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

Which behavioral explanation is commonly offered for the low-risk anomaly?

The lottery-preference explanation says investors overpay for high-volatility stocks offering a small chance of large gains. This demand overprices risky stocks and depresses their subsequent returns, leaving low-risk stocks with higher risk-adjusted performance.

  1. AInvestors rationally demand a premium for holding stocks with low volatility
  2. BRegulation forces investors to hold low-volatility stocks
  3. CInvestors have a lottery-like preference for high-volatility stocks with skewed payoffs, causing them to be overpricedCorrect
  4. DLow-beta stocks have higher systematic risk than CAPM measures

Explanation

Lottery preference and overconfidence lead investors to pay too much for volatile, positively skewed stocks, lowering their subsequent returns. The other options either contradict the anomaly or are not behavioral explanations.

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