Stock Loan Lotteries and Individual Investment Performance

Abstract

Individual investors trade excessively, sell winners too soon, and overweight stocks with lottery features and low expected returns. This paper models a financial innovation to address these biases and improve individual investor performance. Individual investors pledge shares of stock to an exchange for multiple periods and face a steep penalty for redeeming shares early. The exchange lends the shares to institutions and holds a lottery with the lending fees. I extend the Barberis and Xiong (2009) discrete-time model of realization utility to include stock loan lotteries. Investors with cumulative prospect theory preferences are reluctant to forgo trading opportunities for fixed stock loan fees, but are far more willing to forgo trading opportunities for stock loan lottery tickets. For a wide range of feasible parameter values, introducing stock loan lotteries provides individual investors both increased utility and increased expected wealth. Stock loan lotteries provide greater utility to poorer investors, who typically exhibit stronger lottery preferences. Introducing transactions costs, leverage constraints, and taxes strengthens the benefits of stock loan lotteries.

Keywords: Prospect Theory, Individual Investors, Behavioral Finance, Biases

JEL Classification: G02, G11, G12, D11