomaly and, 133–6
long-run consequences of,
108–10
risk and, 110–14
US evidence for, 103–5
beta portfolio returns, 108–9
biased beliefs, 15–17
book-to-market (BM) ratios,
57, 59, 76, 78, 79, 80, 102,
116, 140, 141
bounded rationality, 3
buy-and-hold (BHR) returns,
70, 71, 73–4
buy-and-hold strategy, 26, 45,
73–4
BW index, 146, 147, 150
capital asset pricing model
(CAPM), 79, 80, 102, 103,
104–5, 117, 125
CASH, 118
categorical predictions, 12–14
Chicago Fed National Activity
Index (CFNAI), 150–2
classical finance theory, 157
DOI: 10.1057/9781137381736.0015

closed-end mutual funds (CEFD), 146
cognitive biases, 3, 4, 22–3, 47, 94,
154–5, 158
concentrated portfolios, 6–7
conditioning, 44
confirmation bias, 17
conformity, 23–4
control, illusion of, 16
co-skewness effect, 124
cumulative abnormal returns (CARs),
55–6
cumulative prospect theory (CPT), 3,
8, 154
day trading, 32–3, 34–6
decision making
see also investment decisions
using heuristics, 3, 4, 44–5
disposition effect, 38, 61, 63–4
distress risk, 110–13
diversification, 6–7
dollar-weighted returns (DWR), 70,
71, 72–6
Dow Jones Index (DJI), 52
dumb money effect, 66, 70, 71, 72
earnings growth, 92–4, 97–100, 157–8
efficient market hypothesis, 155
emotions, 3, 4, 18–24, 157
optimism, 21–3, 43
prospect theory and, 18–21
regret, 21
risk-taking and, 114–15
social psychology of, 23–4
equity markets, turnover on, 26–8
equity ownership patterns, 66
excess returns, 105
exchange-trade funds (ETFs), 26
expected utility theory, 153
extrapolation bias, 158
Fama-French three factor model, 29,
79–80, 105, 124
Fama-MacBeth (FM) regression
estimates, 112
familiarity bias, 7–8
DOI: 10.1057/9781137381736.0015
Index 
financial distress, 110–13, 118–19
financial risk, 110–13
firm performance, 92–4
firm size
illiquidity and, 120
relative to S&P 500 (RSIZE), 118
returns and, 102, 104
value premium and, 85–92
FLOW, 54–60, 64
forecast dispersion, 128–9
foreign stocks, 7
four-factor (FF4) model, 33–4, 37, 105
framing, 3, 18–21
narrow, 38–9, 61–4, 106, 114, 118
gains, 18–21, 38–9, 44
gambler’s fallacy, 14–15, 47, 48–51
gambling, 21, 38
gambling-prone investors, 62, 85, 94,
139
growth funds, 91, 115
growth stocks, 6, 9, 77–100, 157–8
arbitrage risk and, 85–7
earnings extrapolation and, 92–4
lottery stock preference and, 85–92
value premium and, 78–84, 85–7,
92–4
hedge funds, 109
Helsinki Stock Exchange, 32
herding, 23–4, 45, 91, 155
heuristics, 3, 4, 44–5, 139
anchoring, 3, 11–12
availability heuristic, 3, 10–11,
44–5
representativeness heuristic, 3, 12–15,
49, 114, 118
high-beta stocks, 101–3, 107, 110, 113–15,
117, 118, 123, 157
high-IVOL stocks, 123–37
high-MAX stocks, 138–55
high-minus-low (HML) value factor,
79
holding periods, 26, 27, 28
home bias, 7
hot-hand fallacy, 15, 44, 47, 48–51
 Index
idiosyncratic risk, 2, 16, 86, 123–4, 148
idiosyncratic skewness (ISKEW), 2, 8,
31, 85, 90, 96, 131–3, 134–5, 154
idiosyncratic volatility (IVOL), 2, 8,
31, 40, 75, 76, 85–7, 90, 95–6,
122–37
illiquidity, 113–14, 116–17, 119–20, 140,
142
income funds, 91
individual, average returns of, 28–34
individual investors
behavioral characteristics of, 60–6
IVOL anomaly and, 129–30
learning by, from trading, 34–5
MAX effects and, 140–55
overtrading by, 25–45
profitability of, 28–34
reasons for trading by, 37–45
stocks held by, 66–71
trend-chasing by, 46–76
information ratio (IR), 115
institutional investors, 28, 76, 115, 117,
129–31
institutional ownership (IO), 66,
68–70, 72–6, 119, 120–1, 148–50
institutional ownership ratio (IOR),
66, 130
internal rate of return (IRR), 70
international markets, beta anomaly
in, 105–7
international value premium, 81–5
internet, 16
internet stock bubble, 109
investment decisions, 3–4, 157–8
investment performance, 28–35
smart investors and, 36–7
trend-chasing and, 65–6
investors
see also individual investors;
institutional investors
beliefs of, 42–3
heuristics used by. see heuristics
in high-IVOL stocks, 128–31
learning by, from trading, 34–5
mature, 62–3
mutual fund, 54–66
overconfident, 15–17. see also
overconfidence
preferences, 3, 5–10, 153–4
rational, 2, 45, 153–4
reasons for trading by, 37–45
sensation-seeking by, 39
smart, 36–7, 62–3
investor sentiment, 42–3, 109, 143–8,
150–5
IVOL, see idiosyncratic volatility
(IVOL)
IVOL anomaly, 123–37
beta anomaly and, 133–6
idiosyncratic skewness and, 131–3
revisited, 123–8
types of investors and, 128–31
jackpot returns, 85, 94, 106, 124, 133,
139
Japan, 82
law of small numbers, 14–15
learning from trading, 34–5
limit orders, 33
limits-to-arbitrage hypothesis, 86–7
liquidity needs, 39
liquidity risk, 113–14, 136
loss aversion, 20–1, 157
losses, 18–21, 38–9, 43, 44
lotteries, 40–1
lottery factors, 95–7
lottery stock preference, 8–9, 61, 85–92,
106, 109, 114, 128–31, 153–5, 157, 158
lottery-type securities, 2, 6, 8–9, 21,
22, 32, 40–1, 45, 85, 107, 117, 128,
155, 158
low-beta stocks, 101, 102–3, 110, 115,
118, 157
low-MAX stocks, 140
low-probability events, 118, 154
low-risk investing, 128
luck, 43, 47
market capitalization, 128
market excess return (MKT), 40, 52,
53, 95, 136, 144
DOI: 10.1057/9781137381736.0015
 Index 

market leverage (MLEV), 118 overtrading, 25–45, 61, 157

market liquidity, 27–8 learning from, 34–5
market portfolio, 128 overconfidence and, 29,
market-valued version of the leverage 31–2, 38
ratio (MLEV), 111 profitability and, 28–34
mature investors, 62–3 reasons for, 37–45
MAX effect, 140–3 smart investors and, 36–7
explanations for, 153–5 turnover on equity markets and,
institutional ownership and, 148–50 26–8
investor sentiment and, 143–8, 150–3
lottery stock preference and, 153–5 paper losses, 21, 39
macroeconomic fundamentals and, Pastor-Stambaugh liquidity risk factor,
150–3 136
risk and, 141, 143 pattern-seeking, 72, 157
salience and, 153–5 pensions, 8
maximum daily returns (MAX), 96, portfolio optimization, 2
138–55 portfolio pyramid, 5–6
MAX strategy, 96, 138–55 portfolios
mean-variance efficient portfolios, 6 beta-sorted, 108–16
media coverage, of stocks, 44–5, 157 concentrated portfolios, 6–7
mental accounting, 5–6, 38–9, 44, 114 IVOL-sorted, 125–7
mental heuristics, see heuristics market, 128
momentum anomaly, 102 MAX, 138–55
momentum effect, 141 underdiversified, 2, 5
momentum traders, 44, 47 value-neutral, 87
mutual fund investors, 54–60 portfolio theory, 3, 5, 6, 26, 38
behavioral biases of, 60–6 positive feedback behavior, 47
mutual fund managers, 87, 115 positive sentiment, 154–5
mutual funds, 2, 7, 26, 28, 91, 115, 146 preferences, 3, 5–10, 153–4
for active trading, 9–10
narrow framing, 38–9, 61, 62, 63–4, for the familiar, 7–8
106, 114, 118 for lottery-type stocks. see lottery
NASDAQ, 73 stock preference
new net cash flows (NNCFs), 57 risk, 38–9
New York Stock Exchange (NYSE), 26, price, 120
27, 73 price per share, 128
noise traders, 9, 11 problem framing, 3, 18–21
novice traders, 34–5 profitability, of individual investor
nucleus accumbens (NAcc) region, trades, 28–34
22–3 prospect theory, 3, 18–21
prudent man rule, 107
optimal expectations model, 154–5 psychology, 2, 4, 15, 23–4, 157
optimism, 21–3, 43
overconfidence, 4, 7, 9, 15, 29, 31–2, 38, random events, 14–15, 72
43, 47, 62, 107, 114, 118, 154, 157, 158 rational investors, 2, 45, 153–4
overpricing, 115, 117, 157 rational learning, 34–5

DOI: 10.1057/9781137381736.0015
 Index
realization utility model, 38–9, 42, 44,
76, 106–7, 133
recessions, 81
regret, 21
reinforcement learning, 17
rejoicing, 21
representativeness heuristic, 3, 12–15,
49, 114, 118
residual analyst coverage, 119–20
residual volatility, see idiosyncratic
volatility (IVOL)
return-chasing, 47, 157
see also trend-chasing
reward anticipation, 21, 115
risk
arbitrage, 85–7, 115, 117
beta anomaly and, 110–14
distress, 110–13
financial, 110–13
idiosyncratic, 2, 16, 123–4, 148
liquidity, 113–14, 136
MAX effect and, 141, 143
returns and, 102, 117
systematic, 117
risk-adjusted returns, 29, 30
risk-averse, 3
risk aversion, 19, 38, 117
risk perception, 18, 19–21
risk preferences, 38–9
risk-seeking, 3, 106, 107, 155
risk-taking, 4, 23, 109, 114–15
ROMA, 118
salience, 10–11, 153–5
Securities and Exchange Commission
(SEC), 129
self-attribution bias, 17, 34, 43, 47
sensation-seeking, 9, 39
sentiment, 42–3
see also investor sentiment
sentiment-driven trading, 4, 22, 42–3,
155
Sharpe ratios, 82
short selling, 115, 137
SIGMA, 118
size, 140, 141
size risk factor (SMB), 136
smart investors, 36–7, 62–3
social psychology of emotions, 23–4
speculative securities, 2, 6, 31–2, 40–1
standard deviation, 128
stereotyping, 12–13
stock bubbles, 42, 51, 109
stock crashes, 51
stock markets
trend-chasing in, 51–4, 66–71
turnover in, 26–8
stocks, as lotteries, 40–1
summary statistics, 75–6
Survey of Consumer Finance (SCF), 66
systematic risk, 117
System I, 4, 12, 48
System II, 4
Taiwan, 38
Taiwan Stock Exchange (TSE), 32–5
three-factor (FF3) model, 29, 79–80,
105, 107, 124
total skewness (TSKEW), 95, 96–7
traders’ curse, 45
trading costs, 26, 32
trend-chasing, 45, 46–76, 94
in aggregate stock market, 66–71
behavioral biases and, 60–6
experimental evidence on, 51–2
gambler’s fallacy and, 48–51
hot-hand fallacy and, 48–51
mutual fund investors and, 54–60
returns and, 65–6
in stock markets, 51–4
survey evidence on, 52–4
turnover, 30, 38
on equity markets, 26–8
underdiversification, 2, 5, 6–7, 8,
16, 45
United States
beta anomaly in, 103–5
value premium, 79–81
up-minus-down (UMD) risk factor,
136
utility theory, 19, 38, 157
DOI: 10.1057/9781137381736.0015

value-neutral portfolios, 87
value premium, 78–84
earnings extrapolation and, 92–4
firm size and, 85–92
international, 81–5
US, 79–81
value risk factor (HML), 136
value stocks, 86
DOI: 10.1057/9781137381736.0015
Index 
venetral striatum region, 22–3, 24
ventral striatum (VS), 154
volatile stocks, 40–1, 76, 107,
114, 117
volatility, see idiosyncratic volatility
(IVOL)
wealth, changes in, 38–9