Liquidity, Favorite-Longshot Bias, and the Return of Lottery-Like Stocks

We document novel results that the lottery effect (lottery-like stocks earn lower returns) is much stronger in liquid stocks. We posit that noise traders dominate the trading of liquid lottery-like stocks, as described in the limits to arbitrage literature, who are attracted by the high jackpot probability of the lottery-like stocks and commit the favorite-longshot bias in which investors overweight the probability of a longshot. The overweight, rather than being driven by preference as suggested in the prospect theory, is more likely caused by overestimation error