Most people know they'll lose money buying lottery tickets, but some still feel compelled to take the gamble on the off-chance they luck out and get rich. Now research by BYU finance professors indicates some investors take that same approach to the purchase of certain risky stocks.
And although their return is probably going to be small, investors drawn to the lottery-like components of some stocks buoy the prices. That defies traditional economics, which says, "higher risk, lower price."
The findings are being published in the Review of Financial Studies, one of the leading financial journals.
Traditional investors care about risk and rate of return, said Keith Vorkink, associate professor of finance and the study's co-author. And low-risk, high-return stocks are the superstars for most folks, which dovetails nicely with oft-used advice to have a well-diversified portfolio.
There are investors, however, who embrace the lottery aspects of some stocks even when they know the returns might be quite poor, as long as there's even slight potential for huge returns, Vorkink said.
The study shows the overpriced stocks earn an average of 12 percent less a year than stocks with similar high risk, but that lack that potential to explode, said Brian Boyer, assistant professor of finance. Normally, stocks that don't perform as well would sell for less.
Understanding such things matters, said Boyer, because it helps explain the preferences of individuals and how that impacts prices. He said the study does not address whether the investors understand that they're apt to get a smaller return or even who those investors are. They may be well aware of the higher price and lower overall rate of return. But it could be a wake-up call for investors who have been drawn to the flashy potential of the stock and don't see the whole picture.
The research also notes that "sophisticated" investors can short-sell the stocks, putting themselves more in the position of the guy who sells the lottery ticket and benefits, instead of the fellow who buys the tickets and loses most of the time.
Variables they tested that most closely predicted which stocks ended up falling into the "lottery" category were new companies, small market capitalization, recent price volatility and, during some decades, specific industries that had more than their share of lottery-like stocks, such as during the Internet boom.
The authors say conservative investors likely want to avoid stocks that have those features.
The other study co-author was Todd Mitton, an associate professor of finance.
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