(Money Watch) If you're like most investors you're highly averse to the risk of large losses. That risk aversion leads investors to demand risk premiums for stocks that have the potential for large losses -- they exhibit excess kurtosis (fat tails) and negative skewness (when the values to the left of [less than] the mean are fewer but farther from the mean than values to the right of the mean).
On the other hand, there have been several studies from the field of behavioral finance that have found that if you're like most investors you have a preference, or what professors Eugene Fama and Ken French referred to as "taste," for stocks that exhibit excess kurtosis and positive skewness (like a lottery ticket). This is either irrational (investors don't know they are making suboptimal decisions) or investors in such stocks derive some extra "non-wealth" utility (such as entertainment value) from these investments. That preference drives up the prices of these stocks, leading to negative risk premiums for them. The result is below market returns.
The study, "Speculative Retail Trading and Asset Prices," by Bing Han and Alok Kumar, published in the Journal of Financial and Quantitative Analysis, examined the characteristics and pricing of stocks that are actively traded by speculative retail investors. They defined the retail trading proportion (RTP) of a stock as the monthly dollar value of the buy- and sell-initiated small-trades (trade size below $5,000) divided by the dollar value of its total trading volume in the same month. The following is a summary of the author's findings:
- RTP closely captures the preferences and trading activities of retail investors.
- Stocks with a high RTP have strong lottery features and they attract retail investors who are known to exhibit a strong propensity to gamble with stocks.
- Stocks with high levels of RTP have younger clienteles with lower income, lower education levels, and non-professional occupations. These stocks also have a greater proportion of male and single investors. Retail investors of high RTP stocks also tend to hold less diversified (more risky) portfolios.
- High RTP stocks tend to have very low market cap, low price, high idiosyncratic volatility, low institutional ownership, and low analyst coverage.
- High levels of RTP reflect active trading by risk-seeking "realization utility" investors.
- Stocks whose trading is dominated by speculative retail investors tend to be overpriced and earn significantly negative alpha -- below market returns.
- The average return difference between the top and the bottom RTP quintiles is about 7 percent per year. This negative RTP premium is stronger among stocks that have lottery features.
- RTP is significantly higher for firms that are headquartered in regions in which people exhibit a greater propensity to gamble.
It's interesting to note that ownership by institutional investors, market capitalization, and stock price all decrease monotonically with RTP. For example, stocks in the top three RTP deciles all have average price below $10 and average market capitalization of less than $100 million dollars. And together the top five RTP deciles represent less than 10 percent of the total stock market capitalization. The stocks in the highest RTP decile have an average institutional ownership of only 3 percent.
These results indicate that speculative retail trading is an important factor in setting the prices of stocks with lottery-like characteristics, leading to overpricing and below-market returns. The high costs of shorting such stocks (such as IPOs, stocks in bankruptcy, "penny stocks", and extreme small growth stocks) along with limits to arbitrage (inability/unwillingness for investors to short stocks), prevents the market from correcting the mispricing. However, it does appear that institutions are aware of the poor returns of high RTP stocks as they underweight them. This paper also contributes to the literature which finds that, as a group, retail investors underperform the market and appropriate risk-adjustment benchmarks by wide margins. If you've been buying such stocks at least you're now aware of the evidence and no longer have the excuse of ignorance.
Image courtesy of Flickr user Taxbrackets.org