Rationale

The low volatility anomaly contradicts the hypothesis of efficient markets and the CAPM assumptions. Instead, several behavioral explanations have been advanced.

The lottery effect builds on empirical evidence that individuals take on bets that resemble lottery tickets with a small expected loss but a large potential win, even though this large win may have a fairly low probability. If investors perceive the risk-return profile of a low price, volatile stock as similar to a lottery ticket, then it could be an attractive bet. As a result, investors may overpay for high volatility stocks and underpay for low volatility stocks due to their biased preferences. The representativeness bias suggests that investors extrapolate the success of a few, well-publicized volatile stocks to all volatile stocks while ignoring the speculative nature of such stocks.

Investors may also be overconfident in their ability to forecast the future, and their differences in opinions are higher for volatile stocks with more uncertain outcomes. Since it is easier to express a positive view by going long, that is, owning an asset than a negative view by going short, optimists may outnumber pessimists and keep driving up the price of volatile stocks, resulting in lower returns.

Furthermore, investors behave differently in bull markets and during crises. During bull markets, the dispersion of betas is much lower so that low volatility stocks do not underperform much if at all, whereas, during crises, investors seek or keep low-volatility stocks and the beta dispersion increases. As a result, lower volatility assets and portfolios do better over the long term.

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