Investigation of the Lottery-like Effect and the Idiosyncratic Volatility Puzzle in the UK Stock Market

Abstract

This work provides an empirical investigation on the return predictability and the informational efficiency of the UK stock market. Specifically, the work examines the predictive power of risk-related anomalies for the returns of UK stocks. Through three overlapped empirical studies, this work investigates the ability of the idiosyncratic volatility (IVOL) and other speculative features (i.e., lottery-like features) to predict the future stock returns in the UK market. Also, the explanations and many issues related to this predictability are investigated. The first study examines the ability of the lottery-like features to predict the future return across UK stocks. The analysis reveals convincing evidence on the existence of the lottery effect and the associated IVOL puzzle among the stocks in the UK market. Despite being risky (e.g., have high beta), on average, the stocks with speculative features, e.g., high IVOL and low price, underperform the stocks with non-speculative features, e.g., low IVOL and high price. The findings suggest a possible role for the arbitrage frictions and the left-tail risk in generating the puzzling performance reported for the lottery-like stocks. In addition to the IVOL puzzle, the second study examines the ability of the left-tail risk to predict the future returns in the UK market and the role of the underreaction behaviour (e.g., the anchoring bias) in explaining the return predictability in the UK market. The results outlined in the third chapter show that both the idiosyncratic volatility risk and the left-tail risk inversely predict the six-month ahead returns across the stocks. Moreover, the portfolio analysis and the Fama-MacBeth procedures indicate the key role of the underreaction behaviour in generating a large part of the reported persistent underperformance of the stocks with high IVOL and left-tail. In addition to the anchoring bias (proxied by the 52-week high ratio). The third empirical work investigates the incremental power of the firm's fundamental-based expected profitability to explain the negative future return associated with the high-IVOL stocks (i.e., IVOL puzzle). The results reveal that the 52-week high ratio (the anchoring bias) and the expected profitability are both independently important in determining the puzzling persistent underperformance of the stocks with high IVOL. The IVOL puzzle is largely generated by the investors' underreaction to the bad news revealed by the market and the firm’s fundamentals. However, the overreaction behavior of the lottery-seeking investors is important to explain the lower future returns for the high IVOL stocks. In sum, the IVOL puzzle is a behavioural phenomenon generated by the irrational underreaction and overreaction behaviour that is magnified by the limit to arbitrage and the investors' emotion.