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The anomaly is explained by limits to arbitrage (investors who would buy a stock they see as overpriced are reluctant, due to the risk of unlimited losses, or unable to short a stock they see as overpriced). Instead, the market seemingly under-reacts to IMIN, incorporating information into prices more slowly than we would expect in an efficient market.” These findings are counterintuitive to the literature on lottery preferences. Their findings led the authors to conclude that “investors pay a premium for lottery stocks but don’t appear to discount hazard stocks. In this setting hazard stocks did earn a premium in future returns - investors price lottery and hazard stocks consistently. Relaxing limits to arbitrage (during the SEC’s Regulation SHO pilot program) eliminates the apparent overpricing of hazard stocks.The hazard stock anomaly is mainly associated with limits to arbitrage.The findings were robust to controls for size, book-to-market, momentum, turnover, lagged returns, idiosyncratic volatility, raw minimum and max daily returns, and idiosyncratic MAX (IMAX).This finding was unchanged when controlled for earnings surprises, thus not related to post-earnings announcement drift. For example, 50 percent of the stocks in the highest (lowest) IMIN quintile remained in the highest (lowest) quintile the following month. The overpricing of hazard stocks persisted, dissipating slowly and dying out after nine months.The greater return to equal-weighted portfolios demonstrates that the IMIN effect is greater in small stocks (where limits to arbitrage are greater). Portfolios that are long high-IMIN stocks and short low-IMIN stocks earned statistically significant abnormal returns of -0.52 percent (-0.78 percent) per month using value-(equal-)weighted portfolios.This implies that investors don’t have symmetric preferences across lottery stocks and hazard stocks. Hazard stocks earn abnormally lower future returns, inconsistent with the notion that they are heavily discounted.Following is a summary of their findings: Their data sample covered the period 1964-2014. They calculated a proxy for hazard stocks as the minimum daily idiosyncratic return (IMIN) with respect to the Fama-French three-factor model and the Carhart four-factor model for each stock every month. Their hypothesis was that if investors are prepared to pay a premium for lottery stocks, they should discount hazard stocks, translating into higher future returns. They called stocks with the most negative recent performance “hazard” stocks. Jared DeLisle, Michael Ferguson, Haim Kassa and Gulnara Zaynutdinova sought to determine if that is the case in their study Hazard Stocks and Expected Returns, published in the April 2021 issue of the Journal of Banking & Finance.
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Given the findings on the performance of stocks with positive MAX performance, it seems logical to expect that stocks with the most negative performance (the opposite of those lottery stocks) would have strong future returns. The explanation for the existence of the anomaly is that investors have a preference for positive skewness and there are limits to arbitrage that prevent sophisticated investors from fully correcting mispricings. The poor returns of these stocks is an anomaly because these stocks are risky. The research also finds that stocks that have experienced recent extreme positive returns (as measured by MAX, the maximum daily return in a month) subsequently produce low returns. Lottery stocks, which are typically either penny stocks or small growth stocks with high investment and low profitability, offer the potential for outsized returns. There is a large body of research, including such studies as Do Investors Overpay for Stocks with Lottery-like Payoffs?, demonstrating that so-called lottery stocks deliver poor performance.
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Should you buy stocks with very negative recent returns? J6:30 am Comments Off on Should you buy stocks with very negative recent returns?.