Stock Loan Lotteries and Individual Investor Performance

Abstract

Individual investors trade excessively, sell winners too soon, and overweight stocks with lottery features and low expected returns. This paper proposes and models a financial innovation, called stock loan lotteries, that improves individual investor performance. An individual investor signs a contract to lend shares of stock to a centralized exchange for multiple periods. The exchange operates a stock loan marketplace. Instead of paying each investor the lending fees on his individual shares, the exchange periodically holds a lottery for the entire pool of lending fees. I extend the Barberis and Xiong (2009) two-period model of realization utility to include stock loan lotteries. In frictionless markets, investors demand high fixed stock loan fees to hold shares for two periods. Because prospect theory investors value low probability payoffs, they demand significantly lower fees denominated in stock loan lottery tickets. In many cases, introducing stock loan lotteries provides individual investors with greater expected utility and greater expected wealth. Stock loan lotteries provide the greatest benefits to the poorest investors, who typically exhibit the strongest lottery preferences. Introducing transactions costs, leverage constraints, and taxes to the model enhances the benefits of stock loan lotteries. I propose a mechanism for exchanges to structure stock loan lottery tickets as derivative securities.

Keywords: Prospect Theory, Individual Investors, Behavioral Finance, Financial Innovation

JEL Classification: G02, G11, G12, D11, G23