Demand for Idiosyncratic Lottery-like Payoffs and the Cross-section of Expected Returns

Abstract

Motivated by existing evidence of a preference among investors for stocks with high maximum daily returns, we document that lottery-like payoffs measured by maximum daily returns are almost entirely idiosyncratic. Firm-level cross-sectional regressions and portfolio-sort analyses prove that there is a significantly negative relation between idiosyncratic maximum daily returns (IMAX) and future stock returns. While beta anomaly, negative (positive) risk-adjusted returns generated by high (low) market beta stocks, disappears when portfolios are constructed to be neutral to idiosyncratic maximum daily returns, the significantly negative return spread between the stocks with extreme idiosyncratic lottery-like payoffs are robust to various firm-specific controls and risk factors. Investor sentiment is the dominant factor to trigger the demand for stocks with high idiosyncratic lottery-like payoffs. Finally, the relationship between idiosyncratic maximum daily returns and subsequent returns is stronger among stocks with low institutional ownership, low market capitalization, low analyst coverage, low liquidity, and high idiosyncratic volatility.