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«June 21, 2016 Abstract – This paper shows that changes in gambling attitudes affect asset prices and corporate decisions. Using the Internet search ...»

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Searching for Gambles:

Investor Attention, Gambling Sentiment, and Stock Market Outcomes*

Yao Chen, University of Warwick

Alok Kumar, University of Miami

Chendi Zhang, University of Warwick

June 21, 2016

Abstract

– This paper shows that changes in gambling attitudes affect asset prices and corporate

decisions. Using the Internet search volume for lottery-related keywords to capture gambling

sentiment shifts, we show that when the overall gambling sentiment is high, investor demand for lottery-like stocks increases, stocks with lottery-like characteristics earn positive abnormal returns in the short-run, managers are more likely to announce stock splits to cater to the increased demand for low-priced lottery stocks, and IPOs perceived as lotteries earn higher firstday returns. Further, the sentiment-return relation is stronger among low institutional-ownership firms and in regions where gambling is more acceptable.

JEL Classification: G11; G12; G14 Keywords: Gambling sentiment; lottery-type stocks; investor attention; catering; stock splits;

IPO underpricing.

__________________________

* Please address correspondence to Alok Kumar, Department of Finance, 514E Jenkins Building, University of Miami, Coral Gables, FL, 33124; Tel: 305-284-1882; Email: akumar@bus.miami.edu. Yao Chen can be reached at yao.chen.12@mail.wbs.ac.uk. Chendi Zhang can be reached at chendi.zhang@wbs.ac.uk. We thank Jawad Addoum, Zhi Da, Richard Taffler, Jeff Wurgler, and seminar participants at the University of Miami and University of Warwick for helpful comments and suggestions. All remaining errors and omissions are ours.

Searching for Gambles:

Investor Attention, Gambling Sentiment, and Stock Market Outcomes June 2016 Abstract – This paper shows that changes in gambling attitudes affect asset prices and corporate decisions. Using the Internet search volume for lottery-related keywords to capture gambling sentiment shifts, we show that when the overall gambling sentiment is high, investor demand for lottery-like stocks increases, stocks with lottery-like characteristics earn positive abnormal returns in the short-run, managers are more likely to announce stock splits to cater to the increased demand for low-priced lottery stocks, and IPOs perceived as lotteries earn higher firstday returns. Further, the sentiment-return relation is stronger among low institutional-ownership firms and in regions where gambling is more acceptable.

JEL Classification: G11; G12; G14 Keywords: Gambling sentiment; lottery-type stocks; investor attention; catering; stock splits;

IPO underpricing.

1. Introduction An emerging literature in finance examines the potential link between gambling behavior and financial market outcomes. Recent theoretical studies predict that investors would be willing to accept a negative return premium for stocks with positively-skewed returns (e.g., Shefrin and Statman, 2000; Brunnermeier, Gollier, and Parker, 2007; Mitton and Vorkink, 2007; Barberis and Huang, 2008). Stocks with lottery-like payoffs are overpriced in the short-run and earn a negative average risk-adjusted return in the long-run. Empirical research on the effects of gambling attitudes has typically focused on the cross-sectional variation in gambling preferences and their impact on financial market outcomes (e.g., Bali, Cakici, and Whitelaw, 2011; Kumar, Page, and Spalt, 2011). For example, Kumar, Page, and Spalt (2011) find that investors’ gambling preferences vary geographically impact stock returns as well as corporate policies.

In this paper, we study how the time-variation in overall gambling attitudes affects various stock market outcomes. We posit that attention to low-probability payoffs in one setting may motivate individuals to overweight low-probability events in other related economic settings.

Specifically, we conjecture that an increase in overall attitudes toward gambling (i.e., gambling sentiment) is likely to generate price pressure on stocks with lottery-like characteristics.

Consequently, if arbitrage costs are high, the return of these stocks may be predictable in the short-run. In addition, corporate financial decisions could be affected as firms respond to changes in investors’ gambling attitudes and their impact on asset prices.

To test these conjectures, we develop a novel measure of gambling sentiment of investors using Google’s search volume intensity (SVI) for lottery-related keywords. We first examine the effects of gambling sentiment on stock returns. We focus on a segment of the U.S. stock market in which stocks have lottery-like return distributions. Following Kumar, Page, and Spalt (2014), we define lottery-like stocks as those with low nominal share prices, high idiosyncratic skewness, and high idiosyncratic volatility. These stocks are also associated with low average returns, high return volatility and high turnover (Scheinkman and Xiong, 2003; Hong, Scheinkman, and Xiong, 2006; Grinblatt and Keloharju, 2009; Dorn and Sengmueller, 2009).

We conjecture that lottery-like stocks are likely to be more affected by gambling sentiment than non-lottery stocks. Specifically, when the overall gambling sentiment is stronger, investor demand for lottery-like stocks would increase. If arbitrage costs are high,1 this excess demand in turn could generate price pressure on lottery-like stocks and generate positive abnormal return in the short-run.





Consistent with our conjecture, we find that when gambling sentiment of investors becomes stronger, lottery-like stocks earn positive abnormal returns in the following month. In economic terms, a one standard deviation increase in investors’ gambling sentiment is associated with an abnormal return of 47 basis points for the lottery-like stock portfolio in the following month.

Further, this positive abnormal return is eventually arbitraged away within three months.

Next, we use attention-grabbing lottery jackpots to identify the source of time-variation in investors’ gambling attitudes. Jackpot announcements are exogenous, attention-grabbing events that are likely to generate excitement among investors who may gamble in the stock market.

Consistent with our expectation, we find abnormal stock returns among lottery-like stocks around these jackpots. The average abnormal return during month -1 to month +1 around the lottery jackpot events is 1.7% per month. In addition, during this period, the average abnormal trading volume is 17.2%.

To directly examine whether shifts in overall gambling attitudes have a positive spillover effect on the demand for lottery-type stocks, we use trading data from a major U.S. discount Given the low prices and high volatility of lottery-type stocks, the costs associated with arbitraging them are likely to be high.

brokerage firm (Barber and Odean, 2000). Consistent with our conjecture of a positive spillover effect on investor demand, we find positive excess buy-sell imbalance on lottery-like stocks around the largest jackpot during the 1992-1996 period. The average excess buy-sell imbalance during month -1 to month +1 is 7%, which indicates a 7% increase in net purchase of lottery-like stocks relative to non-lottery stocks. Similarly, large drawings are associated with excess buysell imbalance of 3% on the next trading day. This positive spillover effect is similar to the evidence in betting markets (e.g., Scott and Garen, 1994; Calcagno, Walker, and Jackson, 2010) and suggests that the demands for various gambling instruments in the U.S. are likely to be positively correlated.2 In the next set of tests, we examine the extent to which geographical differences in gambling sentiment influence the long-term performance of lottery-like stocks. As local investors’ gambling sentiment varies across regions (Kumar, Page, and Spalt, 2011), we posit that the effects of gambling sentiment on stock returns would be stronger among U.S. states with stronger gambling sentiment. In these states, lottery-like stocks are more likely to be overpriced in the short-run and are likely to underperform in the long-run. To test our prediction, we use each firm’s headquarter state to define its location and use the average state-level SVI to capture the gambling sentiment of local investors.

We find that in states with strong gambling sentiment, lottery-like stocks significantly underperform non-lottery stocks (i.e., stocks with high stock price, low idiosyncratic skewness, and low idiosyncratic volatility) by 60 basis points per month. The results are stronger for stocks that are smaller or have lower institutional ownership. In contrast, in U.S. states with relatively Our findings are opposite to the evidence reported in Gao and Lin (2015). They use data from Taiwan and find a negative spillover effect. Our evidence indicates that the results from Taiwan are unlikely to generalize to the U.S.

See Section 4.3 for additional details.

weaker gambling sentiment, lottery-like stocks do not perform differently from non-lottery stocks.

Next, we change our perspective and investigate whether gambling sentiment affects corporate decisions. Low nominal share price is a salient feature of lottery-like stocks. Baker, Greenwood, and Wurgler (2009) show that retail investors’ demand for stocks with low nominal share prices is time-varying. Further, firms cater to such demand by splitting stocks with high nominal share prices. We conjecture that the time-varying demand for low-priced stock would be related to the time-variation in investors’ gambling attitudes. Consistent with this conjecture, we find that firms with high nominal share prices are more likely to split their shares when investors exhibit stronger gambling sentiment.

In the last set of tests, we examine the effects of gambling sentiment on the first-day returns of initial public offerings (IPOs). These tests are motivated by previous research, which demonstrates that IPOs are often perceived as lottery-like by retail investors (Barberis and Huang, 2008; Green and Hwang, 2011). Further, Loughran and Ritter (2004) show that the magnitude of the average first-day return for IPOs changes over time. We conjecture that IPOs would earn higher first-day returns when investors exhibit stronger gambling sentiment.

Consistent with this conjecture, we find that a one standard deviation increase in investors’ gambling sentiment is associated with a 1.6% increase of the average first-day IPO return in the following month.

Overall, these findings suggest that changes in investors’ gambling attitudes have a positive spillover effect on stock market outcomes. In particular, when investors’ gambling sentiment becomes stronger, stocks with lottery-like characteristics earn positive abnormal returns and firms with high nominal share prices are more likely to split their shares. In addition, initial public offerings earn higher first-day returns during these periods of high gambling sentiment.

Our findings contribute to at least four distinct strands of finance literature. First, we contribute to the finance literature on skewness and gambling. Recent literature shows that crosssectional differences in gambling attitudes affect stock returns and corporate decisions (e.g., Bali, Cakici, and Whitelaw, 2011; Kumar, Page, and Spalt, 2011). Our findings suggest that shifts in gambling attitudes over time also matter.

Second, our results provide new evidence on the relation between the lottery market and the stock market. On the one hand, Kumar (2009) and Doran, Jiang, and Peterson (2012) show that the demand for lotteries and lottery-like stocks are positively correlated, especially when gambling sentiment is strong. Relatedly, the introduction of state lotteries has a positive spillover effect on participation in casino gaming and horse racing (Scott and Garen, 1994; Calcagno, Walker, and Jackson, 2010). On the other hand, Dorn, Dorn, and Sengmueller (2015) and Gao and Lin (2015) find a substitution effect between lotteries and aggregate stock trading using international data. With a direct measure of gambling attitudes, we show a positive spillover effect to the stock market in the U.S.

Third, we provide new evidence on the economic effects of investor attention (e.g., Odean, 1999; Barber and Odean, 2008; Palomino, Renneboog, and Zhang, 2009; Da, Engelberg, and Gao, 2011). Specifically, we show that salient lottery events trigger strong gambling sentiment, which generates return predictability among lottery-like stocks.

Fourth, we add to the catering literature in corporate finance. In particular, our results provide new insights into managerial motivation behind stock splits (e.g., Lakonishok and Lev, 1987;

Angel, 1997) and provide an alternative explanation for the time-variation in first-day IPO returns (e.g., Loughran and Ritter, 2004). Specifically, we show that firms cater to the timevarying demand for lottery-like characteristics (e.g., low nominal share prices) by splitting stocks with high nominal share prices. In addition, we demonstrate that time-variation in investors’ gambling sentiment is an important determinant of first-day IPO returns.

2. Hypotheses development We consider four different economic settings to study the impact of gambling sentiment on financial market outcomes. In the first setting, we focus on the short-term mispricing and correction pattern among lottery-like stocks. This analysis is motivated by recent studies, which find that investors are more likely to buy stocks that have recently captured their attention (Barber and Odean, 2008). Specifically, Da, Engelberg, and Gao (2011) show that a surge in attention could lead to temporal overpricing and predict short-term return reversals among the set of attention-grabbing stocks. Further, Google’s daily search interest by retail investors is likely to capture market-level sentiment (Da, Engelberg, and Gao, 2015).

We extend this insight to lottery-like stocks that provide gambling opportunities to investors in the stock market. Kumar (2009) finds that state lottery players have similar behavior as investors who overweight lottery-like stocks, and the propensity to play state lotteries and purchase lottery-like stocks are positively correlated. When investors gamble in the stock market, they are likely to prefer stocks with low nominal share prices, especially those with positive idiosyncratic skewness for the possibility of extreme returns. Investors may also prefer stocks with high idiosyncratic volatility since extreme returns are more likely for these assets.



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