Do the Rich Gamble in the Stock Market? Low Risk Anomalies and Wealthy Households

81 Pages Posted: 12 Aug 2020 Last revised: 10 Dec 2020

See all articles by Turan G. Bali

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

A. Doruk Gunaydin

Sabanci University

Thomas Jansson

Sveriges Riksbank - Research Division

Yigitcan Karabulut

Frankfurt School of Finance & Management; CEPR

Date Written: July 31, 2020

Abstract

We propose a low risk anomaly (LRA) index with high values indicating high-risk stocks with high-beta, high-volatility, and high-lottery-payoffs. We document a significantly negative cross-sectional relation between the LRA index and future returns on individual stocks trading in the U.S. and international countries. We show that the high-LRA stocks are subject to significant overpricing and primarily held by retail investors, whereas the degree of underpricing of low-LRA stocks is so small that the low risk anomaly is driven by retail investors’ demand for high-LRA stocks, leading to temporary overpricing and negative future abnormal returns for these high-beta, high-volatility stocks with large lottery payoffs. To understand how and why individual investors contribute to the low risk anomalies, we use a large-scale individual-level panel dataset from Sweden that allows us to directly observe the stock investments of the entire population at the individual security level. We find that the anomalous negative relation between risk and future abnormal returns is only confined to those stocks held by rich households, whereas there is no evidence of low risk anomaly for stocks held by non-rich households and institutional investors. Further tests also reveal that the skewness preferences of rich households have the potential to explain the demand of wealthy investors for high-risk stocks. In contrast, other potential explanations such as the overconfidence-based preferences, constraints on financial leverage, downside risk, and hedging demand receive little support from the data.

Keywords: low risk anomalies, individual investors, market beta, idiosyncratic volatility, lottery stocks, cross-sectional return predictability

JEL Classification: G10, G11, G12, G14, C13, E20, E30

Suggested Citation

Bali, Turan G. and Gunaydin, A. Doruk and Jansson, Thomas and Karabulut, Yigitcan, Do the Rich Gamble in the Stock Market? Low Risk Anomalies and Wealthy Households (July 31, 2020). Georgetown McDonough School of Business Research Paper No. 3664501, Available at SSRN: https://ssrn.com/abstract=3664501 or http://dx.doi.org/10.2139/ssrn.3664501

Turan G. Bali (Contact Author)

Georgetown University - Robert Emmett McDonough School of Business ( email )

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Washington, DC 20057
United States
(202) 687-5388 (Phone)
(202) 687-4031 (Fax)

HOME PAGE: https://sites.google.com/a/georgetown.edu/turan-bali

A. Doruk Gunaydin

Sabanci University ( email )

School of Management
Orhanli Tuzla
İstanbul, 34956
Turkey

Thomas Jansson

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden

Yigitcan Karabulut

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

CEPR ( email )

London
United Kingdom

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