INVESTOR SENTIMENT & LOTTERY STOCK OVERPRICING

Abstract

Recent studies suggest that the idiosyncratic volatility puzzle is linked to investor’s propensity to gamble. In this study, I explore whether the effects of sentiment on lottery stock overpricing is consistent with this conjecture. Further motivated by studies on profitability of relative strength strategies, I also examine the net profitability of both simple and sentiment-based trading strategies to test for evidence of net positive profits. My empirical findings show that lottery stock overpricing depends critically on the state of investor sentiment. I also find that the IVOL-based relative strength strategies involve trading both cheap and expensive stocks. Contrary to the abnormal return documented in Ang, Hodrick, Xing and Zhang (2006), my findings reveal that once transaction costs have been factored in, the trading profits prove to be an illusion. Taken together, my results provide support for a behavioural-based explanation, suggesting that the idiosyncratic volatility mispricing arises from investor’s behavioural biases and its persistent nature can be due to limits of arbitrage.