Almost everyone knows that playing the lottery is a terrible idea as a matter of simple math, and yet state-run lottery ticket sales run close to $70 billion per year. Why do we waste our money this way? “All you need is a dollar and a dream,” is how the old New York lotto ads put it — and of course that’s what we’re really buying when we play: a dream.
Investors as a group are supposed to be more rational than lottery players. (For one thing, there’s a lot more than a dollar at stake.) But now along comes some new evidence — in case you needed it — that that isn’t always the case. A new research paper by business professors Turan Bali, Stephen Brown, Scott Murray, and Yi Tang finds that “lottery-like” stocks tend to be overpriced, delivering lower future returns.
What are lottery stocks? Ones with unusually high average returns for their five best days in a given month — regardless of how they perform during the other 25 or so days. The idea seems to be that a handful of high return days have the same effect as news stories about big lottery winners. Investors see them and dare to dream.
This effect, the researchers say, explains one of the long-standing puzzles in finance. There’s some evidence that stocks with a high “beta” — a kind of volatility, that is — do worse than you’d expect given their level of risk. And low volatility stocks do better than you’d expect.
As I’ve written about recently, a group at the hedge-fund firm AQR argues that Warren Buffett’s tilt to lower-volatility stocks is one reason he’s done so extraordinarily well. The AQR group says low-volatility stocks have an edge because investors who want to take on more risk don’t have easy access to additional borrowed money. So when they want to goose their returns, they instead tend to crowd into riskier stocks. That drives up the valuations on shares of those highfliers, giving cheaper, low-beta stocks an edge.
Bali and company have a more behavioral explanation. Many high-volatility stocks are also lottery stocks. So perhaps what’s going on is that investors simply see hot returns — never mind they’re short-term gains — and then chase after them. Because, hey, you never know.