Does trading in lottery stocks increase after a stretch of negative market returns?

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School of Business | Master's thesis
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Prospect theory predicts that people increase their risk-seeking behaviour after experiencing losses, because they are in the mindset of breaking-even (Kahneman and Tversky, 1979). As lotteries serve as a fruitful proxy for risk (Friedman and Savage, 1948), this novel study explores trading in lottery-like stocks, i.e. stocks with low price, high idiosyncratic volatility and skewness, during 2001-2015 with U.S. data. Lottery stocks that are in the loss domain of capital gains are expected to experience a surge in turnover following negative market returns. The intuition is that on average investors incur losses, when the market does, and want to break-even relative to their initial wealth by investing into lottery stocks. The prior capital gains are taken into account, because lottery-related anomalies are dependent on capital gains domain (An et al., 2015). The approach is unique, because it combines variables from several previously unlinked studies into a series of OLS regressions. The results show that the absolute dollar-volume-based trading in lottery stocks with prior capital losses increases by 0.78% (1.22%) at the 5% (0.1%) significance level with a 50% (33%) categorization threshold, when previous month's market returns are below -5.0%. The finding is robust to penny stocks, but not to a slight change in model. Evidence for lottery stocks' relative attractiveness against stocks that exhibit oppositional characteristics, on the other hand, can be found only, if penny stocks are excluded from the sample. Overall, the results statistical significance varies considerably across specifications and economical importance is weak.
Behavioural finance, Prospect theory, Risk-seeking tendency, Lottery stocks
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