Why Do Individual Investors Hold Overpriced Stocks? Evidence from Korean Market

Abstract

Campbell, Hilscher, and Szilagyi(2008) reports that firms with a high probability of default risk earn low subsequent returns. This result turns out to be puzzling. Then, Conrad, Kapadia, and Xing(2014, henceforth

CKX) find that stocks with a high probability of default tend to generate extremely high returns (over 100%) over the next year. A feature that those stocks possessing lottery-like (extremely positive skewed) payoffs allow investors to desire to hold them, leading to high valuation and low exante returns. This paper examines whether distress risk puzzle is also present in Korean market by following methodologies from CHS and CKX. I find that a high probability of jackpot returns have low average future returns in Korean market. Also, there exists a strong correlation between the predicted probability of a jackpot return and the probability of default from the CHS model within Korean market, along with a high correlation between returns of a jackpot and distress strategy. Therefore, I can conclude that a high probability of jackpot payoffs is a plausible explanation for at least a portion of the low average future returns of stocks with a high probability of default. Also, this explanation can be applied to distress risk puzzle present in Korea.