The intuition is that “stocks with high prospect theory values are appealing to some investors; these investors tilt toward these stocks in their portfolios, causing them to become overvalued and to earn low subsequent returns.” The authors also noted we should expect the prediction about returns to hold more strongly among stocks that are more heavily traded by less sophisticated individual (versus institutional) investors, for example, among small-cap stocks.
To test their premise, the authors’ metric was the distribution of monthly returns over the past five years in excess of the market’s return. Their U.S. database consisted of all equities for which 60 months of data was available and covered the period 1926 through 2010. The results were consistent with their hypothesis.
Findings
They write: “We find that the coefficient on the stock’s prospect theory value, averaged across all the monthly regressions, is significantly negative: stocks with higher prospect theory values have lower subsequent returns. We also find, again consistent with our framework, that this result is particularly strong among small-cap stocks.”
Furthermore, the alphas on the portfolios they constructed decline in a near-monotonic fashion as they moved from portfolios with the lowest prospect theory value to the highest. In addition, consistent with prior research on limits to arbitrage and the role they play in allowing anomalies to persist, the authors also found that the “predictive power of prospect theory value for subsequent stock returns is stronger among stocks that are less subject to arbitrage—for example, among illiquid stocks and stocks with high idiosyncratic volatility.”
Their findings were consistent across 46 international markets they tested. And the results were robust over the two subperiods studied. They were also robust after controlling for exposure to well-known factors such as size, value, momentum, illiquidity and idiosyncratic volatility.
For investors, the implications of findings from studies into behavioral finance are striking. The combination of investor preference for skewness and limits to arbitrage can result in an equilibrium that leads to overpriced, positively skewed stocks. And price premiums caused by skewness preferences will underperform stocks that are not positively skewed.
These findings have implications for portfolio construction as well. First, investors buying individual stocks should avoid those with lotterylike characteristics. Second, mutual funds can improve performance by screening out stocks with these negative characteristics.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
