Swedroe: Beware Of The Low Price Illusion

October 26, 2016

By way of background, skewness is a measure of the asymmetry in the distribution. When a distribution is skewed to the right (meaning it’s positively skewed, like a lottery ticket’s distribution), the tail on the distribution curve's right-hand side is longer than the tail on the left-hand side, and the mean is greater than the mode.

Yet future skewness doesn’t increase; it actually decreases. On the day of a stock split to a lower price, the authors observed “a greater than 40% increase in skewness expectations.” The result is that investors overpay for the call options. They also found similar evidence of investor-expectation errors following reverse splits. On the day of a stock price increase due to a reverse split taking effect, expectations of future skewness drastically decrease. Yet future realized skewness does not decrease; it actually increases.

In addition, Birru and Wang found evidence from options trading that investors exhibit increased optimism toward low-priced stocks relative to high-priced stocks, and take lotterylike bets in low-priced stocks to a greater extent than in high-priced stocks.

For example, they found that the ratio of call-to-put open interest and volume is substantially higher for low-priced stocks than it is for high-priced stocks. They concluded the evidence shows that “investors also have a preference for utilizing the leverage benefits options provide to take lottery-like bets on these lottery-like stocks.”

The authors add: “Overall, the evidence is consistent with investors suffering from a nominal price illusion in which they overestimate the ‘cheapness’ or ‘room to grow’ of low-priced stocks relative to high-priced stocks. Our evidence also suggests that this nominal price bias has asset-pricing implications.” For example, they found that call options on low-priced stocks are more overpriced than they are on high-priced stocks.

Summary

Birru and Wang present evidence that both confirms and helps explain a nominal price illusion that leads to the asset pricing anomaly described by the overvaluation of low-priced stocks and options on low-priced stocks. It seems that investors surely do have a preference for lotterylike bets. And the authors found that investors also overweight nominal prices in assessing return distribution expectations.

They concluded: “The evidence presented is consistent with investors suffering from the illusion that low-priced stocks ‘have more upside potential.” The result is that “options of low-priced stocks are more overvalued than options of high-priced stocks.” Now, though, you no longer have the excuse of falling for the nominal price illusion.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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