Another Paper on Worthless Stocks: "Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns"

The paper is called "Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns", and is in the same vein as our previous research [1,2,3,4] on the worthless stock inefficiency.

This paper looked at the role of extreme positive returns in the cross-sectional pricing of stocks. They sorted stocks by their maximum daily return during the previous month and examined the monthly returns on the resulting portfolios (over the period from 1962 to 2005).

The relationship between maximum daily return and subsequent returns is negative, consistent with the other research we have seen about "lottery ticket" (worthless) stocks. These authors also believe that (retail) investors overpay for stocks that exhibit extreme positive returns, and that these stocks consequently exhibit lower returns in the future.

Their results were robust to sorting stocks not only on the single maximum daily return during the month, but also the average of the two, three, four or five highest daily returns within the month. That makes sense: what counts is whether a worthless stock experiences a squeeze. Once the squeeze dissipates, the subsequent returns are negative.

Their cognitive bias explanation for this inefficiency is that "errors in the probability weighting of investors cause them to over-value stocks that have a small probability of a large positive return."