The Lottery Mindset: Investors, Gambling and the Stock Market, 2014

Financial markets are growing in complexity, and there is an increased risk that investors are led to investment products and strategies they do not fully understand. The crisis-ridden decade of the 2000s is a stark reminder of how poorly managed finances can wreak havoc on household finances. Traditional finance assumes that all investors are risk-averse and require a risk premium from investing in risky assets such as stocks. However, recent developments in behavioural finance show that many individual investors often adopt strategies that lead to serious investment missteps, including over-investing in lottery-type stocks and securities. Lottery-type securities in fact attract investors who may be risk-seeking or are strongly influenced by cognitive biases ranging from overconfidence to being over-optimistic about future investment returns, especially during periods of high sentiment. Drawing on existing and new research, The Lottery Mindset summarizes the behavioural motivations and detrimental impact of investment strategies which are popular with individual investors. Wai-Mun Fong provides insight and guidance on behavioural biases, and successful investment. By both reviewing and contributing to exiting literature on this topic, this book will be of use to academics and general readers alike.

1. A Survey of Behavioral Finance 1.1 The Behavioral Finance Paradigm 1.2 Investor Preferences 1.2.1 Mental Accounting 1.2.2 Preference for Concentrated Portfolios 1.2.3 Preference for the Familiar 1.2.4 Preference for Lottery-Type Stocks 1.2.4 Preference for Active Trading 1.3 Heuristics 1.3.1 The Availability Heuristic 1.3.2 The Anchoring Heuristic 1.3.3 The Representativeness Heuristic Categorical Predictions The 'Law of Small Numbers' 1.4 Beliefs 1.5 Emotions 1.5.1 Gains and Losses: Prospect Theory 1.5.2 Rejoicing and Regret 1.5.3 Optimism 1.5.4 The Social Psychology of Emotions 1.6 Conclusion 2. Overtrading 2.1 Introduction 2.2 Turnover on Equity Markets 2.3 The Profitability of Individual Investor Trades 2.3.1 U.S. Studies 2.3.2 Non-U.S. Studies 2.4 Learning from Trading 2.5 Do Smart Investors Outsmart the Market? 2.6 Why Do Individual Investors Trade So Much? 2.6.1 Risk Seeking 2.6.2 Sensation Seeking 2.6.3 Stocks as Lotteries 2.6.4 Beliefs and Sentiment 2.6.5 Heuristics 2.7 Conclusion 3. Trend Chasing 3.1 Introduction 3.2 The 'Hot-Hand' Fallacy and the Gambler's Fallacy 3.3 Trend Chasing in Stock Markets 3.3.1 Experimental Evidence 3.3.2 Survey Evidence 3.4 Trend Chasing: Mutual Fund Investors 3.5 Behavioral Biases of Mutual Fund Investors 3.6 Trend Chasing in the Aggregate Stock Market 3.7 Conclusion Appendix: Dollar-Weighted Returns and Institutional Ownership 4. Growth Stocks 4.1 Introduction 4.2 The Value Premium Revisited 4.2.1 The U.S. Value Premium 4.2.2 The International Value Premium 4.3 Lottery Stock Preference, Arbitrage Risk and the Value Premium 4.4 The Persistence of Lottery Stock Preferences 4.5 Earnings Extrapolation and the Value Premium 4.6 Conclusion Appendix 4.1: Lottery Factors? Appendix 4.2: Earnings Growth Persistence: Is It There? 5. The Beta Anomaly 5.1 The Beta Anomaly Around the World 5.1.1 U.S. Evidence 5.1.2 International Evidence 5.2 The Beta Anomaly: Long-Run Consequences 5.3 Omitted Risks 5.3.1 Financial Distress 5.3.2 Liquidity Risk 5.4 Explaining the Beta Anomaly 5.5 Conclusion Appendix 5.1: Distress and Liquidity Measures Appendix 5.2: Institutional Ownership and the Beta Anomaly 6. The IVOL Puzzle 6.1 Introduction 6.2 The IVOL Anomaly Revisited 6.3 Who Invest in High-IVOL Stocks? 6.4 Does Idiosyncratic Skewness Drive the IVOL Effect? 6.5 IVOL and Beta 6.6 Conclusion 7. The MAX Effect 7.1 Introduction 7.2 Sizing Up the MAX Anomaly 7.3 Investor Sentiment and the MAX Effect 7.4 Institutional Ownership and the MAX Effect 7.5 Sentiment or Fundamentals? 7.6 Explaining the MAX Effect: Salience and Lottery Stock Preference 7.7 Conclusion