It is well-established that “lottery” stocks – those offering the potential for outsized returns, like penny and growth stocks – deliver poor performance. While one might expect that naïve, retail investors are the ones buying those stocks, new research shows that is not the case.

Academic research has found that there are investors who have a “taste,” or preference, for lottery-like investments – investments that exhibit positive skewness and excess kurtosis. This leads them to irrationally (from a traditional finance perspective) invest in high-volatility stocks (which have lottery-like distributions), driving their prices higher, with the result being poor returns.

They pay a premium to gamble.

If the markets were perfectly efficient, arbitrageurs would drive prices to their right levels. However, in the real world, limits to arbitrage, and the costs and fear of shorting, can prevent rational investors from correcting mispricings. The low-beta/low-volatility anomaly (low-volatility/low-beta stocks have higher risk-adjusted returns than high-beta/high-volatility stocks) is an example of the lottery effect and mispricings persisting.

Lottery-like distributions have been found in IPOs, “penny stocks,” extreme high-beta stocks, small-growth stocks with low profitability and high investment, and financially distressed stocks that are either in or near bankruptcy. The preference for lottery-like payout distributions has been found in other areas, not just in the world of investing. For example, the authors of the study, Do Investors Overpay for Stocks with Lottery-like Payoffs? An Examination of the Returns on OTC Stocks, noted that when it comes to horse racing, longshots are systematically overvalued. A $1 bet on a longshot (defined as a bet with 1:100 or worse odds of winning) has an average payoff of just $0.39. The average payoff to favorites, by contrast, is $0.95.

Academic literature contains 16 measures of lottery preference, including skewness, expected skewness, maximum daily return and return asymmetry. In their June 2020 study, Lottery Preference and Anomalies, Lei Jiang, Quan Wen, Guofu Zhou and Yifeng Zhu aggregated information on the 16 measures into a single factor and examined its performance in explaining anomalies to the Fama-French five-factor (market beta, size, value, profitability and investment) model and the four-factor (market beta, size, profitability and investment) q-factor model of Hou, Xue and Zhang. Their study covered the period January 1980 to December 2018. They found that all 16 individual lottery proxies are positively correlated with total skewness – the excess return spreads and alphas between the low- and high-skew portfolios ranged from -0.31% to -0.34% per month and were statistically significant. Stocks with more lottery preference are smaller in size, are growth stocks, have higher momentum, are less liquid and have higher market beta than stocks with lower lottery preference.