Hazard Stocks and Expected Returns
48 Pages Posted: 9 Jul 2020
Date Written: June 15, 2020
Hazard stocks are opposite of lottery stocks. We proxy hazard stocks with the minimum daily idiosyncratic return over the past month, a negative shock labelled IMIN, and examine the relation between hazard stocks and expected returns. The literature on lottery-stocks implies that investors should discount hazard stocks. However, we find that investors under-react to hazard stocks, with negative return continuations for up to 24 months without subsequent reversals. An IMIN-based long-short arbitrage portfolio strategy generates monthly alphas of 0.52% to 0.75%. We find consistent results using Fama-MacBeth (1973) regressions and controlling for characteristics such as MAX (Bali et al., 2011), idiosyncratic volatility, and corporate events such as earnings announcements. Furthermore, we find that both firm-level information uncertainty and limits to arbitrage, but not limited investor attention, contribute significantly to the documented under-reaction to hazard stocks.
Keywords: Hazard Stocks, Lottery Stocks, MAX, Under-reaction, Equity Returns, Tail Risk, Information Uncertainty, Limits to Arbitrage
JEL Classification: G10, G11, G12
Suggested Citation: Suggested Citation