Risk Preferences, Investor Sentiment and Lottery Stocks: A Stochastic Dominance Approach

Abstract

Lottery stocks are a puzzle: individual investors value these stocks highly despite their low average returns and high volatility (Kumar [2009]). I argue that individuals are attracted to lottery stocks because they are risk-seeking and sentiment-prone. Because risk preferences are not directly observable, I use a model-free approach based on stochastic dominance to infer aggregate risk preferences. I also use a direct measure of individual investor sentiment, the bull-bear spread, to test whether sentiment affects the returns of lottery stocks. My results show that lottery stock investors are indeed risk seekers. Sentiment also plays an important role in explaining the demand and returns of lottery versus nonlottery stocks. The lottery stock puzzle can thus be understood only by incorporating unusual risk preferences and the propensity for individual investors to trade on sentiment.