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Expert Analysis and Commentary

Larry Swedroe: Why Do Individual Investors Buy “Overpriced” Stocks?

Larry Swedroe Nov 24, 2014




Prospect Theory at Work


Taken together, these factors suggest that investors may be unwilling to trade against the overpricing of skewed securities. This allows the anomaly to persist. The theory is supported by evidence that has found the “lottery effect” is strongest in stocks for which arbitrage trades may be relatively costly.


Death and Jackpot


  • Stocks with a high default probability have a lottery-like distribution of returns and produce negative excess returns.
  • Theory is supported by the evidence, which has found that the “lottery effect” is strongest in stocks for which arbitrage trades may be relatively costly. Low returns to jackpot stocks are associated with high limits to arbitrage in such stocks.
  • Stocks with a high predicted probability of having a jackpot return subsequently earn low average returns and have negative four-factor alphas, with magnitudes similar to stocks with high default probability.
  • Younger firms, firms with fewer tangible assets, lower stock market turnover and smaller stock market capitalization are more likely to have jackpot returns.
  • Sixty-three percent of stocks that realize an ex-post jackpot return are in the top 1 percent of ex-ante predicted jackpot probability; 70 percent of stocks that realize a jackpot return are in the top 10 percent of predicted jackpot probability.
  • Compared to the market, the “high-death” portfolio earns a return of -13.1 percent per year.
  • The probabilities of high-death portfolios and jackpots are highly correlated. More than 50 percent of the firms in the highest quintile of predicted distress are also in the highest quintile of predicted jackpot.
  • The degree of institutional ownership declines significantly as we move to higher default and jackpot probabilities. The preferences of individual investors are driving prices in these stocks. While owning over 80 percent of stocks, institutions own just 15 percent of high jackpot probability stocks.

The authors concluded that while the three Fama-French factors (beta, size and value) cannot explain the low average returns of high-distress stocks, a high probability of earning jackpot returns can. They also demonstrated that their findings were statistically significant.


The Bottom Line



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