Do Investors Overpay for Stocks with Lottery-Like Payoffs? An Examination of the Returns on OTC Stocks

Abstract

We study returns on Over-The-Counter stocks and we find these returns are extremely negative on average. The distribution of OTC stock returns is highly positively-skewed: while many of the stocks in our sample become worthless, a few do extremely well. We investigate whether this negative return premium can be rationalized by investors' preference for positively-skewed payoffs. We show that the equilibrium model of Barberis and Huang (2008) provides a plausible explanation for the negative returns. We also show that OTC stocks that once traded on the regular exchanges perform much better than stocks that originate in the OTC markets.

Keywords: over-the-counter, OTC, pink sheets, skew, skewness, lottery, prospect theory, return anomalies, rational pricing, behavioral finance

JEL Classification: G10, G20, G38