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FRM Part II · FRM Exam Part II · Alpha (and the Low-Risk Anomaly)

Behavioral finance explanations of the low-risk anomaly often cite a lottery preference. Which statement best describes how this explanation generates the anomaly?

Lottery preference means investors like small chances of huge payoffs, so they overpay for volatile, positively skewed stocks. That overpricing lowers the expected returns of high-risk stocks, while low-risk stocks are relatively neglected and earn higher risk-adjusted returns.

  1. AInvestors who like positively skewed payoffs overpay for high-volatility stocks, lowering their expected returnsCorrect
  2. BInvestors are averse to positive skewness and so discount volatile stocks heavily
  3. CInvestors are rational and demand a premium for idiosyncratic volatility
  4. DInvestors prefer stocks with stable earnings, so they overpay for low-volatility stocks

Explanation

Lottery-like stocks offer a small chance of very large gains. Demand for them pushes up prices and lowers subsequent returns, so high-volatility stocks underperform on a risk-adjusted basis. Low-risk stocks, being neglected, earn comparatively more.

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