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Like buying a lottery ticket: BYU research identifies high-risk, low-reward stocks

  • Study found a category of stocks that returned 12 percent less per year than stocks with similar risk.
  • Investors overpay for these stocks with a lottery mentality - accepting high risk in return for hopes of a huge payoff.
  • Conservative investors should avoid them, and sophisticated investors could short-sell them.

Everybody knows the investing mantra that you should expect to earn higher returns on riskier investments. But investors looking to hit it big in 2010 may want to consider a new study by three Brigham Young University finance professors, which found that some risky stocks have historically paid investors low average returns – and we’re not just talking about the 2008 market crash.

It turns out that for some risky stocks – newer, smaller, and with a wider variation in price – the future price carries large lottery component: a very small chance the future price will explode and provide immense returns. Investors attracted to this lottery feature demand the stock and drive up the current price. However, because the lottery rarely pays off, these overpriced stocks on average earn lower returns than stocks with similar total risk – an average of 12 percent a year lower.

The study is forthcoming in Review of Financial Studies, considered one of the top three journals in the field.

“We know that lottery tickets on average lose money, but people that know this still buy lottery tickets because there’s a chance that they’ll get a huge payoff,” said study coauthor Todd Mitton, a Richard E. Cook Associate Professor of Finance. “We wanted to know if those same preferences influence stock prices. Do investors pay relatively higher prices for stocks with lottery-like payoffs? It looks like they do.”

And that thrill does not come cheap.

“Investors may or may not be aware that when they buy lottery stocks they should expect to lose money on a risk-adjusted basis,” said another coauthor Brian Boyer, the H. Taylor Peery Assistant Professor of Finance. “Our study simply shows that some investors are attracted to such stocks even though on average they do underperform others with similar risk.”

On the flip side, sophisticated investors can short-sell stocks with large upside potential. In this way, a sophisticated investor can be like someone who sells lottery tickets instead of buying them, and therefore earn higher returns than other investments with similar risk.

Returns are basically a function of two elements: the price you pay, and the payoff (the price at which you sell plus any dividends). When you buy a stock, you know the price you pay, but no one can predict with certainty at what price you will be able to sell. According to the traditional view, stocks for which there is greater uncertainty about the future price should command lower current prices, and therefore, provide higher returns on average. That is, in any given year a risky tech stock may increase or decrease in value. But if you could wind back time, and replay the year over and over again, on average, the tech stock would provide a higher return than, say, a boring low-risk stock for which the uncertainty about future prices is much lower. The return is high on average for the tech stock because the price is low relative to the average payoff received.

Identifying the characteristics of stocks that have lottery features is the key to acting on the research findings. For their study, these researchers tried to build a predictive model to determine these characteristics using information that would have been available to an investor at given points in time in the past. They analyzed millions of pieces of financial information, looking at daily data for nearly every publicly traded stock since 1929.

“The model we built, which seems to do a pretty good job identifying lottery stocks, could have been estimated and used by investors in the past using only the information available to them” explained coauthor Keith Vorkink, a Richard E. Cook Associate Professor of Finance. “Although the future is always uncertain, there is no reason believe this model would not be able to continue to indentify such stocks in the future.”

The variables they tested that came closest to predicting which stocks ended up falling into the “lottery” category included:

· New companies

· Small market capitalization

· Recent price volatility

· In certain decades some industries had more than their share of lottery-type stocks, such as the Internet boom in the 1990s or the deregulation of utilities in the 1930s and 1940s

Conservative investors who choose to accept the study’s predictions are best served by avoiding stocks with these characteristics, and may even want to short-sell them in the expectation that collectively their price will actually decline over time -- that is, unless these stocks “win the lottery.”

Writer: Brooke Stevens

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