Do the Rich Gamble in the Stock Market? Low Risk Anomalies and Wealthy Households

We propose a low risk anomaly (LRA) index with high values indicating high-risk stocks with high-beta, high-volatility, and high-lottery-payoffs. We document a significantly negative cross-sectional relation between the LRA index and future returns on individual stocks trading in the U.S. and international countries. We show that the high-LRA stocks are subject to significant overpricing and primarily held by retail investors, whereas the degree of underpricing of low-LRA stocks is so small that the low risk anomaly is driven by retail investors’ demand for high-LRA stocks, leading to temporary overpricing and negative future abnormal returns for these high-beta, high-volatility stocks with large lottery payoffs. To understand how and why individual investors contribute to the low risk anomalies, we use a large-scale individual-level panel dataset from Sweden that allows us to directly observe the stock investments of the entire population at the individual security level. We find that the anomalous negative relation between risk and future abnormal returns is only confined to those stocks held by rich households, whereas there is no evidence of low risk anomaly for stocks held by non-rich households and institutional investors. Further tests also reveal that the skewness preferences of rich households have the potential to explain the demand of wealthy investors for high-risk stocks. In contrast, other potential explanations such as the overconfidence-based preferences, constraints on financial leverage, downside risk, and hedging demand receive little support from the data.