Investor Attention, Lottery Stocks and the Cross-Section of Expected Returns

Motivated by previous studies on limited investor attention, preferences for lottery-type assets and poor diversification of many investors' portfolios, we examine the impact of extreme positive stock returns and their relation to expected returns. We find a consistently negative relationship between maximum daily stock returns over the past one month (MAX) and expected stock returns for three broad equity markets, namely the United States, Europe and Japan. This finding generally confirms (but is weaker than) earlier evidence by Bali, Cakici and Whitelaw (2011). As we use a more recent and a broader sample of firms, our study serves as a robustness check of their analysis. Our results cast some doubt, however, on the explanation that this expected return pattern is simply due to high demand for stocks with lottery-type payoffs by certain investors. Instead our findings are more consistent with limited investor attention which affects expected returns of stocks with extreme returns (positive or negative) more generally. Moreover, as opposed to Bali, Cakici and Whitelaw (2011), we find no evidence that controlling for MAX resolves the puzzling negative relationship between idiosyncratic volatility and returns reported in Ang, Hodrick, Xing and Zhang (2006, 2009).