Swedroe: Investors Pay Premiums For Bad Bets

June 01, 2015

The first formal asset pricing model—the capital asset pricing model—was built on certain assumptions, including that investors are risk-averse; will maximize the expected utility of absolute wealth; and care only about the mean and variance of return.


However, academic research has found that these assumptions don’t necessarily hold. In the real world, some investors have a “taste,” or preference, for lotterylike investments—investments that exhibit positive skewness and excess kurtosis.


This leads such investors to “irrationally” (from an economic perspective) invest in high-volatility stocks (which have lotterylike distributions) despite their poor returns.


In other words, these investors pay a premium to gamble. If the markets were perfectly efficient, arbitrageurs would enter and drive prices to their “right” level. But in actual practice, limits to arbitrage, and the costs and fear of shorting, can prevent rational investors from correcting mispricings.


Overpaying For ‘The Lottery’

Bjorn Eraker and Mark Ready—authors of the paper “Do Investors Overpay for Stocks with Lottery-like Payoffs?”, which appears in the March 2015 issue of the Journal of Financial Economics—studied the performance of over-the-counter (OTC) stocks to determine if there was evidence of persistent mispricing. The authors note that this issue increased in importance when Congress passed the Jumpstart Our Business Startups Act in April 2012.


By reducing the disclosure requirements for initial public offerings (IPOs) by new, smaller companies, the law was intended to facilitate the raising of capital. It even included a “crowdfunding” provision that allows companies to sell up to $1 million of stock each year and have up to 2,000 shareholders without formally registering with the SEC, as long as most of those shareholders are “accredited investors” who are investing less than 10 percent of their net worth in the company.


Naturally Risky Stocks

The authors explain that newer and smaller companies are naturally risky. They have a higher probability of failure and little probability of dramatic, overnight success. In other words, they are stocks that “will have payoffs that look much like a lottery,” which raises the question: Will investors overpay for stocks with these characteristics?


In their study, Eraker and Ready included all U.S. OTC stocks that had price data available, both from FactSet and Bloomberg, and covered the period from 2000 through 2008. They chose 2000 as their starting point because, beginning in that year, all OTC Bulletin Board stocks were required to file annual financial statements with the SEC.


There were more than 11,000 U.S. common stocks with at least some OTC price information, and more than 2,500 that traded on the exchanges for at least some part of the sample period.


What They Found

To deal with the relatively high costs of trading in these stocks, a 24-month buy-and-hold and then rebalance strategy was used. Portfolios were equal-weighted. Following is a summary of their findings:

  • Not surprisingly, the stocks in the sample loaded heavily on the size factor and negatively on the value factor (they tend to be growth stocks).
  • The stocks in the sample had large negative average returns. About 25 percent of the OTC stocks lost between 99 and 100 percent of their value over the period studied, and 75 percent of OTC stocks produced negative cumulative returns.
  • A portfolio of OTC stocks underperforms the market by more than 1 percent per month, excluding transaction costs.
  • Transaction costs are quite high, even for the more liquid OTC stocks. Although their portfolios were designed to have very low turnover, underperformance in the sample was about 2 percent per month, including transaction costs. Given typical spreads of roughly 10 percent, round-trip transaction costs explain a little less than half of the underperformance.
  • The distribution of OTC stock returns is highly positively skewed. While many of the stocks in the sample become worthless, a few do extremely well.



Overweighting Extreme Outcomes

The authors concluded that investors overweight extreme outcomes. But why? Is it a preference for skewness? Are investors uninformed and truly unaware of the low probability of positive outcomes, leading to mispricing?


To try and determine the answer to these questions, Eraker and Ready analyzed separately the returns on two subsets of OTC stocks: those that previously had traded on a major U.S. exchange and those that hadn’t.


The authors created this dichotomy because the stocks previously listed on major U.S. exchanges are included in data from the Center for Research in Security Prices (CRSP) before appearing in OTC stock return data. Their assumption was that, because there’s much more information available for the firms with stock once tracked by CRSP, it should be easier for investors to assess probabilities for these companies. Here’s what they found:

  • The average return for stocks previously tracked by CRSP is significantly higher than the average return for stocks that not previously tracked by CRSP.
  • The skewness statistics for the two subsamples are similar.


Given that the statistics on skewness were similar, the authors concluded: “The negative average return for OTC stocks (which is primarily limited to those that were never on CRSP) could be at least partially due to missestimation of probabilities.”


Systematically Fooled

What’s the reason for these poor returns, which (given the riskiness of the assets) is a major violation of the efficient market hypothesis? One explanation the authors offer is that investors purchasing OTC stocks are systematically fooled.


They note: “The loose disclosure requirements make OTC stocks a favored playground for fraudsters. Popular press, books, and movies, including the recent Scorsese/DiCaprio movie, ‘The Wolf of Wall Street,’ depict massive frauds where investors are lured into purchasing worthless OTC stock.”


Another explanation is that, because it’s extremely difficult to short OTC stocks (many broker-dealers either outright ban short sales on these stocks or put severe limits on short sales), arbitrageurs cannot correct mispricings.


A third explanation for the poor returns to these stocks is that investors simply “overpay” as a result of their preference for skewness. This preference leads to “a premium” for gambling.


The ‘Long Shot’ Mentality

The preference for lotterylike payout distributions has been found in other areas, not just in the world of investing. For example, the authors observe that when it comes to horse racing, long shots are systematically overvalued. Long shots, defined as bets with 1/100 or worse odds of winning, lose 61 percent of the time, on average. Favorites, by contrast, lose “only” 5.5 percent.


Unfortunately, while lotterylike stocks represent only a small fraction of the total stock market, they’re still economically significant. The authors found that, in aggregate, investors in OTC stocks lost about $180 billion over the sample period. These losses were incurred almost exclusively by individuals (not institutions).


This study adds to the body of research demonstrating that individual investors exhibit a preference for lotterylike distributions. This preference, and the inability of arbitrageurs to correct the mispricings that result, can lead investments with these characteristics to post very poor returns.


It’s important to note that lotterylike distributions aren’t limited to just OTC stocks. They’re also found in IPOs, “penny stocks,” extreme high-beta stocks and small growth stocks with low profitability and high investment.


Therefore, investors are best served by avoiding them. Findings like the ones in this study are why “passive” fund families, such as Dimensional Fund Advisors and Bridgeway Capital Management, screen out these stocks from their portfolios. Hopefully, now that you are aware of this information, you will too.

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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