Why Lottery-Like Stocks Can Attract Investors Despite Lower Expected Returns
Summary
The discussion explains why investors may favor lottery-like stocks, which are described as having low prices, high volatility, and positive skewness. Under classical expected-utility reasoning, investors focus on expected return and volatility, so skewness should not independently make a stock attractive. This creates the puzzle when individuals show a preference for stocks with pronounced upside tails.
The answer connects the preference to behavioral finance and prospect theory. Investors who overweight unlikely outcomes may perceive the rare large gains as more probable or more influential than they are under physical probabilities. If this behavior is widespread, demand can raise the prices of lottery-like stocks; higher prices can then imply lower expected returns. The explanation draws on cited theoretical work but the discussion itself provides no empirical estimates or tests. Its account depends on behavioral decision weighting and market equilibrium, and should not be read as a claim that every investor values skewness in the same way.
Key ideas
- Classical expected-utility models do not treat skewness as an independent driver of asset choice.
- Lottery-like stocks combine low prices, high volatility, and positive skewness in the cited description.
- Prospect theory can explain demand when investors overweight unlikely high-payoff outcomes.
- Strong demand for lottery-like stocks may bid up their prices and reduce their expected returns.
- The explanation is theoretical and does not provide empirical evidence in this discussion.
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Full text
# Why individual investors are attracted to lottery stocks is a puzzle?
# Why individual investors are attracted to lottery stocks is a puzzle?
Han et al. 2021 mention one puzzle in investment is
> individual investors are attracted to stocks with high skewness, so-called lottery stocks(...). This behavior is not consistent with standard investor preferences
I am wondering what is standard investor preferences and why that individual investors are attracted by lottery stocks is a puzzle?
## Answer by T123 (score 1, accepted)
https://quant.stackexchange.com/a/68605
Standard preferences in classical economics follow certain "consistency rules" such as transitivity etc.pp. These classical preferences such as expected utility capture only the first two moments of a say normal distribution (expected value and volatility/standard deviation). Lottery-like stocks as defined by Alok Kumar ("Who gambles in the stock market") are characterized by a low price, a high volatility and a certain positive skewness. The latter one is the crucial additional feature as, if you believe in the classical utility paradigm, skewness and other higher moments shouldn't matter for asset allocation. However, if you sympathize with behavioral finance and prospect theory in particular, skewness is taken into account by the decision weights. Barberis and Huang have shown in 2007 ("stocks as lotteries") that given an investor with decision weighting functions instead of classical expectations will perceive a certain amount of lottery-like stocks as favourable compared to a portfolio without them. If all investors think this way, they will put a premium on the price (as markets have to be in an equilibrium), which will result in below-average expected returns from that stock. Thats why it's a paradox: people want to pay a higher price as they perceive those unlikely but high returns (=positive skewness) as more likely as physical probabilities suggest, thus driving up the price and lowering the returns..Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.